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Subir Lall
International Monetary Fund
Global Issues Seminar Series
October 25, 2006
1
Outline
Introduction: Why Financial Systems Matter
for Economic Fluctuations
A Framework for Characterizing Financial
Systems
The Interaction between Financial Systems
and the Economy
Conclusions and Policy Implications
2
Interaction between Financial Systems
and Economic Cycles:
New Area of Research....
Financial Systems are Changing
Becoming Less Relationship Based
Becoming More Arms-Length Based
Due to Changes in Regulations, Policies,
Globalization and Technology
3
Why is this important?
If the relationship between financial systems and the
economy changes, the response of households and firms
to changes in the environment will change
It also implies changes may be needed in policies
Economies may become more sensitive to changes in
financial variables and the channels through which
financial instability affects households and firms
This is an emerging area of interest to the policymaking
community
4
How to Characterize Financial
Systems
Differences in national financial
systems
We classify the financial systems of advanced
economies based on the degree to which
financial transactions are conducted at arm’s
length or are based on a direct (long-term)
relationships between the parties.
An index is created that captures the arm’s
length content of a financial system.
6
Arm’s length financial
transactions
The parties involved have no special
knowledge or information about each
other that is not already available to the
general public.
Open competition among lenders.
Stronger role for price signals.
7
Relationship-based financial
transactions
Financial transactions are conducted on the basis
of a direct and generally longer-term relationship
between two entities, usually a customer and a
bank.
The lender has information about the borrower
which is not available publicly.
This gives the lender direct influence on the
borrower and monopolistic power in the market.
8
Two key points
In practice no financial system is purely
relationship-based or purely arms-
length.
Other classifications are possible, but
this one seems especially important
when discussing how households and
firms react to different shocks.
9
Financial Index
The overall index comprises three sub-
indices (which are weighted equally) that
capture key elements of a financial
system:
The degree of traditional bank intermediation.
The degree to which new financial
intermediation has developed to provide an
alternative non-bank channel for financing.
The role played by financial markets.
10
Financial Index
Financial Index
Traditional
New Financial Financial
Banking
Intermediation Markets
Intermediation
Volume of Disclosure of
Competition in Non Traditional Non-Bank Financial Contract
Funds financial Access Liquidity
Banking Banking Intermediation Innovation Enforcement
Intermediated information
Interest Spread Household Number of
Non Financial Credit Banks: Non Asset Backed Number of
(Lending Rate assets with non- listed Stock Market
Sector Liabilities
less Money
Information Interest Income Securities, gross procedures o
vis-à-vis Banks (over bank assets) bank companies per Turnover Ratio
Market Rate) Index issuance resolve disputes
institutions person
Bank liabilities Corporate debt
Non Financial Percent of Bank vis-à-vis non Loans by non Private Bond Time of
Public registry Venture capital and equities (as a
Sector Assets with Assets in Top
bank bank share of
Market procedures to
Banks Three Banks coverage investment
institutions institutions liabilities) Capitalization resolve disputes
Bank assets Cost of
Percent of Bank Bonds issued Interest rate and
Private bureau with non-bank procedures to
Assets Foreign- by non-bank exchange rate
coverage institutions resolve disputes
Owned institutions derivatives
disputes
Average Number of Investor
number of bank reported items in Protection
firms’ statements
relationships Index
Stock Price
Synchronicity
11
Main conclusion
The importance of arm’s length transactions
has increased in almost all countries.
There remains a significant divide between
the “Anglo-Saxon” and the other advanced
countries, with the United States still
substantially more arms-length than any
other.
12
Australia
Austria
Belgium
Canada
Denmark
Finland
France
German
Greece
Italy
Japan
Financial Index
Netherla
Norway
Portugal
Spain
1995
2004
Sweden
UK
US
Average
0.0
0.2
0.4
0.6
0.8
1.0
13
Main conclusion
This divergence is mainly driven by still
large differences in the area of new
financial intermediation,
particularly the pace at which
intermediaries such as mutual and
pensions funds have emerged, the wider
use of financial innovation, and banks’
expansion into nontraditional banking
activities.
14
Main conclusion
Little evidence that advanced countries
are converging to the “same” type of
financial system.
Not only have other advanced
economies failed to catch up with the
United States over the past decade, but
cross-country variations have not
diminished. 15
How Do Financial Systems
Affect Business Cycles
Why does the type of system
matter ?
Financial systems provide credit that
can help smooth “shocks” and adapt
to them:
Households face income uncertainty
Firms face temporary changes to demand
during business cycles
Firms also face permanent changes in
business opportunities
17
Households
If financial systems can provide credit that
is less dependent on current income, it
allows better smoothing
A main channel for this is if financial
systems are better able to assess credit
risk and the value of collateral
Well developed mortgage markets can
help smooth consumption
18
Features of Mortgage Markets
Features of Mortgage Markets
(Percent of countries)
120
Countries in the upper half of the Financial Index1
Countries in the lower half of the Financial Index 2
100
80
60
40
20
0
Mortgage equity Typical mortgage term Typical loan-to-value
withdrawal available over 20 years ratio over 75 percent
Sources: Tsatsaronis and Zhu (2004); Catte and others (2004); and IMF staff calculations.
