Benoît Coeuré: On the optimal size of the financial sector
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the ECB Conference "The optimal size of the financial sector", Frankfurt am Main,
2 September 2014.
* * *
I would like to thank Alexander Popov for his contributions to this speech. I am also grateful to Philipp Hartmann
for his comments. All views expressed here remain mine.
Ladies and gentlemen,
Thank you very much for giving me the opportunity to speak here today.
The recent global financial crisis has made us rethink the contribution of the financial sector
to the real economy. Today, I will talk about how our understanding of the finance and growth
nexus has changed over the past years, and how policy-makers in Europe - in particular,
here at the European Central Bank (ECB) - have used this knowledge.
Introduction
In the years prior to the financial crisis, the empirical literature on finance and growth
accumulated a substantial body of evidence suggesting that financial sector deepening is a
key component of the economic development process. This appeared to be true, both in
respect of emerging markets and industrialised economies.1 Encouraged by such evidence,
policy-makers did not question the ability of the financial sector to innovate and channel
funds to their most socially productive uses. In the words of the Federal Reserve's then
Chairman Alan Greenspan: "[...] our financial system, whose job it is to ensure the
productive use of physical capital, has been such a crucial part of our overall economy,
especially over the past two decades. It is the signals reflected in financial asset prices,
interest rates, and risk spreads that have altered the structure of our output in recent
decades towards a different view of what consumers judge as value."2
Yet, economies with large, dynamic, and complex financial sectors are not immune to severe
macroeconomic contractions. In fact, the banking crises literature provided some evidence
on a causal link between rapid credit growth and systemic banking distress long before the
emergence of the global financial crisis.3 Furthermore, the output costs of severe banking
crises have been found to be of a large magnitude.4
Are these two observations contradictory? Not necessarily - both are related to
wellunderstood economic mechanisms. On the one hand, mature financial industries ensure the
efficient allocation of productive resources, supporting long-term growth. On the other hand,
excessive leverage can throw the financial system into a crisis resulting in deep and abrupt
economic downturns.5
The crisis has made us understand that the size of the financial sector can exacerbate the
trade-off between economic efficiency and financial stability. While finance per se is
necessary for growth, an oversized financial industry can be detrimental to real economic
activity. Of course, the question of what constitutes an "oversized" financial sector is a
complex one, and the collection of papers on the programme of this conference makes great
progress towards providing an answer.
Recent changes to the global regulatory architecture, particularly regarding the banking
union in Europe, are in part aimed at mitigating the negative effects that a large and complex
modern financial industry can have. These changes should be implemented in a way that
avoids eliminating the positive impact of financial services on growth and tackling financial
complexity with overly complicated and excessive regulatory interventions. In addition,
policy-makers should be increasingly aware of the importance of overcoming fragmentation
in European capital markets and of achieving a single market for capital.
Identifying the problem
As regards the link between finance and growth, for a long time, it was common to say that
finance affects growth in a positive, monotonic way, as if more is always better. Recent
empirical evidence, however, has qualified this conventional wisdom. The analysis has now
been refined to show that, beyond a threshold size, the effect of finance on long-term
economic growth can weaken and even become negative.6
Why is the effect of finance on growth non-linear? Recent academic research puts forward at
least five possible explanations.
First, the financial sector has gradually extended its scope beyond the traditional activity of
intermediation towards so-called "non-intermediation" financial activities, such as trading.
The evidence strongly suggests that banking strategies which are heavily geared towards
generating non-interest income are riskier.7 This change in focus is naturally associated with
a higher potential for systemic crisis. Moreover, as a result, it has become increasingly more
difficult to come up with empirical measures of financial services that are consistent with
what modern-day finance actually does. This is especially true for high-income economies
whose financial sectors are particularly sophisticated.
Second, the financial system can grow too large relative to the real economy because it can
extract excessively high informational rents and pay excessively high wages. For example,
while in the wake of World War II the financial sector accounted for less than 2.5% of total
labour income, in 2006, this share was 8.3%. As a result, too much young talent can be
reallocated towards the financial industry.8 To put it more bluntly: the world before the crisis
5
Brunnermeier, M., and Y. Sannikov, 2014, A macroeconomic model with a financial sector, American Economic
Review 104, 379-421.
