PART II: Analytical Focus: Strengthening Financial Systems

International Monetary Fund. European Dept.
Published Date:
November 2007
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Following a period of sustained progress in financial deepening, innovation, and integration, turbulence has recently been testing Europe’s financial systems. The transformation of these systems has generally been beneficial, but financial sector efficiency still has considerable upward potential, and new policy challenges and risks have surfaced. Against this background, strengthening financial systems has become more important than ever. Each of the following chapters focuses on a priority area of reform: advanced economies need to tune up the efficiency and resilience of financial systems; converging economies in emerging Europe need to manage rapid financial deepening; and all emerging economies need to sustain development of their financial systems.

While much attention has been paid recently to the speed of financial deepening in emerging economies and its attendant risks, the financial systems of advanced economies have undergone a similar expansion already since the mid-1990s, and, as it turned out, not without risk (Figure 13). Clearly, common factors have been at work, such as the low-interest-rate environment and the search for yield. In the process, households have gained greater access to financial resources across Europe, especially through mortgage lending. The corporate sector too has rapidly increased its use of external financing in the form of credit and securities, and has done so more in advanced than in emerging economies.

Figure 13.Bank Credit to the Private Sector in Europe, 1995–06

(Percent of GDP)

Source: IMF, International Financial Statistics.

Financial innovation has been transforming the face of intermediation (Figure 14). Derivatives, structured finance, and securitization products have proliferated, allowing a broader menu of risk-return choices and altering the distribution of risks. In advanced economies, banks have increasingly embraced these innovations, producing synergies between bank- and market-based intermediation. In emerging economies, banks are expected to remain focused on their traditional intermediation function, but consolidation triggered by foreign bank penetration may quickly lead to the adoption of new products as well.

Figure 14.Financial Innovation in Europe, June 1995–June 2007

Source: European Securitization Forum; Bank for International Settlements, Quarterly Review, Table 23A.

1/ Notional principals in trillions of U.S. dollars.

2/ Billions of euros.

At the same time, financial integration in Europe has been proceeding at a sustained pace. The rising scale and persistence of cross-border capital flows have allowed current account deficits (and surpluses) to be larger and sustained for much longer than previously thought possible.

Moreover, gross holdings of assets and liabilities across borders have expanded even faster than net flows (Figure 15), with continuing cross-border consolidation and expansion of the banking system playing a key role.

Figure 15.Financial Integration in Europe, 1995–06

(Cross-border holding of gross assets; U.S. dollar index, 1995 = 100)

Source: Lane and Milesi-Ferretti (forthcoming).

Note: Excluding financial centers (Ireland, Luxembourg, Switzerland, and the United Kingdom).

The dynamic evolution of the financial system is generally having positive effects. Better access of households to the financial system is welfare improving, and allows a greater diversification and sharing of risk. Effective financial intermediation fosters efficient resource allocation and speeds its reallocation across sectors. And financial integration exports technology and skills and contributes to the better management of risks and lower macroeconomic volatility. However, benefits have not been distributed uniformly, reflecting the uneven state of development of financial systems across Europe and their still-limited cross-border integration. Hence, more flexible and more integrated financial services sectors could appreciably boost productivity in Europe.7

In addition, as brought home by the recent subprime mortgage turbulence, risks need to be well managed to reap the benefits of financial innovation. Even with less sophistication, financial systems may exacerbate rigidities and distortions, and raise the costs of policy mistakes. And increasing financial integration may propagate external shocks more strongly and quickly across borders.

Against this background, to enjoy the benefits of financial development without incurring excessive risk, advanced and emerging economies in Europe need to further strengthen their financial systems. Recognizing country differences in the level of financial development, the following chapters highlight three priority items on the reform agenda:

  • Chapter 1, “Tuning the Financial Systems of Advanced Economies,” examines what is needed for advanced economies to better exploit their financial depth for greater efficiency while safeguarding the resilience of the financial system. It looks at the economic benefits of financial systems that offer a wider range of financing options and discusses the reforms needed to move financial systems in that direction. At the same time, it identifies key risks posed by increasing financial sophistication and the required policy response.

  • Chapter 2, “Managing Rapid Financial Deepening in Emerging Europe,” focuses on how finance has been contributing to the economic convergence of emerging economies and which aspects of the financial system affect the sustainability of this process. It identifies financial sector policies to safely manage the boom associated with convergence and prepare emerging economies for a smooth reallocation of productive resources to the tradable sector.

  • Chapter 3, “Sustaining Financial Development in Emerging Europe,” takes stock of the financial system in emerging economies, identifies the factors that contribute to financial development, and lays out the unfinished policy agenda. It complements the chapter that precedes it, with many of its policy recommendations also pertinent for making rapid financial deepening a success.

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