Policymakers face new challenges as financial systems evolve

• Author: Subir Lall/Roberto Cardarelli/Irina Tytell
• Position: IMF Research Department
• Pages: 283

Page 283

Financial systems in advanced countries have undergone remarkable changes in recent years, driven primarily by improved technology and deregulation. But considerable differences remain across countries, and these differences have important effects on economic cycles, according to the IMF's September 2006 World Economic Outlook (WEO).

The study, published as Chapter IV of the WEO, uses a unique new index (see chart) to distinguish between financial systems that rely heavily on arm's length transactions (in which the parties rely on publicly available information) and traditional arrangements that depend on longer-term borrower-lender relationships.

In general, financial intermediation is now driven more by arm'slength transactions, but there are important differences in the pace at which changes are taking place.

Financial systems in Australia, Canada, the Netherlands, the United Kingdom, and the United States are increasingly characterized by arm's length transactions, whereas relationship-based finance continues to play a key role in most of Europe and Japan.

Implications for economic cycles

The WEO analysis shows that households and firms react differently to changes in the economic environment depending on the type of financial system. Their different reactions have important implications for economic cycles, asset price changes, and economies' responses to opportunities created by globalization and to new technology.

Households in countries with more arm's length systems, for example, have easier access to financing and are better able to smooth consumption spending, but they are also more vulnerable to asset price declines. For example, U.K. and U.S. households can borrow against the rising value of their homes-thus boosting consumption and supporting strong growth. But this borrowing also increases debt and leaves these households more vulnerable to rising interest rates and a downturn in asset prices.

There are clear differences, too, in how the two types of financial systems respond to technological innovation and globalization pressures. Financial systems that depend on relationship-based transactions are slower to respond to new growth opportunities and tend to favor existing industries.

Arm's length systems find it easier to reallocate resources to new and more vibrant industries, with substantial benefits for productivity growth. This finding has...