Global Competitiveness Report 2015 Home

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.

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73 This characterization is based on Tobin’s 1984 definition of financial efficiency. In more technical terms, these characteristics are (1) information arbitrage efficiency, (2) fundamental valuation efficiency, (3) full insurance efficiency, and (4) functional efficiency.
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74 Omitted in the neoclassical growth model, the role of financial markets for economic growth was raised by Schumpeter 1911, Goldsmith 1969, and King and Levine 1993. The importance of this issue rests on the question of causality: is financial intermediation the result of economic growth, or does it also spur economic growth? Lucas 1988 argued that finance merely responds to changing demands from the “real sector.” However, more recent evidence suggests that financial development precedes economic growth. For example, King and Levine 1993 show a strong relationship between the initial level of financial development and growth, and Rajan and Zingales 1998 show that industrial sectors that are relatively more capital intensive develop much more in countries where financial markets are already developed.
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75 Levine 2005.
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76 Acemoglu and Zilibotti 1997 show that, since large investment projects require a large amount of capital, in the absence of financial institutions that collect and allocate capital it would not be possible to finance such large projects because there could be no single investor with sufficient capital or willing to invest in such projects.
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77 King and Levine 1993; Norden 2015.
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78 Galetovic 1996; Blackburn and Hung 1998; Morales 2003.
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79 Diamond 1984; Bencivenga and Smith 1991.
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80 Greenwood and Smith 1997.
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81 On the concept of “too large,” see Arcand et al. 2012. On risk taking, see Beck 2011. On political capture, see Johnson 2009.
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82 The concept of hysteresis has been discussed in the context of the macroeconomic environment since, although financial crises are produced in the financial sector, when they take place they impact the stability of the economy at large.
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83 Macro-prudential policies have been defined as the use of primarily prudential tools (i.e., caps on loan-to-value ratios, limits on credit growth and sheets restrictions, capital and reserve requirements and surcharges, and taxes) to limit systemic risk—the risk of disruptions to the provision of financial services that is caused by an impairment of all or parts of the financial system, and that can cause serious negative consequences for the real economy. For further discussion, see IMF 2013 and Claessens 2014.
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84 The discussion about how to best implement regulation is therefore outside the scope of our analysis and we assume that the regulation is effective as long as financial markets are deep and stable.
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