Why banking can be too much of a good thing

Want to know whether an emerging market will be a good investment in the future?  Then have a look at whether any of the major banks are investing there. The reason is twofold. First, big banks are trained to spot the new consumer, legal, regulatory and economic dynamics that would make a developing country a good investment for them. (And for you.) Second, a robust economy needs to have a well-developed banking system. In fact, you’d be hard-pressed to name one robust economy that doesn’t have a developed banking system. (And that also includes the illegal economy — see this and this.)

So a banking and / or market-based financial system is the spine of an economy — but is it ever possible to have too much of it?

Until recently it was commonly accepted that the more banking there is, the better. This is the philosophy that helped to drive the waves of de-regulation both in the US and the UK. However a new working paper from the Bank for International Settlements (aka the central banks’ bank) shows why this may be wrong. Too much banking can actually be a bad thing, even in the absence of a dramatic financial crisis.

In their paper Stephen Cecchetti and Enisse Kharroubi looked at various developed and emerging countries to see how their respective growth was impacted once the level of financial development passed certain thresholds. They found the thresholds by measuring three things:

• the ratio of all private credit to a country’s GDP
• the ratio of bank-provided private credit to a country’s GDP
• the amount of labor and other resources used by the country’s financial sector

[A]t low levels, a larger financial system goes hand in hand with higher productivity growth. But there comes a point – one that many advanced economies passed long ago – where more banking and more credit are associated with lower growth.

For example, in Portugal, private credit by banks was 160% of GDP at the onset of the financial crisis. The corresponding figure for the UK was 180% of GDP and even reached 200% of GDP in Denmark. By contrast, a country like India, where bank credit is less than 50% of GDP, can still reap significant benefits from further financial deepening in terms of increasing productivity growth.

[A]t low levels, an increase in the financial sector’s share in total employment is actually associated with higher GDP-per-worker growth. But there is a threshold beyond which a larger financial sector becomes a drag on productivity growth.

Standouts on this graph include Canada, Ireland, the US and Switzerland. In the case of Switzerland we see that Cecchetti and Karroubi’s conclusions don’t square up with the concept of comparative advantage, which would dictate that a country that is particularly good at banking should throw as much investment into it as possible. Switzerland is doing just this and hasn’t had any bad effects…yet. (A sustained G20 crackdown on tax havens or another factor beyond Switzerland’s control might change this.)

Cecchetti and Karroubi make a good start in taking an empirical look at the question of whether too much banking is a good thing. They’ll still have an uphill battle to make their case. The financial crisis has inspired lots of tactical firefighting but precious little of the soul-searching needed to determine whether the fundamental design of our modern economy is the right one.

Tags: Bank for International Settlements, BIS, Enisse Kharroubi, GDP, growth, macroeconomics, Stephen Cecchetti

Category: Banking