1 Countries included are Australia, Canada, Denmark, Italy, the Netherlands, Norway,
Sweden, the United Kingdom, and the United States.
2 Countries included are Austria, Belgium, Finland, France, Germany, Greece, Japan,
Portugal, and Spain.
19
Households (cont’d)
More generally, households can access
greater credit in financial systems with
greater arm’s length content
More arm’s length systems allow
repackaging of credit exposures into
portfolios that can be sold
Opens up balance sheets to initiate new
lending
20
Total Household Liabilities
Total Household Liabilities
(Ratio to disposable income; group average)
Countries in the upper half of the Financial Index1
180
Countries in the lower half of the Financial Index 2
160
140
120
100
80
60
40
20
0
1995 2000 2005
Sources: National financial accounts from Eurostat and OECD; OECD Analytic Database;
and IMF staff calculations.
1Countries included are Australia, Canada, Denmark, Italy, the Netherlands, Norway,
Sweden, the United Kingdom, and the United States.
2Countries included are Austria, Belgium, Finland, France, Germany, Greece, Japan,
Portugal, and Spain.
21
Consumption-Income
Correlations
Based on these characteristics, we find
that the correlation between changes in
consumption and income is weaker in
more arm’s length systems
22
Consumption-Income Correlations and the Financial Index,
Consumption-Income Correlations and the Financial
1985-2005 1985–2005
Index,
(Correlations between quarter-on-quarter growth rates)
(Times 1E-1 )
0.9
0.8
Germany
0.7
0.6
Finland 0.5
Italy Canada
Portugal
Norway 0.4
Netherlands
Greece
Australia
Belgium 0.3
Austria
Japan Denmark 0.2
United Kingdom
Sweden
Spain United States 0.1
France
0.0
0.2 0.3 0.4 0.5 0.6 0.7 0.8
Financial Index
Sources: OECD Analytic Database; and IMF staff calculations.
23
Do asset prices matter (more)?
Since the value of collateral becomes
more important for credit
Since households hold more securities
on their balance sheets …
....consumption should become more
sensitive to changes in the price of assets
24
Private Consumption: Response to Equity
Private Consumption: Response to Equity Busts, Busts, 1985-2005
1985–2005
(Percent change year-on-year; constant prices; x-axis in quarters) 1
5
4
Countries in the lower half of the
Financial Index 2
3
2
Countries in the upper half of the
Financial Index3
1
-8 -6 -4 -2 0 2 4 6 8
Sources: OECD Analytic Database; and IMF staff calculations.
1 Zero denotes the quarter after which a bust begins.
2 Countries included are Austria, Belgium, Finland, France, Germany, Greece, Japan,
Portugal, and Spain.
3 Countries included are Australia, Canada, Denmark, Italy, the Netherlands, Norway,
Sweden, the United Kingdom, and the United States.
25
Changes in real estate prices
With real estate typically the biggest item
on household balance sheets, house
prices may also matter more
Consumption may respond more as credit
is more sensitive to the value of house
prices
Residential investment is also dependent
more on credit (e.g. smaller down
payments)
26
Private Consumption and Residential Investment:
Response to Housing Busts, 1970-2005 1
Private Consumption and Residential Investment:
Response to Housing Busts, 1970–2005
1
(Percent change year-on-year; constant prices; x-axis in quarters) 2
Private Consumption 5
4
Before 1985 3
2
1
0
Since 1985
-1
-8 -6 -4 -2 0 2 4 6 8 10 12
Residential Investment 10
8
6
4
Before 1985
2
0
-2
-4
-6
Since 1985
-8
-10
-8 -6 -4 -2 0 2 4 6 8 10 12
Sources: OECD Analytic database; and IMF staff calculations.
1Countries included are Australia, Canada, Denmark, Italy, the Netherlands, Norway,
Sweden, the United Kingdom, and the United States.
2 Zero denotes the quarter after which a bust begins.
27
Are Asset Price Swings Themselves
More Pronounced?
