Thursday, March 28, 2013

Too Cold, Too Hot, Or Just Right? Assessing Financial Sector Development Across the Globe

Too Cold, Too Hot, Or Just Right? Assessing Financial Sector Development Across the Globe. By A Barajas et alii.
IMF Working Paper No. 13/81
March 28, 2013

Summary: This paper introduces the concept of the financial possibility frontier as a constrained optimum level of financial development to gauge the relative performance of financial systems across the globe. This frontier takes into account structural country characteristics, institutional, and macroeconomic factors that impact financial system deepening. We operationalize this framework using a benchmarking exercise, which relates the difference between the actual level of financial development and the level predicted by structural characteristics, to an array of policy variables. We also show that an overshooting of the financial system significantly beyond levels predicted by its structural fundamentals is associated with credit booms and busts.


Ample empirical evidence has shown a positive, albeit non-linear, relationship between financial system depth, economic growth, and macroeconomic volatility. At the same time, rapid expansion in credit has been associated with higher bank fragility and the likelihood of a systemic banking crisis.1 This seemingly conflicting evidence is actually consistent with theory. The same mechanisms through which finance helps growth also makes it susceptible to shocks and, ultimately, fragility. Specifically, the maturity and liquidity transformation from short-term savings and deposit facilities into long-term investments is at the core of the positive impact finance on the real economy, but it can also render the system susceptible to shocks. The information asymmetries and ensuing agency problems between savers and entrepreneurs that banks help to alleviate can also turn into a source of fragility given agency conflicts between depositors/creditors and banks.

The importance of the financial sector for the overall economy raises the question of the “optimal” or “Goldilocks” level of financial depth and the requisite policies to reach this optimum. Given the dual-faced nature of financial deepening, contributing to growth while often resulting in boom-bust cycles, and the identification of non-linear relationships between growth, volatility, and financial depth, it is apparent that additional deepening is not always desirable. Further, there is increasing evidence for a critical role of the financial system in defining policy space and the transmission of fiscal, monetary and exchange rate policies (IMF, 2012). Both shallow as well as over-extended financial systems can severely reduce the available policy space and hamper transmission channels.

The conceptual and empirical frameworks offered in this paper are relevant for the academic and policy debate on financial sector deepening, particularly in developing countries. We introduce the concept of a financial possibility frontier as a constrained optimum level of financial development to gauge the relative performance of financial systems around the globe. Specifically, this concept allows us to assess the performance of countries’ financial systems over time relative to structural country characteristics and other state variables (e.g., macroeconomic and institutional variables). Depending on the position of country’s financial system relative to the frontier, policy options can be prioritized to address deficiencies.

Three different sets of policies can be delineated depending on a country’s standing relative to the frontier. Market-developing policies, related to macroeconomic stability, long-term institution building, and other measures to overcome constraints imposed by a small size or volatile economic structure, can help push out the frontier. Market-enabling policies, which address deficiencies such as regulatory barriers and lack of competition, can help a financial system move toward the frontier. Finally, market-harnessing policies help prevent a financial system from moving beyond the frontier (the long-term sustainable equilibrium), and include regulatory oversight and short-term macroeconomic management.

We also operationalize this conceptual framework by presenting a benchmark model that predicts countries’ level of financial development based on structural characteristics (e.g., income, size, and demographic characteristics) and other fundamental factors. The most straightforward approach for assessing a country’s progress in financial deepening is to benchmark its financial system against peers or regional averages. Such comparisons, while useful, do not allow for a systematic unbundling of structural and policy factors that have a bearing on financial deepening. Using regression analysis, we relate gaps between predicted and actual levels of financial development to an array of macroeconomic, regulatory, and institutional variables. We also provide preliminary evidence that overshooting the predicted level of financial development is associated with credit boom-bust episodes, underlining the importance of optimizing rather than maximizing financial development.

This paper is related to several literatures. First, it is directly related to an earlier exercise to derive an access possibilities frontier as a conceptual tool to assess the optimal level of sustainable outreach of the financial system (Beck, and de la Torre, 2007). While Beck, and de la Torre (2007) focus on the microeconomics of access to and use of financial services, this paper provides a macroeconomic perspective on financial sector development. Second, our paper is related to the empirical literature on benchmarking. Based on Beck et al. (2008) and Al Hussainy et al. (2011), we derive a benchmarking model that relates a country’s level of financial development over time to a statistical benchmark, obtained from a large panel regression.

