Axel A Weber: Financial system modernisation and economic growth in Europe
Concluding remarks by Professor Axel A Weber, President of the Deutsche Bundesbank, at the
Conference of the ECB-CFS Research Network, Berlin, 29 September 2006.
* * *
1. Introduction
Ladies and gentlemen
It is a great pleasure to make the closing remarks at the end of this very stimulating conference. As
you know, the Bundesbank has hosted this event; and I should like to thank the organisers of the
conference for the excellent way they have handled everything. But more importantly, this is already
the seventh conference of the ECB-CFS Research Network. Success speaks for itself.
This conference - like its predecessors - has brought together experts with different perspectives: It
has given researchers the opportunity to exchange views on their projects, it has advised
policymakers in their efforts to foster financial modernisation1 in the EU and, finally, it has confronted
us with the valuable (though - thinking of the policy panel - often divided) opinions of market
participants.
Today and yesterday, we had a very wide-ranging and in-depth debate on the various aspects of
financial system modernisation and its impact on economic growth. We tried to focus on aspects that
are relevant in the European context, which is not always easy considering the vast literature which
builds on large cross-country studies and which might thus be dominated by the experience of
developing and transformation countries. I will not try to undertake a comprehensive review of each
and every one of these debates, but rather focus on my personal list of the most fruitful results of this
conference. I have three main messages in mind.
•
Financial systems matter for growth.
•
Financial integration and modernisation should be furthered in the EU.
• In this respect, financial system regulation supporting competition is helpful, but not a
panacea for spurring growth.
2. Finance and growth
2.1 Impact on the level of output
The fact that the finance-growth nexus is an extensive and fast-growing field of research has been well
demonstrated by the wide range of subjects discussed during the last two days, which encompassed
banking sector outreach, corporate governance and start-up financing.
The literature builds on the generally recognised fact that financial modernisation contributes to higher
long-run economic growth: It encourages the mobilisation of savings from many disparate savers,
allows a better screening and monitoring of information on borrowers and improves risk-sharing.
Even though reverse causality makes the quantitative importance of the finance and growth
relationship hard to determine, the channels through which the finance-growth nexus works have been
subjected to detailed analysis. It is mostly assumed that financial modernisation affects growth either
directly via lower cost of capital or indirectly via (1) the productivity channel, (2) its effect on the
buildup of physical and knowledge capital or (3) a reduction in risk premia.
Indeed, one major strand of cross-country/cross-industry research has emphasised the productivity
channel, stating that financial modernisation has a positive impact on the growth of industries that are
more dependent on external finance. The first (and highly influential) paper to promote this idea was
by Rajan and Zingales (1998).
Yesterday, we saw their approach extended by Antonio Ciccone and Elias Papaionannou. Their paper
focuses on the role of financial modernisation for the speed of capital reallocation towards rising
industries and suggests that financial modernisation fosters productivity by fastening the adjustment of
capital investment to global productivity, price and demand shocks.
This argument should be of particular interest to the euro area: One cause of output heterogeneity
across member states is an asymmetric reaction to euro-area wide symmetric shocks (such as oil
price shocks). Thus, all things being equal, a faster adjustment of capital allocation should facilitate a
single monetary policy.
2.2 Impact on the volatility of output
A common thread running through most of the finance and growth literature is the focus on output
growth. Policymakers, however, also take a great interest in the volatility of output growth. One of the
most striking features of the economic landscape over the past twenty to thirty years has been the
well-documented decline in the volatility of output growth (and inflation), dubbed the "great
moderation". Volatility of GDP growth roughly halved in all G-7 countries - even though the specific
pattern and timing often differed from country to country.2
Reduced macroeconomic volatility has numerous benefits: It improves market functioning, makes
economic planning easier and reduces the resources devoted to hedging inflation risks - thereby
implying more stable employment and a reduction in economic uncertainty confronting households
and firms.
The jury is still out on the main driver of the great moderation. Several explanations have been
proposed, among them better monetary policy (in other words, central bankers learnt the lessons of
the 1970s) and plain good luck (that is milder economic shocks). A third explanation refers to structural
changes, namely in economic institutions, technology, business practices - and in the financial
system.
