A growing number of economic studies confirm an important truth about the relationship between the financial sector and the “real” economy: a healthy financial sector is necessary for economic growth, but after a certain point growth is hampered as the financial sector grows larger. A new study from the Bank for International Settlements lends further support to this thesis and contributes to the literature on this topic by examining the relationship between growth and macroprudential regulation:
This paper studies the effects of prudential regulation, financial development, and financial openness on economic growth. Using both existing models and a new OLG framework with banking and prudential regulation in the form of capital requirements, the first part presents an analytical review of the various channels through which prudential regulation can affect growth. The second part provides a reduced form empirical analysis, based on panel regressions for a sample of 64 advanced and developing economies. The results show that growth may be promoted by prudential policies whose goal is to mitigate financial risks to the economy. At the same time, financial openness tends to reduce the growth benefits of these policies, possibly because of either greater opportunities to borrow abroad or increased scope for cross-border leakages in regulation.
The first result, that macroprudential regulation designed to promote financial stability does an economy good, is unsurprising. Higher capital requirements, the weapon of choice for many macroprudential regulators, have a number of benefits, the study finds. By curbing excessive risk-taking, financial catastrophes are mitigated or avoided, and greater faith in a country’s banking system encourages greater deposits by entrepreneurs, creating a virtuous cycle of investment and growth.
Additionally, curbing the size of the financial sector benefits the “real” economy because “beyond a threshold [a growing financial sector] may induce a slowdown in technological progress due to a reallocation of talent from core innovation activities…as a result of higher compensation there.”
The second, and more interesting finding of the study, is that the degree of financial openness, measured as access to international capital markets, limits the benefits of macroprudential policies.
Why is this the case? First, greater access to financial markets means greater access to credit, which beyond a certain point can be a drag on growth, especially if an overextension leads to a bust.
Second, greater integration with international financial institutions creates an opportunity for “leakages” in macroprudential policy with firms better able to circumvent national macroprudential regulations.
Financial openness, like globalization more generally, has clear benefits but is itself not without costs. To address this problem, especially with respect to regulatory arbitrage or “leakages” in macroprudential policy, the authors recommend greater support for international financial regulation agreements, such as the Basel accords.
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