Too much bank lending slows economic growth, OECD says

Thursday 18th June 2015

The growth of bank lending has gone too far and has become a drag on economic growth, says ground-breaking economic analysis by the Organisation for Economic Cooperation and Development.

The Paris-based 'rich countries' club', covering 34 nations including New Zealand, published the new findings overnight, saying that for every 10 percent of gross domestic product increase in bank credit, there was a corresponding 0.3 percent reduction in annual GDP growth rates.

It suggests that while widespread financial deregulation over the past 40 years had initially boosted economic growth rates, "it appears to have gone too far, weakening economic fundamentals."

It also found there was a larger reduction in economic growth after the 2008 global financial crisis in countries where banks were bailed out as 'too big to fail' than in countries where banks faced at least some losses as a result of the meltdown predominantly felt in the North American, European and Japanese financial sectors, where credit expansion and the growth of poorly understood financial innovations caused what is now referred to as the Great Recession, which is still under way in some OECD countries.

New Zealand and Australia largely escaped the worst effects of the GFC because its banks were not heavily involved in the kinds of financial products that saw bank bailouts and the disappearance from the global stage of banking houses such as Lehman Brothers and Bear Stearns, which had previously been assumed to be rock-solid.

"Finance is a vital ingredient of economic growth, but there can be too much of it," the OECD study says. "Over the past 50 years, credit by banks and other institutions to households and businesses has grown three times as fast as economic activity.

"At these levels, further expansion is likely to slow long-term growth and raise inequality."

The paper suggests bank financing also crowds out more growth-producing uses for money, including stock-market equity raising.

"More stock market financing boosts growth in most OECD countries," the report says, along with findings that "credit is a stronger drag on growth when it goes to households rather than businesses."

While there is short-term harm to economic growth when measures are taken to restrict the growth of bank credit, "reforms to make the financial sector more stable can be expected to boost long-term economic growth and improve economic inequality."

The banking sector contributes to inequality both because higher income earners derive greater benefits from credit-financed activity than people on low incomes and because of its high wages, compared to other industries.

"This premium is particularly large for top income earners," the study notes, with bank sector workers in Europe making up 20 percent of the top 1 percent of income earners, while the sector provides only 4 percent of total European jobs.

"The strong presence of financial sector workers among top earners is justified as long as very high productivity underpins their earnings. However, detailed econometric investigations find that financial firms pay wages well above what employees with similar profiles earn in other sectors."

There was also an observable relationship between high banker pay and "deeper credit intermediation, a finding consistent with the possible presence of rent sharing", while lack of finance sector competition could also explain high wages.

"In particular, subsidies associated with public support such as too-big-to-fail guarantees can accrue to employees with bargaining power through higher wages, consumers through cheaper and more abundant borrowing, as well other stakeholders involved in banks' business.

"Simulation analysis indicates that credit over-expansion slows income growth for most of the population, even though top income earners benefit from it."

Public trust in the banking sector would improve if there were restrictions on "pay that rewards short term success without taking account of long term consequences."

The study suggests much progress has been made since the GFC to require banks to hold more capital to improve their buffers in the event of financial sector volatility, but proposes that 'too-big-to-fail' banks should be forced to break up into smaller pieces, be structurally separated, and be subject to capital surcharges and "credible resolution plans".

"Reforms to reduce the tax bias against equity financing" are also required to reduce the bias towards debt financed growth, "which leads to too much debt and not enough equity", which in turn slows growth and "compromises investments for the future."

(BusinessDesk)

BusinessDesk.co.nz

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