Against this background, I found the paper by Viral Acharya, Jean Imbs and Jason Sturgess very
stimulating. Inspired by portfolio theory, their paper concludes that the kind of financial modernisation
they examine - deregulation of branching restrictions in the US - affects the efficiency of capital
allocation through its effect on the volatility of output growth, rather than through its effect on the
growth rate of output itself. This is so because the primary effect of branching restrictions appears -
from a risk standpoint - to limit banks' scope for diversification (and thus scope for investment activity
as a whole). Hopefully, other researchers will follow suit and investigate further the link between
structural changes in financial systems and output volatility.
As an aside, I would like to add that the paper by Imbs et al. might also be interesting from a totally
different angle: Their application of portfolio theory aims at further diversifying the finance and growth
methodology. Only yesterday, George von Furstenberg and Ulf von Kalckreuth reminded us not to fall
into the trap of taking well-known methodological assumptions for granted. Therefore, the attempt to
tackle the finance-growth nexus using "unorthodox" methods (such as portfolio theory) might serve as
a promising robustness check.
3. Financial market integration and modernisation in the EU
3.1 Financial market integration
Why is the finance-growth nexus relevant to the EU? Or, put differently, why did the ECB-CFS
research network decide to devote this conference to it? As we are well aware, many European
countries urgently need to strengthen growth and increase employment. Real GDP growth (yoy) in the
euro area averages out at only about 2% in the last ten years, compared with slightly more than 3% in
the US. The same goes for real GDP growth per person employed, which has been roughly 1% (yoy)
over the last ten years in the euro area, compared with a little more than 2 % in the US.
The reasons for the economic slowdown in the EU are manifold, and the Lisbon Agenda underlines
the need for a multi-faceted approach. One of the main goals of the Agenda is to foster financial
integration in the EU. Indeed, research expects financial integration to be associated with a
quantitatively significant "growth dividend". For example, an often cited study by London Economics
(2002) estimates the benefits of the integration of European bonds and equity markets to be around
1% of real GDP over a ten-year period.
While such figures can always be subject to estimation error, economic reasoning suggests that the
overall benefits of financial integration are significant. First, financial integration is a key factor in the
modernisation of the financial system: The integration process fosters competition, the expansion of
markets and intermediation, thereby leading to further financial modernisation. Second, as a central
banker, I take a natural interest in financial integration because a well-integrated financial system
contributes to a smooth and effective implementation of monetary policy throughout the euro area.
For both reasons, we should not content ourselves with the present degree of integration in EU
financial markets, which still varies widely depending on the market segment: Integration is furthest
advanced in market segments close to the single monetary policy. Bond and equity markets are fairly
integrated. However, local factors continue to have some influence on demand and on returns,
especially in equity markets. Retail banking, in particular, remains highly fragmented and financial
infrastructure services are lagging behind. Both areas are still among the least integrated parts of the
European financial system.
The completion of the single market in the domain of financial services is crucial as only a fully
integrated financial system will be able to reap all the benefits brought by financial modernisation.
3.2 Financial modernisation
Additionally, financial sector performance in the EU can be further improved by addressing other
aspects of financial modernisation as well. It is essential that all aspects of financial systems keep
pace with the rapid and ongoing changes in today's global financial architecture. This is a great
challenge even for industrialised countries.
This morning, Philipp Hartmann highlighted several useful factors which are vital for a smooth
functioning of financial systems. They ranged from financial innovation to transparency, corporate
governance and financial regulation. Needless to say, his approach - based on a comparison of
indicators - must be considered with care and its results should not be overinterpreted: Indicators
reflect a limited image of reality. Moreover, they are often biased for reasons of data unavailability or
non-comparability across countries. Therefore, an indicator approach should rather serve as a starting
point for further analyses.
Still, Hartmann's presentation demonstrated that there is a fair amount of heterogeneity in how
financial systems work across European countries. This heterogeneity might in some ways create
frictions in an increasingly integrated EU financial market. Additionally, Hartmann highlighted that EU
financial markets still suffer from several shortcomings. To my mind, the most obvious are risk capital
markets, which are still small and represent bottlenecks in the areas of start-up financing (as
highlighted by Marco Da Rin and Luísa Farinha in this morning's session), and the limited use of
securitisation, which hampers risk allocation and unnecessarily binds banks' capital.