In a broader sense, the paper is also related to the literature on the finance-growth nexus, financial crises, and studies identifying policies needed for sound and effective financial systems. The finance and growth literature, as surveyed by Levine (2005), among others, has found a positive relationship between financial deepening and growth. More recent work, however, has uncovered non-linearities in this relationship. There is evidence that the effect of financial development is strongest among middle-income countries (Barajas et al., 2012), whereas other work finds a declining effect of finance on growth as countries grow richer.2 More recently, Arcand et al. (2012) find that the finance-growth relationship becomes negative as private credit reaches 110 percent of GDP, while Dabla-Norris and Srivisal (2013) document a positive relationship between financial depth and macroeconomic volatility at very high levels.

Our paper is also related to a growing literature exploring the anatomy of financial crises. This literature has pointed to the role of macroeconomic, bank-level and regulatory factors in driving and exacerbating financial fragility. Finally, our paper is related to a diverse literature exploring macroeconomic and institutional determinants of sound and efficient financial deepening.

Cyprus: Some Early Lessons. By Thorsten Beck

Cyprus: Some Early Lessons. By Thorsten Beck
World Bank Blogs, Mar 28, 2013

The crisis is Cyprus is still unfolding and the final resolution might still have some way to go, but the events in Nicosia and Brussels already offer some first lessons. And these lessons look certainly familiar to those who have studied previous crises.  Bets are that Cyprus will not be the Troika’s last patient, with one South European finance minister already dreading the moment where he might be in a situation like his Cypriot colleague.  Even more important, thus to analyze the on-going Cyprus crisis resolution for insights into where the resolution of the Eurozone crisis might be headed and what needs to be done.

1. A deposit insurance scheme is only as good as the sovereign backing it

One of the main objectives of deposit insurance is to prevent bank runs. That was also the idea behind the increase of deposit insurance limits across the Eurozone to 100,000 Euro after the Global Financial Crisis. However, deposit insurance is typically designed for idiosyncratic bank failures, not for systemic crises.  In the latter case, it is important that public back stop funding is available.  Obviously, the credibility of the latter depends on a solvent sovereign. As Cyprus has shown, if the solvency of the sovereign is itself in question, this will undermine the confidence of depositors in a deposit insurance scheme.  In the case of Cyprus, this confidence has been further undermined by the initial idea of imposing a tax on insured deposits, effectively an insurance co-payment, contradicting maybe not in legal terms but definitely in spirit the promise of deposit insurance of up to 100,000 Euros. The confidence that has been destroyed with the protracted resolution process and the back-and-forth over loss distribution will be hard to re-establish. A banking system without the necessary trust, in turn, will be hard pressed to fulfill its basic functions of facilitating payment services and intermediating savings. Ultimately, this lack of confidence can only be overcome by a Eurozone wide deposit insurance scheme with public back-stop funding by ESM and a regulatory and supervisory framework that depositors can trust.

2. A large financial system is not necessarily growth enhancing

An extensive literature has documented the positive relationship between financial deepening and economic growth, even though the recent crisis has shed doubts on this relationship (Levine, 2005, Beck, 2012).  However, both theoretical and empirical literature focus on the intermediation function of the financial system, not on the size of the financial system per se. Very different from this financial facilitator view is the financial center view, which sees the financial sector as an export sector, i.e. one that seeks to build a nationally centered financial center stronghold based on relative comparative advantages such as skill base, favorable regulatory and tax policies, (financial safety net) subsidies, etc. Economic benefits of such a financial center might also include important spin-offs coming from professional services (legal, accounting, consulting, etc.) that tend to cluster around the financial sector.

In recent work with Hans Degryse and Christiane Kneer (2013) and using pre-2007 data, we have shown that a large financial system might stimulate growth in the short-term, but comes at the expense of higher volatility. It is the financial intermediation function of finance that helps improve growth prospects not a large financial center, a lesson that Cyprus could have learned from Iceland.

3. Crisis resolution as political distribution fight

Resolution processes are basically distributional fights about who has to bear losses.   The week-long negotiations about loss allocation in Cyprus are telling in this respect.  While it was initially Eurozone authorities that were blamed for imposing losses on insured depositors, there is an increasingly clear picture that it was maybe the Cypriot government itself that pushed for such a solution in order to avoid imposing losses on large, (and thus most likely) richer and more connected depositors.

While the Cypriot case might be the most egregious recent example for the entanglement of politics and crisis resolution, the recent crises offer ample examples of how politically sensitive the financial system is.  Just two more examples here:  First, even during and after the Global Financial Crisis of 2008 and 2009, there was still open political pressure across Europe to maintain or build up national champions in the respective banking systems, even at the risk of creating more too-big-to-fail banks.  Second, the push by the German government to exempt German small savings and cooperative banks from ECB supervision and thus the banking union can be explained only on political basis and not with economic terms, as the "too-many-to-fail" is as serious as the "too-big-to-fail" problem.