6
Rioja, F., Valev, N., 2004, Does one size fit all? A reexamination of the finance and growth relationship, Journal of
Development Economics 74, 429-447; Shen, C., Lee, C., 2006, Same financial development yet different economic
growth - why?, Journal of Money, Credit and Banking 38, 1907-1944; Arcand, J.-L., Berkes, E., and U. Panizza,
2012, Too much finance?, IMF Working Paper 12/161; Manganelli, S., and A. Popov, 2013, Financial dependence,
global growth opportunities, and growth revisited, Economics Letters 120, 123-125; Beck, R., Georgiadis, G., and
R. Straub, 2014, The finance and growth nexus revisited, Economics Letters, forthcoming.
7
De Jonge, O., 2010, Back to the basics in banking? A micro-analysis of banking system stability, Journal of Financial
Intermediation 19(3), 387-417, Demirguc-Kunt, A., and H. Huizinga, 2010. Bank activity and funding strategies: The
impact on risk and return. Journal of Financial Economics 98, 626-650, or Hahm, J.-H., H.S. Shin and K. Shin
(2013), Noncore bank liabilities and financial vulnerability, Journal of Money, Credit and Banking 45(s1), 3-36.
8
Tobin, J., 1984, On the efficiency of the financial system, Lloyds Bank Review 153, 1-15; Philippon, T., 2010,
Financiers vs. engineers: should the financial sector be taxed or subsidized?, American Economic Journal:
was one where there were too many bankers and too few engineers. This particular type of
"brain drain" can harm the overall productivity of the real economy. It can be highly inefficient
if the social returns to financial services are lower than their private returns, which is probably
the case when the financial sector is very large to begin with.
Third, an expansion in the financial sector can signal a misallocation of credit to less
productive economic activities. Textbook models of financial intermediation usually assume
the mobilisation of savings for entrepreneurial credit. However, much of the spike in financial
intermediation before the crisis was associated with household credit, and mostly with
mortgage credit. In fact, in a number of countries (e.g. Canada, Denmark and the
Netherlands), loans to households accounted for more than 80% of overall bank lending. In
most cases, an additional euro of mortgage lending contributes less to overall economic
growth than an additional euro of credit to a young innovative company.
Fourth, an oversized financial sector can reflect increased risk-taking. For example, it has
been argued that increased bank competition can erode individual banks' franchise values.
This, in turn, can encourage banks to engage in imprudent behaviour.9 Competitive
behaviour can increase the resilience of the system, while a competitive market structure can
weaken it.10 A similar logic applies to an environment where liquidity is abundant. This can
result from a very accommodative monetary policy (as outlined in the "risk-taking" view of
monetary policy transmission,11) from a leveraged financial system with high inside money
creation,12 or from a combination of both. Such an environment exacerbates moral hazard
problems in the banking sector, increasing banks' appetite for risk. Meanwhile, increased
risk-taking makes both individual banks and the banking sector as a whole more fragile,
increasing the probability of a systemic meltdown and thereby harming long-term growth.
Last but not least, there is a link between the size of the financial sector and its complexity. It
is likely that the complexity and interconnectedness of financial institutions increases
(presumably in a non-linear way) with the size of the overall financial system, making it more
difficult for regulators to understand what is going on within its bounds. Policy-makers have
allowed the financial system to balloon without availing themselves of the instruments to
understand its complexity and monitor the propagations of shocks.13 We cannot afford to be
caught off guard again, simply guessing where the real problems may lie.
The policy response
Now that we have identified the problem, what is the solution? In the wake of the financial
crisis, the global regulatory architecture has evolved to meet the challenge posed by the
financial sector's potential to generate economic distress. For one, we have proceeded
towards a more integrated governance of the banking sector in Europe. The first components
of a genuine banking union - the Single Supervisory Mechanism and the Single Resolution
Mechanism - are already being implemented. By aiming to make the banking activities
Macroeconomics 2, 158-182; Bolton, P., Santos, T., and J. Scheinkman, 2011, Cream skimming in financial
markets, NBER Working Paper 16804; Kneer, C., 2013, The absorption of talent into finance: Evidence from US
banking deregulation, DNB Working Paper 391.
9
Hellmann, T., Murdock, K., and J. Stiglitz, 2000. Liberalization, moral hazard in banking, and prudential regulation:
Are capital requirements enough? American Economic Review 90, 147-165.
10
Schaeck, K., Cihak, M., and S. Wolfe, 2009. Are competitive banking systems more stable? Journal of Money, Credit
and Banking 41, 711-734.
