Financial market efficiency
An efficient financial market is characterized by prices that reflect all available public information, a lack of bubbles, the capacity to manage risks through hedging, and the tendency to allocate savings to their most productive investment uses.73 Such efficiency is achieved only when financial markets are both developed and stable.74 Although these concepts are already defined in the current GCI, the measurement of some of their elements has improved and the 2008–09 financial crisis has reconfirmed the importance of achieving stability. Both these developments will be better reflected in the updated version of the Index.
Financial development is defined here as the depth of the intermediation system, including the availability and liquidity of credit, equity, debt, insurances, and other financial products. Given financial stability, financial development promotes productivity in four main ways.75 First, developed financial markets enable risks to be pooled. This allows for investments in larger and riskier projects that tend to be more productive: without the capacity to pool risks, individual investors would prefer smaller and lower-risk but also lower-return projects.76 It also makes it easier for individual investors to diversify, improving access to finance for small- and medium-sized enterprises (SMEs), which tend to be more risky than larger firms but also more dynamic and innovative, increasing a country’s productivity.77
Second, the development of financial markets improves the allocation of capital to entrepreneurs and investment opportunities by enabling investors to find information about investment opportunities that have the best chance of improving productivity.78 Third, large financial intermediaries are more able than individual investors to develop long-run relationships with the firms to which they lend, and monitor those firms, incentivizing borrowers to invest the borrowed money productively.79 And fourth, by providing an efficient payment system, the banking sector reduces the transaction costs associated with the exchange of goods and services, which generates productivity gains.80
Without sound financial institutions and stability, however, excessive financial development can lead to costly financial crises. Rousseau and Wachtel (2011) show that the financial crises neutralized the growth-enhancing effect of financial deepening that had taken place in previous periods. Financial sectors that grow “too large” relative to the rest of the economy appear to be associated with risks of financial instability, through promoting excessive risk taking and producing political capture.81
Given the possibly permanent effects that financial crises may have on the growth trajectory of an economy,82 policymakers have started to consider preventive macro-prudential policies;83 however, the debate on how such policies should balance the development and stability of financial sectors is still ongoing.84 Therefore the updated GCI will focus on improving the measurement of the concepts of financial development and stability, but will not provide indications of what specific banking regulations would be optimal.