Claudia Buch: Finance and growth - guidelines for financial sector
reform
Speech by Prof Claudia Buch, Deputy President of the Deutsche Bundesbank, at the
Frankfurt Finance Summit 2015: "The Last Word", Frankfurt am Main, 17 March 2015.
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Ladies and gentlemen
It is my pleasure to share a few thoughts with you at the end of this year's Frankfurt Finance
Summit. Given the challenges that lie ahead, the Summit's key question: "How to foster
growth in a new regulatory framework?" could not be more timely.
At the moment, economies worldwide are still struggling with the adverse effects of the
financial crisis. The average loss of potential output resulting from the financial crisis has
been estimated at 8.4%. And these output effects can be very persistent. Crises reduce an
economy's capital stock - and the catch-up process via investment takes time. Constrained
credit supply in times of financial crisis can lead to inefficient capital allocation. Investment in
innovations is postponed.This shrinks potential output and productivity, thereby slowing down
long-run growth.
In order to weaken the negative effects of financial crises on growth, many new regulations
have been designed. In Europe, the Banking Union and, more recently, the Capital Markets
Union feature prominently. At an international level, the regulation of globally significant
financial institutions has been at the core. Overall, these reforms are headed in the right
direction. Yet concerns are being raised that the regulatory system is becoming too complex
and thus less transparent. This makes it necessary to focus on the key principles of
regulatory reform.
In the next 15 minutes, I would like to step back and ask
• What is the relationship between finance and economic growth?
• And is there a "double dividend" in the sense that financial systems which are
conducive to growth are also more stable?
To answer these questions, we can draw on a large body of empirical (and theoretical)
evidence that can give us guidance for financial sector reform.
Let me start with the evidence we have on the link between financial development and
growth.
1. Financial development and growth
In the 1990s, there was a widespread consensus that financial development fosters
economic growth. Developed financial sectors stimulate entrepreneurship, innovation,
investment, and productivity. Many of these beneficial features of financial markets arise
through equity finance. Through venture capital finance, for instance, new start-ups obtain
not only financial resources but also management expertise. Yet, in much of the academic
and policy debates, "financial development" has been associated with the share of credit
intermediated through the banking system. And empirical research in fact supported the view
that countries with larger banking systems also grow faster.
However, the financial crisis raised a critical question. Is there a turning point after which
additional financial sector growth no longer spurs, but perhaps even hinders economic
growth? Or put differently: is more bank credit a bit like water in that there can be too much
of a good thing? Water is certainly needed for life, but when there is too much water, there
can also be a fatal water overdose which can lead to water intoxication. And if the financial
sector can grow beyond the limit that is good for economic health, what are the implications
for the reform agenda?
Recent empirical evidence indeed shows that the link between finance and growth is
nonlinear. In middle-income countries, financial sector development has positive effects on
economic growth. In high-income countries, additional growth in the financial sector may
even have negative effects on growth.
Hence, there is no "optimal" size of the financial sector. This is important for us as
policymakers. It shows that we should aim at providing the right institutional framework and
incentives for the financial sector. The goal should be to prevent excessive leverage and risk
taking.
But before discussing regulatory implications, let me shed some light on the mechanisms
that are at work. In 2009, Paul Krugman coined the term "boring banking" to describe banks
focusing on their core business - taking household deposits and being conservative in giving
out corporate loans. Banks fulfilled their role of financing entrepreneurship and firm entry,
leading to positive firm dynamics and innovation. This raises the question why, at some
point, the banking sector fails to support economic growth.
A first explanation is related to the structure of banks' activities. In banking sectors that grow
fast, business tends to shift towards non-interest income generating activities. Banks tend to
rely on wholesale instead of deposit funding. Banks no longer fulfil their traditional role of
taking deposits and providing credit to the real economy. When market sentiment shifts,
banks with a high share of wholesale funding are affected most and have to cut back credit
to a greater extent.
A second explanation distinguishes between household and corporate credit. In general,
corporate credit is more closely aligned with the financing of investment and innovation. Yet,
as countries develop and reach the productivity frontier, it becomes more difficult to stimulate
growth further. Often, bank credit then shifts from the corporate to the household sector, with
negative implications for growth.
A third explanation is based on the structure of employment in the financial sector. In the US,
the financial sector was a relatively high-skill and high-wage industry at the beginning of the
20th century as well as in the past 30 years. In the interim period, thefinancial sector lost its
high human capital position and its wage premium relative to the rest of the private sector.
This raises the question whether a highly developed financial sector attracts high-skilled
labour - and whether such labour might be employed more efficiently in other sectors of the
economy.
All these factors - changes in the structure of bank funding, in bank assets, and in the skill
composition of bankers - help explain why the financial sector may at some point become
detached from the real economy. These explanations would remain incomplete, however,
without stressing the role of regulations and the role of the public safety net. Regulations
which encourage high leverage and public sector safety nets that subsidise risk taking leave
the financial sector vulnerable to shocks. Systemic financial crises, which impose large costs
on society, are the result.