4. Plus ca change, plus c'est la meme chose

European authorities and many observers have pointed to the special character of each of the patients of the Eurozone crisis and their special circumstances. Ireland and Spain suffered from housing booms and subsequent busts, Portugal from high current account deficits stemming from lack of competitiveness and mis-allocation of capital inflows, Greece from high government deficit and debt and now Cyprus from an oversized banking system. So, seemingly different causes, which call for different solutions!
But there is one common thread across all crisis countries, and that is the close ties between government and bank solvency. In the case of Ireland, this tie was established when the ECB pushed the Irish authorities to assume the liabilities of several failed Irish banks. In the case of Greece, it was the other way around, with Greek banks having to be recapitalized once sovereign debt was restructured.  In all crisis countries, this link is deepened as their economies go into recession, worsening government’s fiscal balance, thus increasing sovereign risk, which in turn puts balance sheets of banks under pressure that hold these bonds but also depend on the same government for possible recapitalization. This tie is exacerbated by the tendency of banks to invest heavily in their home country’s sovereign bonds, a tendency even stronger in the Eurozone’s periphery (Acharya, Drechsler and Schnabl, 2012).  Zero capital requirements for government bond holdings under the Basel regime, based on the illusion that such bonds in OECD countries are safe from default, have not helped either.

5. If you kick the can down the road, you will run out of road eventually 

The multiple rounds of support packages for Greece by Troika, built on assumptions and data, often outdated by the time agreements were signed, has clearly shown that you can delay the day of reckoning only so long. By kicking the can down the road, however, you risk deteriorating the situation even further. In the case of Greece that led eventually to restructuring of sovereign debt. Delaying crisis resolution of Cyprus for months if not years has most likely also increased losses in the banking system.  A lesson familiar from many emerging market crises (World Bank. 2001)!  On a first look, the Troika seemed eager to avoid this mistake in the case of Cyprus, forcing recognition and allocation of losses in the banking system early on without overburdening the sovereign debt position. However, the recession if not depression that is sure to follow in the next few years in Cyprus will certainly increase the already high debt-to-GDP ratio and might ultimately lead to the need for sovereign debt restructuring.

6. The Eurozone crisis — a tragedy of commons

The protracted resolution process of Cyprus has shown yet again, that in addition to a banking, sovereign, macroeconomic and currency crisis, the Eurozone faces a governance crisis. Decisions are taken jointly by national authorities who each represent the interest of their respective country (and taxpayers), without taking into account the externalities of national decisions arising on the Eurozone level. It is in the interest of every member government with fragile banks to "share the burden" with the other members, be it through the ECB’s liquidity support or the Target 2 payment system. Rather than coming up with crisis resolution on the political level, the ECB and the Eurosystem are being used to apply short-term (liquidity) palliatives that deepen distributional problems and make the crisis resolution more difficult. What is ultimately missing is a democratically legitimized authority that represents Eurozone interests.

7. Learning from the Vikings

In 2008, Iceland took a very different approach from the Eurozone when faced with the failure of their oversized banking system. It allowed its banks to fail, transferred domestic deposits into good banks and left foreign deposits and other claims and bad assets in the original banks, to be resolved over time.  While the banking crisis and its resolution has been a traumatic experience for the Icelandic economy and society, with repercussions even for diplomatic relations between Iceland and several European countries, it avoided a loss and thus insolvency transfer from the banking sector to the sovereign.  Iceland's government has kept its investment rating throughout the crisis. And while mistakes might have been made in the resolution process (Danielsson, 2011), Iceland’s banking sector does not drag down Iceland’s growth any longer and might eventually even make a positive contribution.

The resolution approach in Cyprus seems to follow the Icelandic approach. While the Cypriot case might be a special one (as part of the losses fall outside the Eurozone and Cypriot banks are less connected with the rest of the Eurozone than previous crisis cases), there are suggestions that future resolution cases might impose losses not just on junior and maybe senior creditors of banks, but even on depositors to thus reduce pressure on government’s balance sheets.  A move towards market discipline, for certain; whether this is due to learning from experience, tighter government budgets across Europe or for political reasons remains to be seen.

8. Banking union with just supervision does not work

The move towards a Single Supervisory Mechanism has been hailed as major progress towards a banking union and stronger currency union.  As the case of Cyprus shows, this is certainly not enough.  The holes in the balance sheets of Cypriot banks became obvious in 2011 when Greek sovereign debt was restructured, but given political circumstances, the absence of a bank resolution framework in Cyprus and — most importantly — the absence of resources to undertake such a restructuring, the problems have not been addressed until now.  Even once the ECB has supervisory power over the Eurozone banking system, without a Eurozone-wide resolution authority with the necessary powers and resources, it will find itself forced to inject more and more liquidity and keep the zombies alive, if national authorities are unwilling to resolve a failing bank.

