16 February 2010

Thoughts on financial liberalisation

Lord Turner's speech at the 14th CD Deshmukh Memorial Lecture in Mumbai examines the costs and benefits of financial liberalisation. The concluding section highlights the practical problems facing policy makers:
And more generally, the sensible conclusion on the overall benefits of financial intensity and financial liberalisation, would seem to be that it is valuable up to a point in some markets, but not in all markets and not limitlessly   There is a strong case that the development of a modern financial system, combining banks and corporate bond and equity markets, retail and wholesale insurance services is strongly favorable for economic growth. Walter Bagehot argued in Lombard Street that the sophistication of the nineteenth century British banking system enabled the UK more effectively than some continental European countries to mobilize savings which might otherwise have lain dormant, and there are a number of studies which illustrate either cross sectional or time series correlations between the development of basic banking and financial systems and economic growth.26  It is highly likely that in India financial deepening, in the sense of the extension of basic banking services and sound credit extension to sectors of the population currently largely outside the banking system, would be positive for welfare and growth.

Well developed corporate bond markets which enable non-bank debt finance to flow in a simple transparent form to corporate borrowers and can play a major beneficial role in financing investment. And competition in basic banking services, including competition by global banks with transferable skills and willing to make long term commitment to a country is likely to prove a beneficial form of liberalisation.

But we cannot extrapolate from the beneficial impact of financial deepening and sophistication up to a point, and assume that still more financial deepening, innovation and complexity is limitlessly beneficial. That if a good basic banking system benefits a country so too does ever more active trading in all categories of derivative. And it is possible that beyond some point, increased financial intensity, measured by the many sorts of indicators which I considered earlier, may cease to deliver positive benefits or indeed have negative effects. 

We do not know for sure and the truth is likely to differ between different markets. The problem for regulators and central bankers is that this conclusion does not provide us with nice easy answers on which to base policy. It might be optimal simultaneously to seek to make one market (say spot equities) more liquid and more efficient in a technical sense, while in another market (eg, complex bi-lateral CDS contracts) to be indifferent if capital requirements and collateral management rules result in the market dwindling in size.  Such a complex conclusion will make many people uneasy. It is much easier to proceed in life on the basis of a clearly defined and simple credo which provides the answer to all specific issues. But it is more likely to produce good results if we live in the real world of complex trade-offs and of relationships which are true up to a point.

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