11
Jimenez, G., Ongena, S., Peydro, J.-L.,and J. Saurina, 2014. Hazardous times for monetary policy: What do
23 million loans say about the impact of monetary policy on credit risk-taking? Econometrica 82, 463-505.
12
Brunnermeier, M., and Y. Sannikov, 2014. The I theory of money. Princeton University working paper.
13
See Haldane, A., and V. Madouros, 2012. The dog and the frisbee. Federal Reserve Bank of Kansas City
36th Economic Symposium, 109-159.
conducted in Europe safer, the banking union implicitly touches on some of the aspects of
"oversized finance" in general, and "overbanking" in particular.14
We need to be mindful of the fact that the macro problem (the financial sector being "too big")
and the micro problem (individual financial institutions being "too big") are not necessarily
identical. Even if the financial sector is small relative to the real economy, it may be
comprised of banks whose incentives are misaligned due to "too big to fail" considerations.
This can lead to excessive risk-taking and inefficient credit growth and has inspired recent
changes to regulation and prudential policy. For example, Basel III includes a revised
leverage ratio framework that has the goal of preventing banks from operating with excessive
leverage. This should reduce the discrepancy between social and private returns in banking
and limit the rents extracted by the financial sector. A similar role is envisaged for recent
rules on liquidity coverage. The size of individual banks is also a relevant consideration
(albeit not the primary one) when it comes to measuring their importance in terms of
systemic risk and determining their contribution to the Single Resolution Fund. Finally, some
recent suggestions for regulatory reform propose separating activities that are currently
implemented by commercial banks under "one roof", limiting the size of individual banks and
at the same time increasing the relative importance of traditional financial intermediation
activities.
Timely data reporting is another critical issue because policy-makers need to know in real
time what is going on inside the system. The Financial Stability Board's work on data
harmonisation and on filling data gaps15 is critical in this respect.
Finally, Europe needs to move towards the re-creation of a genuine single market for capital.
By this, I do not mean the convergence of prices for euro-denominated financial assets. The
crisis provided a painful reminder of the limitations of such measures of financial integration.
What I have in mind instead is "genuine" integration, whereby financial resources are
allocated with reference to the risk-return relationship and not to location - a process which
would improve economic diversification in that it would cushion both entrepreneurs and
households against local shocks.16 This should naturally reduce the negative impact of an
overextended financial sector by decreasing the probability of inefficient booms and severe
busts.
How can a single market for capital be realised? In addition to the better integration of
governance that I have just talked about, the process rests on the improved integration of
retail banking and capital markets. As regards retail banking, even before the crisis, we at the
ECB acknowledged that this is one of the least integrated markets in the euro area.17 The
crisis undermined the process of integration by prompting a further retrenching of retail
banking services within national borders. The new regulatory and supervisory framework has
the potential to steer us towards deeper cross-border integration, and, in the process, to
address Europe's over-reliance on large banks. Evidence before the crisis suggested that the
integration of retail lending markets may be a more efficient mechanism for cross-border
risksharing than secured or unsecured interbank markets. It is important that the banking union
and the regulation against the "too big to fail" problem effectively encourage banks to reach
an optimal size relative to the European market - that is, large enough to operate across
borders and diversify risks, but small enough to be resolved with the resources of the Single
Resolution Fund. This would be Europe's best contribution in terms of improving the trade-off
between financial stability and economic efficiency.
Regarding capital market integration, things can only improve in the future, given Europe's
high reliance on bank funding. It is likely that the ongoing deleveraging of the global banking
sector will stimulate the development of non-bank financial intermediation in Europe. As a
sign of things to come, the decline in bank credit is already to some extent compensated for
by an increased issuance of corporate bonds. And the recent initiatives to create an active
market for high-quality securitisation18 will help further in this direction.
Conclusion
Let me conclude.
The global financial crisis was, to a large extent, driven by an oversized and overleveraged
financial sector whose risk-creating capacity was left unchecked by regulators and
supervisors. We believe that we have learned our lesson and the recent flurry of policy
initiatives reflect, in large measure, our new understanding of the destabilizing role of an
oversized financial sector.
The academic literature, as well as our own experience in the crisis, has proven that the size
of the financial sector can exacerbate the trade-off between economic efficiency and financial
stability. I hope that the regulatory reforms that are now being enacted and the recent
changes in the European supervisory architecture, combined with the renewed push for a
single market for capital in Europe, will go some way in addressing this trade-off.
Thank you very much for your kind attention.