4. Regulation, financial systems and growth
Once we acknowledge that both financial integration and financial modernisation still fall short of our
expectations, the essential question is: Is there a need for structural reforms of the EU financial
system? Or will markets be able to cope with the situation on their own?
Indeed, much of the ongoing financial integration process has been policy-driven - for example, the
introduction of the euro or the implementation of single market legislation (FSAP). Moreover, research
such as that presented by Alain de Serres, Shuji Kobayakawa, Torsten Sløk and Laura Vartia
underlines the fact that financial system regulation (concerning both banking and securities markets)
has a statistically significant influence on output and productivity growth - provided that this regulation
allows for stronger competition in financial markets.
When it comes to financial integration, it is generally accepted that it is - in principle - a market-driven
process. For the reasons mentioned earlier, however, policymakers should facilitate full financial
integration (especially of retail banking markets and payment systems) by acting as a catalyst. That is
to say, they should address the familiar obstacles - legal, regulatory, competition, tax or technical -
faced by financial institutions in their cross-border activity within the EU.
Unlike integration, the issue of modernising financial structures does not lend itself to simple answers.
Think of the popular question of whether a capital-market based financial system is more efficient than
one that still relies heavily on banking. The answer is inextricably intertwined with other structural
issues and national peculiarities, which have evolved over a long period of time and have jointly
formed individual financial systems: the design of pension schemes, the role of public banks, and the
degree of regulation in securities markets. Furthermore, it might well be that differences in preferences
among economies will result in different optimal financial systems. A financial system which is better
suited to growth might be less suited to risk insurance, for example. Therefore, specific positive
characteristics of one system should not be transferred blindly to another.
As a consequence, it is hardly surprising that there is no clear-cut answer. Hence, the preliminary
conclusion of the finance-growth nexus is: Financial markets and intermediaries should be regarded
as complements in the provision of financial services rather than substitutes. Research cannot
determine a mix of a capital-market and a bank-based system that is most beneficial for output growth.
What matters in promoting long-run economic growth is the overall level, the quality and, especially,
the completeness of financial services.
Similarly, no straightforward answer has yet been found as to which system - a bank or a
capitalmarket based one - might be better suited to smoothing the cyclical behaviour of national economies.
In its latest World Economic Outlook, the International Monetary Fund (IMF) embarks on such an
assessment for advanced economies. It juxtaposes the comparative advantages of both systems with
regard to business cycle synchronisation.
As for the household sector, it concludes that, in capital market-oriented financial systems, households
can borrow more to support consumption. In predominantly bank-based economies, however,
households are less vulnerable to rising interest rates and declining asset prices. Turning to the
corporate sector, the IMF states that capital-market oriented financial systems are better equipped to
reallocate capital from declining to growing industries. In predominantly bank-based economies,
cyclical changes in investment seem to be shallower, perhaps because such systems provide greater
support to firms in the face of temporary changes in demand.
Hopefully, these first thought-provoking results from the IMF will serve as an appetiser for further
research. But they also prove that theory is still divided over the desirable characteristics of financial
systems. If this is the case, we can and should trust market developments to find appropriate
solutions. Policymakers should only pave the way for further financial modernisation by providing a
general framework that encourages the proper functioning of both markets and intermediaries and
enhances competition between them, both on a national and an international level. This includes, as
mentioned earlier, supporting risk capital markets and securitisation.
5. Concluding remarks
In conclusion, it is generally accepted that efficient financial structures contribute to increasing the
potential for stronger non-inflationary economic growth. Therefore, the promotion of European financial
integration and modernisation is highly relevant when aiming to strengthen economic growth in the
European Union. Financial integration and modernisation are, first and foremost, market-driven
processes. Policymakers should support them by providing an effective legislative and regulatory
framework, but should not intervene with market characteristics.
The Eurosystem attaches great importance to furthering progress in integration and modernisation by
acting as a catalyst for market-led initiatives like STEP, providing central banking services (TARGET2,
TARGET2-Securities), providing advice on the legislative and regulatory framework for the European
financial system and monitoring progress and raising awareness - not least by hosting this
conference.
Hopefully, the past two days will foster an ongoing and productive debate that will take us forward in
gaining a better understanding of the growth implications of financial modernisation. Thank you for
your attention.