economic growth and the stability and efficiency of the financial sector -mario i. blejer

7/18/2019 Economic Growth and the Stability and Efficiency of the Financial Sector -Mario I. Blejer

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Economic growth and the stability and efficiencyof the financial sector q

Mario I. Blejer

CCBS, Bank of England, Threadneedle Street, London EC2R 8AH, United Kingdom

Available online 21 July 2006

Abstract

It has been claimed that the ability of emerging markets to adopt optimal stabilization policies ishampered by a number of factors. Among them, it has been recently emphasized the role of financialinstability, inefficiencies, and financial market imperfections. It is claimed here that the current finan-cial regulatory paradigm, embodied in Basel II, may improve financial stability but reinforces cycli-

cality. Therefore, countries should emphasize financial efficiency since it would lead to enhancedfinancial stability, without increasing cyclicality.Ó 2006 Elsevier B.V. All rights reserved.

JEL classification: E31; G20; G21

Keywords: Financial stability; Financial efficiency; Cyclicality; Growth; Institutions

1. Introduction

The development literature has emphasized a number of links between the stance of fis-cal and monetary policies and the process of economic growth. These links include a vari-ety of mechanisms such as the crowding-out that public spending exerts on private sectorinvestment, all types of distortions arising from excessive and/inefficient taxation, frompoor allocation of resources through inefficient public sector expenditures, and from

0378-4266/$ - see front matter Ó 2006 Elsevier B.V. All rights reserved.

doi:10.1016/j.jbankfin.2006.06.001

q The views are solely those of the author. The author is indebted to Kevin James for his many insights on

financial efficiency that form the core of this comment. For details see James (2005).E-mail address: [email protected]

Journal of Banking & Finance 30 (2006) 3429–3432

www.elsevier.com/locate/jbf

mailto:[email protected]

mailto:[email protected]



sub-optimal allocation of credit and other financial resources. The literature has also dealtwith the ‘‘uncertainty’’ effect arising from erratic and unpredictable fiscal and monetarypolicies. This later effect tends to create risks that reduce investment, induce capital out-flows and induce financial disintermediation.

What has not been emphasized enough is the importance of ‘‘optimal’’ macroeconomicstabilization embodied in the cyclicality of fiscal and monetary policies. One can indeedexpect that growth is fostered by optimal stabilization policies, i.e. by the ‘‘ability to con-duct counter-cyclical macroeconomic policies, aimed at stabilizing and smoothing businesscycle fluctuations’’.

Policies have been, in the main, counter-cyclical among industrial countries, but this isnot the general situation in emerging market economies: while macroeconomic policiestend to stabilize business cycle fluctuations in a number of emerging market economies,in many others fiscal and monetary policies display a strong pro-cyclical pattern.

It has been claimed that the ability of emerging markets to adopt optimal stabilizationpolicies is hampered by a number of factors. Among them: (a) the recurring credit rever-sals in world capital markets (the so called ‘‘sudden stops’’); (b) political-economy con-straints; and (c) the pervasive adoption of inappropriate exchange rate regimes.

More recently, some additional working hypotheses have been added to this list. Theyclaim that in fact the capacity to apply optimal, counter-cyclical, policies is related to insti-

tutional quality, and to financial instability, inefficiencies, and financial market imper-fections.

The first claim, namely the role of institutions, would imply that emerging markets thathave managed to strengthen their institutions would not suffer from this syndrome and

their fiscal and monetary policies would tend to be counter-cyclical as in advanced coun-tries. In a recent study by Calderon et al. (2004) it is found that mature institutions andpolicy credibility allow emerging countries to implement stabilizing, counter-cyclical pol-icies, and that these policies, by reducing business cycles and sharp economic fluctuations,lead to more predictability and a better investment environment that result, eventually, inmore rapid growth.

On the second claim, namely on the negative impact on growth of financial instability,inefficiencies, and financial market imperfections, a number of considerations should bemade. On a fundamental level, bank lending tends to be strongly pro-cyclical (creditbooms and busts are positively correlated with the cycle). This correlation has been con-

sidered a source of financial instability and a justification for financial regulation andsupervision. But a number of questions arise from this connection. It is possible to askwhether is it always true that financial instability causes uncertainties that are detrimentalto growth. And, if so, whether the current prudential paradigm – embodied in Basel II – increasing stability and reducing uncertainty.

2. Financial instability and growth

The effect of financial instability on growth is ambiguous. It is indeed reasonable toargue that pure cyclical instability (including asset price bubbles, excessive leverage, and

credit mispricing) tend to affect growth negatively. But instability arising from increasemarket volatilities may in fact reflect increasing risk taking and an improved flow of infor-mation, and may actually be positively correlated to growth. This may well be the case if volatility happens when prices change to incorporate the new information that is con-

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stantly arriving to the market. As a matter of fact, financial markets exist to price this newinformation and the process of prices reacting to new information creates volatility.

