External publications

Effects of financial system size and structure on the real economy: what do we know and what do we not know?

Volz, Ulrich
External Publications (2015)

Geneva: UNEP Inquiry into the Design of a Sustainable Financial System (Inquiry Working Paper 15/10)

This paper provides an overview of the findings in the empirical economics and finance literature on the effects that various financial system characteristics have on real economic outcomes. Starting with a brief overview of the nexus between the deepening of financial systems and economic growth and development, the paper reviews to what extent financial market concentration, system diversity, the size of institutions, and the type and mandate of financial institutions have on outcomes such as access to finance by firms, the cost of finance, financial stability and the provision of sustainable finance. Although the empirical evidence on various relationships is mixed, there appears to be relatively robust empirical evidence that: financial deepening promotes economic development only up to a certain size of financial systems relative to GDP and that ‘too much finance’ may actually harm economies; that smaller banks tend to have more stable lender-borrower relationships than large banks and that smaller banking institutions extend more credit to SMEs; that market-based banking provides less financing to the real economy than traditional banking while being more prone to financial crisis; and that more concentrated banking markets are less cost efficient. Overall, it seems fair to conclude that more diverse financial systems with moderate market concentration, a mix of small and large institutions and a combination of different bank and non-bank financial institutions seem to better cater the needs of the real economy than financial systems with a high degree of market concentration dominated by large institutions.