If asset price swings become larger, then
the impact on households could be greater
in more arm’s length systems
If more arm’s length systems allow better
continuous adjustments of prices and less
“mispricing”, then the overall impact would
be smaller despite greater sensitivity
28
Depth of Equity and Housing Busts and the Financial Index,
1985-2005 of Equity and Housing Busts and the Financial
Depth
Index, 1985–2005
Depth of Equity Busts 0
(average real equity price decline; percent)
-10
Spain Denmark -20
Belgium Norway
Japan United Kingdom -30
Austria
Australia United States -40
Italy Canada
Germany Sweden
Finland Netherlands -50
France
-60
0.2 0.3 0.4 0.5 0.6 0.7 0.8
Financial Index
Depth of Housing Busts 0
(average real house price decline; Netherlands
percent) Australia -10
Sweden
United States
Finland -20
Canada
Denmark United Kingdom -30
Spain
-40
Norway -50
-60
0.2 0.3 0.4 0.5 0.6 0.7 0.8
Financial Index
Sources: OECD Analytic Database; and IMF staff calculations.
29
How do Firms Respond?
In response to temporary changes
during a business cycle, access to credit
could smooth fluctuations in investment
In relationship based systems, lenders
would give greater weight to the value of
the long term relationship
In more arm’s length systems, with greater
competition, lenders may reallocate credit
away from firms
30
Investment and Financing by the Corporate Sector
Investment and Financing by the Corporate Sector
Business Investment: Response to B usiness Cycles, 1985–2005 12 Nonfinancial C orporate Internal Financing over the 130
(percent change year-on-year; constant prices) Last Equity Valuation Cycle
United States 120
(percent of investment)
8 110
Countries in the lower half of the
Financial Index 1 100
4
4
Euro 3 90
0 80
Countries in the upper half of Japan 70
-4
the Financial Index 2
60
-8 50
-8 -6 -4 -2 0 2 4 6 8 -4 -3 -2 -1 0 1 2 3 4
3
Quarters Years 3
Nonfinancial C orporate Investment-to-GDP Ratio over the 110 Sources: National financial accounts from Eurostat and OECD; OECD Analytic Database;
Last Equity Valuation Cycle and IMF staff calculations .
1Countries included are Austria, Belgium, Finland, France, Germany, Greece, Japan,
(100 at peak)
100 Portugal, and Spain.
2Countries included are Australia, Canada, Denmark, Italy, the Netherlands, Norway,
Sweden, the United Kingdom, and the United States.
3Zero denotes the peak quarter or year of the business cycle.
90 4
GDP-weighted average of France, Germany, and Italy (GDP at market exchange rates).
4
Euro 3
United States 80
Japan
70
-5 -4 -3 -2 -1 0 1 2 3 4
Years3
31
More long term changes
Due to technology and globalization,
there may be fundamental shifts in
business opportunities
Relationship based systems may favor
incumbent firms and industries
More arm’s length systems may be better
able to provide firms to new firms and new
industries
32
Do Financial Systems Matter
for Capital Flows?
More arm’s length systems may allow
easier access to foreign financing as
information is public and priced into the
value of securities
The diversification opportunities are
greater
Greater foreign participation may serve to
deepen the investor base and reduce the
cost of financing
33
Figure 4.13. The Foreign Portfolio
The Financial Index and Financial Index and Foreign PortfolioInvestment
Investment
Foreign Portfolio Inflows 25
(percent of imports plus exports)
Greece 20
United States
Portugal France United Kingdom 15
Spain Australia
Austria Finland
10
Italy Netherlands
Japan
Germany
Denmark Norway 5
Belgium Canada
Sweden
0
0.2 0.3 0.4 0.5 0.6 0.7 0.8
Financial Index
Foreign and Domestic Holdings of Debt Securities
(percent of GDP)
Domestic securities held by nonresidents
Domestic securities held by residents
Debt securities Equity securities
Austria
Belgium
Euro area
Finland
France
Germany
Greece
Italy
Japan
Netherlands
Portugal
Spain
United Kingdom
United States
300 250 200 150 100 50
-300 -250 -200 -150 -100 -50 0 50 100 150 200
Sources: Bank of International Settlements; Lane and Milesi-Ferretti (2006); OECD; and
IMF staff calculations.
34
Conclusions
More arm’s length systems help smooth consumption
Households more vulnerable to asset price movements
under such systems
Firms can smooth business cycle shocks in more
relationship based systems
The corporate sector may be less able to shift resources
from declining to emerging sectors
Financial Stability matters not just because of the impact
on financial systems, but also in helping households and
firms use the financial system to optimally respond to
changes in the economic environment
35
Policy Implications?
Monetary policy. Impact of interest rate
changes on asset prices increasingly important
channel of monetary policy.
Regulatory and supervisory policies. Need
to upgrade tools to match financial systems’
increased sophistication and monitor new risks.
Policy changes in other areas. Flexible labor
market and effective bankruptcy legislation
would enable firms to maximize benefits from the
changing financial environment.
36
For more information:
On the IMF’s role in promoting financial
stability: www.imf.org
IMF World Economic Outlook Chapter
IV (September 2006) at
www.imf.org/weo
IMF Global Financial Stability Reports at
www.imf.org/external/pubs/ft/gfsr
37
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