Financial systems in advanced countries have undergone remarkable changes in recent years, driven primarily by improved technology and deregulation. But considerable differences remain across countries, and these differences have important effects on economic cycles, according to the IMF’s September 2006 World Economic Outlook (WEO).
The study, published as Chapter IV of the WEO, uses a unique new index (see chart) to distinguish between financial systems that rely heavily on arm’s length transactions (in which the parties rely on publicly available information) and traditional arrangements that depend on longer-term borrower-lender relationships. In general, financial intermediation is now driven more by arm’s-length transactions, but there are important differences in the pace at which changes are taking place.
Financial systems in Australia, Canada, the Netherlands, the United Kingdom, and the United States are increasingly characterized by arm’s length transactions, whereas relationship-based finance continues to play a key role in most of Europe and Japan.
Implications for economic cycles
The WEO analysis shows that households and firms react differently to changes in the economic environment depending on the type of financial system. Their different reactions have important implications for economic cycles, asset price changes, and economies’ responses to opportunities created by globalization and to new technology.
Households in countries with more arm’s length systems, for example, have easier access to financing and are better able to smooth consumption spending, but they are also more vulnerable to asset price declines. For example, U.K. and U.S. households can borrow against the rising value of their homes—thus boosting consumption and supporting strong growth. But this borrowing also increases debt and leaves these households more vulnerable to rising interest rates and a downturn in asset prices.
An uneven pace of change
Arm’s length transactions increasingly characterize the financial sectors of advanced economies, but the pace of change has been uneven.
Citation: 35, 18; 10.5089/9781451968699.023.A006
Note: Index reflects an average of 27 variables that measure a financial sector’s dependence on publicly available—that is, arm’s length—information.
Data: IMF, September 2006 World Economic Outlook.
There are clear differences, too, in how the two types of financial systems respond to technological innovation and globalization pressures. Financial systems that depend on relationship-based transactions are slower to respond to new growth opportunities and tend to favor existing industries. Arm’s length systems find it easier to reallocate resources to new and more vibrant industries, with substantial benefits for productivity growth. This finding has particularly telling implications for Europe, whose labor productivity growth has significantly lagged behind that of Australia, the United Kingdom, and the United States over the past decade.
Differences in financial systems may also help explain widening global imbalances. U.S. households, for example, have been able to borrow far more than those in other countries—reducing saving at the same time that sophisticated and liquid U.S. financial markets have attracted foreign investors, who have helped finance the current account deficit. If other systems catch up, however, the U.S. deficit may be harder to finance.
How can policymakers maximize the benefits of the continuing shift toward arm’s length finance? The WEO offers three pertinent policy conclusions:
Monetary policy. With households using their assets as collateral for borrowing, interest rate changes are likely to become an increasingly important channel through which monetary policy affects the economy. As monetary policy is tightened, central banks will need to carefully assess whether rising interest rates are having a larger effect on household spending.
Regulatory and supervisory policies. As financial systems change, so do the risks. Financial regulators and supervisors must adapt, as the proliferation of innovative financial instruments exposes holders of these instruments to new risks.
Complementary reforms. The full benefit of changes in financial systems will be realized only if there are complementary changes. This is particularly true in Europe, where more flexible labor markets and bankruptcy reforms will be crucial in allowing countries to use resources more efficiently.
Subir Lall, Roberto Cardarelli, and Irina Tytell
IMF Research Department