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Subir LallInternational Monetary Fund

Global Issues Seminar SeriesOctober 25, 2006

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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

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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

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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

How to Characterize Financial Systems

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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.

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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.

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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.

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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.

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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.

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Financial IndexFinancial Index

Traditional Banking

Intermediation

New Financial Intermediation

Financial Markets

Volume of Funds

Intermediated

Non Traditional Banking Access

Disclosure of financial

information

Competition in Banking

Financial Innovation

Non-Bank Intermediation

Contract EnforcementLiquidity

Non Financial Sector Liabilities vis-à-vis Banks

Non Financial Sector Assets with

Banks

Interest Spread (Lending Rate less

Money Market Rate)

Percent of Bank Assets in Top Three Banks

Percent of Bank Assets Foreign-

Owned

Credit Information

Index

Public registry coverage

Private bureau coverage

Banks: Non Interest Income

(over bank assets)

Bank liabilities vis-à-vis non

bank institutions

Bank assets with non-bank

institutions

Household assets with non-

bank institutions

Average number of bank relationships

Number of reported items in firms’ statements

Stock Price Synchronicity

Bonds issued by non-bank institutions

Loans by non bank

institutions

Asset Backed Securities,

gross issuance

Interest rate and exchange rate

derivatives

Venture capital investment

Number of listed

companies per person

Corporate debt and equities (as a

share of liabilities)

Stock Market Turnover Ratio

Private Bond Market

Capitalization

Number of procedures o

resolve disputes

Time of procedures to

resolve disputes

Cost of procedures to

resolve disputesdisputes

Investor Protection

Index

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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.

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Financial Index

0.0

0.2

0.4

0.6

0.8

1.0

Australia

Austria

Belgium

Canada

Denm

ark

Finland

France

German

Greece

Italy

Japan

Netherla

Norway

Portugal

Spain

Sweden UK US

Average

1995

2004

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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 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.

How Do Financial SystemsAffect Business Cycles

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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

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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

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Features of Mortgage Markets

0

20

40

60

80

100

120

Features of Mortgage Markets(Percent of countries)

Mortgage equity withdrawal available

Typical loan-to-value ratio over 75 percent

Typical mortgage term over 20 years

Sources: Tsatsaronis and Zhu (2004); Catte and others (2004); and IMF staff calculations. Countries included are Australia, Canada, Denmark, Italy, the Netherlands, Norway, Sweden, the United Kingdom, and the United States. Countries included are Austria, Belgium, Finland, France, Germany, Greece, Japan, Portugal, and Spain.

1

2

Countries in the upper half of the Financial Index1Countries in the lower half of the Financial Index2

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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

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Total Household Liabilities

1995 2000 20050

20

40

60

80

100

120

140

160

180Countries in the upper half of the Financial IndexCountries in the lower half of the Financial Index

Total Household Liabilities(Ratio to disposable income; group average)

Sources: National financial accounts from Eurostat and OECD; OECD Analytic Database; and IMF staff calculations. Countries included are Australia, Canada, Denmark, Italy, the Netherlands, Norway, Sweden, the United Kingdom, and the United States. Countries included are Austria, Belgium, Finland, France, Germany, Greece, J apan, Portugal, and Spain.

1

2

12

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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

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Consumption-Income Correlations and the Financial Index, 1985-2005

0.2 0.3 0.4 0.5 0.6 0.7 0.80.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9(Times 1E-1 )

Consumption-Income Correlations and the Financial Index, 1985–2005(Correlations between quarter-on-quarter growth rates)

Sources: OECD Analytic Database; and IMF staff calculations.

Germany

FinlandItalyPortugal

NorwayCanada

AustraliaNetherlands

United Kingdom

United StatesFrance

Greece

Austria

Belgium

Denmark

SpainSweden

Japan

Financial Index

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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

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Private Consumption: Response to Equity Busts, 1985-2005

Countries in the lower half of the Financial Index

-8 -6 -4 -2 0 2 4 6 81

2

3

4

5

Countries in the upper half of the Financial Index

2

3

Sources: OECD Analytic Database; and IMF staff calculations. Zero denotes the quarter after which a bust begins. Countries included are Austria, Belgium, Finland, France, Germany, Greece, Japan, Portugal, and Spain. Countries included are Australia, Canada, Denmark, Italy, the Netherlands, Norway, Sweden, the United Kingdom, and the United States.

