Subir Lall International Monetary Fund Global Issues Seminar Series October 25, 2006

1. Subir Lall International Monetary Fund Global Issues Seminar Series October 25, 2006

2. 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

3. 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

4. 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

5. How to Characterize Financial Systems

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. Financial Index

12. 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.

13. Financial Index 1995 2004

14. 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.

15. 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.

16. How Do Financial SystemsAffect Business Cycles

17. 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

18. 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

19. Features of Mortgage Markets

20. 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

21. Total Household Liabilities

22. 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

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

24. 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

25. Private Consumption: Response to Equity Busts, 1985-2005

26. 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)

27. Private Consumption and Residential Investment: Response to Housing Busts, 1970-2005 1

28. 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

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

30. 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

31. Investment and Financing by the Corporate Sector

32. 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

33. 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

34. The Financial Index and Foreign Portfolio Investment

35. 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

36. 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.

37. 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