Download How to Characterise Financial Systems

Subir Lall
International Monetary Fund
Global Issues Seminar Series
October 25, 2006
1
Outline

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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
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Due to Changes in Regulations, Policies,
Globalization and Technology
3
Why is this important?
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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
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How to Characterize Financial
Systems
Differences in national financial
systems

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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.
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Stronger role for price signals.
7
Relationship-based financial
transactions
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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.
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Two key points
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In practice no financial system is purely
relationship-based or purely armslength.
Other classifications are possible, but
this one seems especially important
when discussing how households and
firms react to different shocks.
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Financial Index

The overall index comprises three subindices (which are weighted equally) that
capture key elements of a financial
system:
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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.
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Financial Index
Financial Index
Traditional
Banking
Intermediation
Volume of
Funds
Intermediated
Competition in
Banking
New Financial
Intermediation
Disclosure of
financial
information
Non Traditional
Banking
Non-Bank
Intermediation
Financial
Markets
Financial
Innovation
Access
Liquidity
Contract
Enforcement
Non Financial
Sector Liabilities
vis-à-vis Banks
Interest Spread
(Lending Rate
less Money
Market Rate)
Credit
Information
Index
Banks: Non
Interest Income
(over bank assets)
Household
assets with nonbank
institutions
Asset Backed
Securities, gross
issuance
Number of
listed
companies per
person
Stock Market
Turnover Ratio
Number of
procedures o
resolve disputes
Non Financial
Sector Assets with
Banks
Percent of Bank
Assets in Top
Three Banks
Public registry
coverage
Bank liabilities
vis-à-vis non
bank
institutions
Loans by non
bank
institutions
Venture capital
investment
Corporate debt
and equities (as a
share of
liabilities)
Private Bond
Market
Capitalization
Time of
procedures to
resolve disputes
Percent of Bank
Assets ForeignOwned
Private bureau
coverage
Bank assets
with non-bank
institutions
Bonds issued
by non-bank
institutions
Interest rate and
exchange rate
derivatives
Average
number of bank
relationships
Number of
reported items in
firms’ statements
Stock Price
Synchronicity
Cost of
procedures to
resolve disputes
disputes
Investor
Protection
Index
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Main conclusion
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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.
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Australia
Austria
Belgium
Canada
Denmark
Finland
France
German
Greece
Italy
Japan
Netherla
Norway
Portugal
Spain
Sweden
UK
US
Average
Financial Index
1995
1.0
2004
0.8
0.6
0.4
0.2
0.0
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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.
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Main conclusion

