“ 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 bis central bankers ’ speeches 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

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