Chapter 2 reviews 27 studies of the costs and benefits of higher capital requirements for banks, several of which report research conducted at or for official institutions.
Not a single one of these studies incorporates into its estimates a quantification of the gains that might be obtained from squeezing down the size of the financial sector by making activity more costly as a consequence of higher capital requirements.
A recent strain of literature implies that such gains could be obtained, because the financial sectors are typically already too large and are inhibiting growth as a consequence. An analysis of optimal capital requirements would thus be incomplete without considering the merits and implications of this recent “too much finance” literature.For nearly three decades, the dominant view on the role of the financial sector in economic development has been that greater financial depth facilitates faster growth. The Great Recession has shaken confidence in that view, however, because of the contributing role of high leverage and such financial innovations as collateralized subprime mortgage-backed assets and derivatives on them.[206] [207] Important research underlying the view that financial depth fosters growth includes the seminal study by King and Levine (1993), who used data for 77 countries for 1960-89 relating growth to financial depth as measured by the ratio of liquid liabilities of the financial system to GDP. They estimated that, controlling for per capita income and other influences, expected growth was 1 percentage point higher for economies at the top quartile of financial depth (average ratio of 0.6) than for economies at the bottom quartile (0.2).[208] Recently, however, prominent studies at major international financial institutions have argued that too much finance reduces growth. Apparently working independently (neither study reports the other in its references), Cecchetti and Kharroubi (2012) for the Bank for International Settlements (BIS) and Arcand, Berkes, and Panizza (2012) for the International Monetary Fund (IMF) find that when a quadratic term is introduced into the usual regression of growth on financial depth, it has a negative coefficient. As a consequence, once financial depth exceeds an optimal level, additional financial deepening reduces rather than increases growth. This chapter shows that these recent findings warrant considerable caution, however. For three of them, a negative quadratic term may be an artifact of spurious attribution of causality. I first show that correlation without causation could similarly lead to the conclusion that too many doctors spoil growth (for example). I then demonstrate algebraically that if the variable of interest, be it financial depth, doctors, or any other good or service that rises along with per capita income, is incorporated in a quadratic form into a regression of growth on per capita income, there will be a necessary but spurious finding that above a certain point more of the good or service in question causes growth to decline. As for the fourth study finding a negative impact of finance even in a linear form, both technical issues and the implausibility of the logical implication that the impact of more finance would be negative even at near-zero financial depth (e.g., in poor economies) are grounds for skepticism.