2

3

1

Private Consumption: Response to Equity Busts, 1985–2005(Percent change year-on-year; constant prices; x-axis in quarters)1

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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)

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Private Consumption and Residential Investment: Response to Housing Busts, 1970-2005

-8 -6 -4 -2 0 2 4 6 8 10 12 -10-8-6-4-20246810Residential Investment

Before 1985

Since 1985

-8 -6 -4 -2 0 2 4 6 8 10 12 -1

0

1

2

3

4

5Private Consumption

Before 1985

Since 1985

Private Consumption and Residential Investment: Response to Housing Busts, 1970–2005(Percent change year-on-year; constant prices; x-axis in quarters)

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Sources: OECD Analytic database; and IMF staff calculations. Countries included are Australia, Canada, Denmark, Italy, the Netherlands, Norway, Sweden, the United Kingdom, and the United States. Zero denotes the quarter after which a bust begins.

1

2

1

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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

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Depth of Equity and Housing Busts and the Financial Index, 1985-2005

0.2 0.3 0.4 0.5 0.6 0.7 0.8-60

-50

-40

-30

-20

-10

0

0.2 0.3 0.4 0.5 0.6 0.7 0.8-60

-50

-40

-30

-20

-10

0

GermanyFinland

Italy

Norway

Canada Australia

Netherlands

United Kingdom

United States

France

AustriaBelgium

DenmarkSpain

Sweden

Japan

Financial Index

Depth of Equity Busts(average real equity price decline; percent)

Depth of Housing Busts(average real house price decline; percent)

Finland

Norway

Canada

AustraliaNetherlands

United Kingdom

United States

DenmarkSpain

Sweden

Financial Index

Sources: OECD Analytic Database; and IMF staff calculations.

Depth of Equity and Housing Busts and the Financial Index, 1985–2005

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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

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Investment and Financing by the Corporate Sector

-5 -4 -3 -2 -1 0 1 2 3 4 70

80

90

100

110Nonfinancial Corporate Investment-to-GDP Ratio over the Last Equity Valuation Cycle(100 at peak)

Sources: National financial accounts from Eurostat and OECD; OECD Analytic Database; and IMF staff calculations. Countries included are Austria, Belgium, Finland, France, Germany, Greece, J apan, Portugal, and Spain. Countries included are Australia, Canada, Denmark, Italy, the Netherlands, Norway, Sweden, the United Kingdom, and the United States. Zero denotes the peak quarter or year of the business cycle. GDP-weighted average of France, Germany, and Italy (GDP at market exchange rates).

1

2

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United States Japan

Euro 34

-4 -3 -2 -1 0 1 2 3 4 5060708090100110120130Nonfinancial Corporate Internal Financing over the

Last Equity Valuation Cycle(percent of investment) United States

Japan

Euro 34

Years

Years

-8 -6 -4 -2 0 2 4 6 8 -8

-4

0

4

8

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Quarters

Business Investment: Response to Business Cycles, 1985–2005(percent change year-on-year; constant prices)

Countries in the upper half of the Financial Index2

Countries in the lower half of the Financial Index1

Investment and Financing by the Corporate Sector

3

3

3

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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

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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

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The Financial Index and Foreign Portfolio Investment

Domestic securities held by nonresidentsDomestic securities held by residents

Foreign and Domestic Holdings of Debt Securities(percent of GDP)

Figure 4.13. The Financial Index and Foreign Portfolio Investment

Sources: Bank of International Settlements; Lane and Milesi-Ferretti (2006); OECD; and IMF staff calculations.

0.2 0.3 0.4 0.5 0.6 0.7 0.80

5

10

15

20

25

Financial Index

GreeceUnited States

United Kingdom

Foreign Portfolio Inflows(percent of imports plus exports)

Austria Finland

PortugalAustralia

CanadaSwedenDenmark Norway

JapanItalyGermany

Belgium

FranceSpain

Netherlands

AustriaBelgium

Euro areaFinlandFrance

GermanyGreece

ItalyJapan

NetherlandsPortugal

SpainUnited Kingdom

United States-300 -250 -200 -150 -100 -50 0 50 100 150 200

Equity securitiesDebt securities

300 250 200 150 100 50

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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

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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.

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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