All this could be regarded as growth enhancing because with these more informativeprices, people can make better economic decisions. In other words, volatile markets are

better markets. However, volatility can be exceedingly high. This is so because the tradersreaction to new information can largely magnify price movements and in a world of incomplete and imperfect markets, many agents may not be able to hedge/insure againstthis volatility at a feasible price. In the absence of insurance, volatility can impose massivecosts upon an economy by causing a crisis.

Volatility has, therefore, benefits but very high levels may cause, as a by-product, anoccasional crisis. Can one get the ‘‘positive’’ volatility without magnifying the cycle andwith no crises? And can prudential regulation eliminate excessive risk taking and cyclicalinstability?

To attempt to answer this question, one needs to refer to the current regulatory para-digm as embodied in Basel II. But Basel II will not resolve the problem. This is so becausecapital requirements will be based on more risk sensitive data–which is by definition cycli-cal. In the Basel II world, during an upswing capital reduces both because the perceivedcredit risk declines and the value of the quality of the protection provider or underlyingasset (collateral) increases. The regulatory capital decline then brings about an increasein available credit, leading to a pro-cyclical push. In a downturn, credit risk increases whilethe quality of protection reduces, and the regulatory capital rises so that a credit crunchmay emerge exactly when output is already slackening.

Therefore, while Basel II is expected to strengthen financial buffers and reduce financial

uncertainty, it will not solve (and could intensify) the cyclicality problems of macropolicies.Is there any additional, complementary, way in which financial instability could be

addressed without intensifying cyclicality? The answer is to promote not just a stable

but also an efficient financial sector.Financial system’s efficiency can be gauged by the efficiency with which it transforms

resources into capital. In other words, the financial sector functions efficiently if it inter-mediates at a minimum price and reduces the comprehensive cost of capital to its optimallevel.1

Of course, the question could be asked: will the invisible hand get the financial market

to optimal efficiency? The answer is, in general, ‘‘No’’. Market forces alone will – as a rule – not lead to an efficient outcome. That is so, for a number of reasons. In particular is thefact that in an inefficient market, outside participants pay inside participants a higher than

optimal price for financial services. Increasing efficiency, therefore, transfers wealth frominsiders to outsiders and, obviously, inside participants do not have much incentive togo along with policies that increase efficiencies.

Inefficiencies arise, then, from imperfections related to inside information, scale issues – natural monopolies, and specialized skills. They arise also from ‘‘Manipulation Risk ’’: therisk that one party acquires a corner and squeezes the market, driving the market price farabove its fundamental value.

1 The comprehensive cost of capital is the sum of the cost of: raising funds by selling capital claims, monitoring

the users of capital, and managing the portfolios of the capital claims themselves.

M.I. Blejer / Journal of Banking & Finance 30 (2006) 3429–3432 3431



Since there is no market solution to these imperfections, there is room for policy inter-vention in order to improve efficiency. The justification is also rooted on the fact thatfinancial market efficiency matters to the economy.

It has been shown that countries with efficient financial systems are less prone to bank-

ing crises.2 Countries with efficient financial systems are less prone to currency crises (evenif they cannot borrow in their own currency).3 Countries with efficient financial systemssuffer (much) less when a crisis does occur.4 And, overall, countries with efficient financialsystems grow faster.5

And, in our context, probably the most important conclusion would be that financialefficiency would lead to financial stability, without increasing cyclicality. One can conclude,therefore, that central banks, that have put so much effort on financial stability, shouldintensify their attention to this partially neglected consideration and intensify their effortsto strengthen financial efficiency.

References

Beck, Demirguc-Kunt, Levine, 2003. Bank Concentration and Crises. NBER Working Paper 9921.Beck, Levine, Loayza, 2000. Finance and sources of growth. J. Finan. Econ. 58 (1).Bekaert, Harvey, Lundblad, 2003. Equity market liberalization in emerging markets. J. Financ. Res., 26.Bordo and Meissner, 2005. Financial Crises, 1880–1913: The Role of Foreign Currency Debt. NBER Working

Paper 11173.Calderon, C., Duncan, R., Schmidt-Hebbel, K., 2004. The role of credibility in the cyclical properties of

macroeconomic policies in emerging markets. J. World Econ.James, K., 2005. Efficiency or Stability?: A Market Failure Analysis PP Presentation. CCBS, Bank of England.Ongena, Smith, Michalsen, 2003. Firms and their distressed banks: Lessons from the Norwegian banking crisis. J.

Finan. Econ. 67 (1).Ranciere, Tornell, Westermann, 2003. Crisis and Growth: A re-Evaluation. NBER Working Paper 10073.

2 Beck et al. (2003).3 Bordo and Meissner (2005).4 Ongena et al. (2003).5 Beck et al. (2000), Bekaert et al. (2003), Ranciere et al. (2003).

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economic growth and the stability and efficiency of the financial sector -mario i. blejer

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