Too Much Finance?
Chapter 6 addresses the recent literature purporting to identify a negative influence of high levels of financial intermediation on growth. If one believes that the financial sector is already too large in the major economies and is suppressing potential growth, the appropriate measure of the benefits of higher capital requirements would need to incorporate an economic gain from the fact that they would tend to reduce the size of the financial sector.
The issue is thus highly germane to the policy debate on capital requirements, although it is virtually absent from the capital requirements literature and has instead proceeded on a separate path in the cross-country growth literature.However, the analysis of chapter 6 suggests that the too much finance studies may be mistaking correlation for causation. Across countries, the depth of financial intermediation increases as per capita income rises. But the rate of growth per capita tends to decline as per capita income rises, reflecting the process of convergence. One could mistakenly conclude as a result that “too many doctors” or “too many telephones” or “too much R&D” cause growth to decline, as rising levels of these variables per capita also tend to accompany higher per capita incomes. For the purposes of identifying optimal capital requirements for banks, evidence of too much finance is insufficiently robust to welcome shrinkage of financial intermediation as a side benefit of raising capital requirements further.
Framing Issues
Several key contextual issues should be kept in mind in interpreting the results of this study.
Lender of Last Resort and Resolution of Large Banks after Dodd- Frank
The Dodd-Frank Act of 2010 imposed new constraints on the ability of the Federal Reserve to act as the lender of last resort. At the same time, it emphasized and created a special framework for the resolution (expedited bankruptcy workout) of large banks. It gives the Federal Deposit Insurance Corporation (FDIC) Orderly Liquidation Authority (OLA), which it implements through the Single Point of Entry (SPOE) approach. Under this approach bank holding companies would become effectively bankrupt even as their subsidiaries would be kept in regular operating condition. Because of the possibly narrower scope for crisis response than in the Great Recession, and in view of the possibility that resolution of the largest banks under the new arrangements could well be far less seamless and more traumatic to the system than assumed under OLA and SPOE, Dodd-Frank increases the importance of preventing crises through the adequate capitalization of banks.