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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.
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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:
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Households face income uncertainty
Firms face temporary changes to demand
during business cycles
Firms also face permanent changes in
business opportunities
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Households
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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)
Countries in the upper half of the Financial Index1
Countries in the lower half of the Financial Index 2
120
100
80
60
40
20
Mortgage equity
withdrawal available
Typical mortgage term
over 20 years
Typical loan-to-value
ratio over 75 percent
0
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.
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Households (cont’d)
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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
Countries in the lower half of the Financial Index 2
180
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.
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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
Index, 1985–2005
(Correlations between quarter-on-quarter growth rates)
(Times 1E-1 )
0.9
0.8
Germany
0.7
0.6
Finland
0.5
Italy
Portugal
Canada
Norway
Greece
Australia
Belgium
Austria
Japan
France
0.2
0.3
0.4
Netherlands
0.4
0.3
Denmark
United Kingdom
Sweden
Spain
United States
0.5
Financial Index
0.6
Sources: OECD Analytic Database; and IMF staff calculations.
0.7
0.2
0.1
0.0
0.8
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Do asset prices matter (more)?
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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
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Private Consumption:
Response
toEquity
Equity
Private Consumption:
Response to
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.
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Changes in real estate prices
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With real estate typically the biggest item
on household balance sheets, house
prices may also matter more
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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)
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Private Consumption and Residential Investment:
1
Consumption
and Residential
Investment:
Response toPrivate
Housing
Busts,
1970-2005
1
Response to Housing Busts, 1970–2005
(Percent change year-on-year; constant prices; x-axis in quarters) 2
5
Private Consumption
4
Before 1985
3
2
1
0
Since 1985
-8
-6
-4
-2
0
2
4
6
8
10
12
Residential Investment
Before 1985
Since 1985
-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.
-1
10
8
6
4
2
0
-2
-4
-6
-8
-10
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Are Asset Price Swings Themselves
More Pronounced?
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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
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Depth of Equity and Housing Busts and the Financial Index,
Depth of Equity and Housing Busts and the Financial
1985-2005
Index, 1985–2005
Depth of Equity Busts
(average real equity price decline; percent)
0
-10
-20
Spain Denmark
Norway
Belgium
Japan
Austria
Australia
Italy
Canada
Sweden
Netherlands
France
Germany
Finland
0.2
0.3
United Kingdom
0.4
0.5
0.6
United States
-30
-40
-50
0.7
-60
0.8
Financial Index
Depth of Housing Busts
(average real house price decline;
percent)
0
Netherlands
Australia
Sweden
-10
United States
Finland
Canada
Spain
Denmark
United Kingdom
-20
-30
-40
Norway
0.2
0.3
0.4
0.5
-50
0.6
0.7
-60
0.8
Financial Index
Sources: OECD Analytic Database; and IMF staff calculations.
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How do Firms Respond?
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In response to temporary changes
during a business cycle, access to credit
could smooth fluctuations in investment
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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
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Investment and Financing by the Corporate Sector
Investment and Financing by the Corporate Sector
Business Investment: Response to Business Cycles, 1985–2005
(percent change year-on-year; constant prices)
12
8
Countries in the lower half of the
Financial Index1
130
Nonfinancial Corporate Internal Financing over the
Last Equity Valuation Cycle
(percent of investment)
120
United States
110
100
4
Euro 3
4
90
0
Countries in the upper half of
the Financial Index 2
-8
-6
-4
-2
60
0
2
3
Quarters
4
6
8
-8
110
90
Euro 3
United States
-3
-2
-1
0
-4
-3
-2
-1
0
1
2
3
4
50
Years 3
100
-4
70
Japan
-4
Nonfinancial Corporate Investment-to-GDP Ratio over the
Last Equity Valuation Cycle
(100 at peak)
-5
80
1
4
80
Japan
2
3
Sources: National financial accounts from Eurostat and OECD; OECD Analytic Database;
and IMF staff calculations.
1Countries included are Austria, Belgium, Finland, France, Germany, Greece, Japan,
Portugal, and Spain.
2 Countries included are Australia, Canada, Denmark, Italy, the Netherlands, Norway,
Sweden, the United Kingdom, and the United States.
3 Zero denotes the peak quarter or year of the business cycle.
4
GDP-weighted average of France, Germany, and Italy (GDP at market exchange rates).
4
70
Years3
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More long term changes

Due to technology and globalization,
there may be fundamental shifts in
business opportunities
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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
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Do Financial Systems Matter
for Capital Flows?
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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 Financial
Index and
Foreign PortfolioInvestment
The Financial Index
and
Foreign
Portfolio
Investment
25
Foreign Portfolio Inflows
(percent of imports plus exports)
20
Greece
United States
France
Spain
Portugal
Austria
United Kingdom
Australia
15
Finland
10
Italy
Netherlands
Japan
Germany
Norway
Denmark
Canada
Belgium
Sweden
0.2
0.3
0.4
0.5
Financial Index
5
0.6
0.7
0
0.8
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
300 -250
250 -200
200 -150
150 -100
100 -50
50
0
50
100 150 200
Sources: Bank of International Settlements; Lane and Milesi-Ferretti (2006); OECD; and
IMF staff calculations.
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Conclusions
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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?

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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.
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For more information:
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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
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