In short: financial systems that are built on equity rather than debt are inherently more stable.
A related question is: which balance between bank-based and market-based finance is most
conducive to growth? This question is not new. In the early 1990s, for instance, the Eastern
European countries had to decide whether to opt for a bank-based or a market-based
financial system. Both systems indeed have advantages, depending on the stage of
economic development and the stage of the business cycle.
As countries develop, the growth-enhancing effects of banking sector development
decreases while the beneficial effects of capital markets become more important. As for
individual firms, there is a "pecking order of finance": at early stages of development, internal
funds and external working capital loans dominate. As firms (or markets) mature, external
funds raised through bond and equity markets become more important. Also, while
marketbased systems help alleviating recessions after financial crises, bank-based systems are
more effective in smoothing the impact of "normal" business cycle fluctuations.
2. Financial structure and financial stability
The structure of finance is important not only when discussing the implications of finance for
growth. Rather, the structure of finance also has important implications for the stability of the
financial system. The higher the share of debt finance, the larger "financial accelerator"
effects can be - seemingly small shocks can have large and systemic implications.
Economic fluctuations magnify and threaten the stability of the entire financial system. The
channel of transmission can run through consumption or investment.
• High levels of household debt affect output stability through the adjustment of
consumption. Evidence for the US shows that households with high levels of real
estate debt cut back consumption in response to shocks to asset prices, thus
amplifying the cycle.
• Firms with high levels of debt cannot smooth investment when an adverse shock
hits.
• High levels of public sector debt can be destabilising. As well Government spending
cannot cushion the effects of financial crises when public debt levels are already too
high.
These effects are further magnified if households, firms, and governments have borrowed
from a banking sector which is insufficiently capitalised. Adverse shocks then set into motion
a downward spirals of asset valuations and prices that ultimately threaten the solvency of
financial institutions.
The destabilising effects of debt arise from its contractual features. Standard debt contracts
are insensitive to the borrower's situation. After risks have materialised an adjustment to
shocks can occur only through new lending or through haircuts on existing loans. In contrast,
the value of equity adjusts if the situation of the borrower changes so that equity provides a
risk sharing mechanism. In other words, equity as a claim on real assets has stabilising
features compared to debt as a claim on nominal assets.
The stabilising features of equity contracts have also been visible during the European debt
crisis. In Europe, debt finance has been more prone to capital flight than equity finance.
Furthermore, diversified cross-border equity holdings help detach consumption from
business cycle fluctuations. Cross-border equity allows more effective cross-border risk
sharing and consumption smoothing. Increased reliance on equity finance would be
particularly beneficial in the European Monetary Union, where exchange rates cannot adjust
to cope with regional macroeconomic shocks.
3. What are the policy implications?
Financial systems which rely more on equity rather than debt finance can be conducive to
growth, and they tend to be more resilient to shocks. This suggests that there might indeed
be a "double dividend" - financial sector reforms that contribute to financial stability also
promote growth.
Viewed in this light, there are a couple of takeaways for policymakers and regulators.
The first is that a more developed financial system is the basis for economic growth.
However, our reform efforts should not be aimed at the mere size and growth of the financial
sector. Instead, we must ensure that the financial sector fulfils its intermediation role and
processes information efficiently. Microprudential regulations that improve banks' risk
assessment and ensure the application of common rules are crucial in this regard. The
Banking Union is a key step forward, because it specifically aims at establishing common
supervisory standards in Europe.
Second, macroprudential policy is a necessary complement to microprudential regulation.
There might be risks to the stability of the entire financial system that microprudential
supervision cannot detect. For instance, increasing household debt might threaten stability
through its impact on consumption - while individual banks may remain sound.
Third, post-crisis private sector deleveraging was much lower in the euro area than in the
US. This could partly explain the slower economic recovery in Europe. Reducing debt to
levels which do not threaten stability requires efficient mechanisms to deal with distressed
financial institutions. Bank recovery and resolution regimes provide important tools to
restructure banks' balance sheets. This is where the second pillar of the Banking Union - the
Single Resolution Mechanism - plays a key role. Through the bail-in tool it facilitates, most
importantly, increased private sector risk sharing.
Fourth, the Banking Union needs to be complemented by reforms that strengthen the
development and integration of equity markets.
The Capital Markets Union offers a great opportunity. Many initiatives that are currently being
discussed aim at integrating European markets for debt instruments, such as securitisations
or covered bonds. The Capital Markets Union can indeed contribute to an improved
functioning of debt markets. To facilitate debt restructuring, reforms of insolvency regimes
are needed in some countries. The goal should be to allow for quick recovery or liquidation in
a predictable and transparent manner.
Yet, the Capital Markets Union ought to put more emphasis on the development and
integration of European equity markets. Improving access to venture capital, and the sharing
of information on local markets can be important in this regard. The Capital Markets Union
should also be taken as an opportunity to remove the preferential tax treatment of debt
versus equity. These measures would strengthen banks' and firms' loss-absorbing equity
buffers and stabilise growth in Europe.