9. A banking union is needed for the Eurozone, but won't help for the current crisis!

While the Eurozone will not be sustainable as currency union without a banking union, a banking union cannot help solve the current crisis. First, building up the necessary structures for a Eurozone or European regulatory and bank resolution framework cannot be done overnight, while the crisis needs immediate attention. Second, the current discussion on banking union is overshadowed by distributional discussions, as the bank fragility is heavily concentrated in the peripheral countries, and using a Eurozone-wide deposit insurance and supervision mechanism to solve legacy problems is like introducing insurance after the insurance case has occurred. The current crisis has to be solved before banking union is in place. Ideally, this would be done through the establishment of an asset management company or European Recapitalization Agency, which would sort out fragile bank across Europe, and also be able to take an equity stake in restructured banks to thus benefit from possible upsides (Beck, Gros and Schoenmaker, 2012).  This would help disentangle government and bank ties, discussed above, and might make for a more expedient and less politicized resolution process than if done on the national level.

10. A currency union with capital controls?

The protracted resolution process of the Cypriot banking crisis has increased the likelihood of a systemic bank run in Cyprus once the banks open, though even if the current solution would have been arrived at in the first attempt, little confidence in Cypriot banks might have been left.  As in other crises (Argentina and Iceland) that perspective has led authorities to impose capital controls, an unprecedented step within the Eurozone. Effectively, however, this implies that a Cypriot Euro is not the same as a German or Dutch Euro, as they cannot be freely exchanged via the banking system, thus a contradiction to the idea of a common currency (Wolff, 2013).

However, these controls only formalize and legalize what has been developing over the past few years: a rapidly disintegrating Eurozone capital market.  National supervisors increasingly focus on safeguarding their home financial system, trying to keep capital and liquidity within their home country (Gros, 2012).  Anecdotal evidence suggests that this does not only affect the inter-bank market but even intra-group transaction between, let’s say, Italian parent banks and their Austrian and German subsidiaries.  Another example of the tragedy of commons, discussed above.

11. Finally, there is no free lunch

This might sound like a broken disk, but the Global Financial Crisis and subsequent Eurozone crisis has offered multiple incidences to remind us that you cannot have the cake and eat it.  This applies as much to Dutch savers attracted by high interests in Icesave and then disappointed by the failure of Iceland to assume the obligations of its banks as to Cypriot banks piling up on Greek government bonds promising high returns even in 2010 when it had become all but obvious that Greece would require sovereign debt restructuring.  On a broader level, the idea that a joint currency only brings advantages for everyone involved, but no additional responsibilities in term of reduced sovereignty and burden-sharing and insurance arrangements also resembles the free lunch idea.

On a positive note, the Cyprus bail-out has shown that Eurozone authorities have learnt from previous failures by forcing an early recognition of losses in Cyprus and by moving towards a banking union, even if very slowly. As discussed above, however, there are still considerable political constraints and barriers to overcome, so that it is ultimately left to each observer to decide whether the glass is half full or half empty.


Acharya, Viral, Itamar Drechsler and Philipp Schnabl. 2012. A tale of two overhangs: the nexus of financial sector and sovereign credit risks. Vox 15 April 2012
Beck, Thorsten. 2012. Finance and growth: lessons from the literature and the recent crisis. Paper prepared for the LSE growth commission.
Beck, Thorsten, Hans Degryse and Christiane Kneer. 2012. Is more finance better?
Disentangling intermediation and size effects of financial systems. Journal of Financial Stability, forthcoming.
Beck, Thorsten, Daniel Gros, Dirk Schoenmaker (2012): Banking union instead of Eurobonds — disentangling sovereign and banking crises, Vox 24 June 2012.
Danielsson, Jon. 2011. How not to resolve a banking crisis: Learning from Iceland’s mistakes  Vox, 26 November 2011
Gros. Daniel. 2012. The Single European Market in Banking in decline — ECB to the rescue? Vox , 16 Ocotber 2012
Levine, Ross. 2005. Finance and growth: theory and evidence. In Handbook of Economic
Growth, ed. Philippe Aghion and Steven N. Durlauf, 865–934. Amsterdam: Elsevier.
Wolff, Guntram. 2013. Capital controls are a grave risk to the eurozone. Financial Times 26 March 2013.
World Bank. 2001. Finance For Growth: Policy Choices in a Volatile World. Policy Research Report

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