Too Cold, Too Hot, or Just Right? Assessing Financial Sector Development Across the Globe

This paper introduces the concept of the financial possibility frontier as a constrained optimum level of financial development to gauge the relative performance of financial systems across the globe. The frontier takes into account structural country characteristics, institutional, and macroeconomic factors that impact financial system deepening. The paper provides an empirical application for this framework in the form of a benchmarking exercise, and makes the following observations:

• Market-enabling and market-developing policies, such as lower restrictions on lending, limited government ownership of banks, and strong creditors rights, can spur development of financial systems;
• Promoting greater competition in banking can enhance financial deepening, even if the system becomes more concentrated;
• Stronger supervisory and regulatory frameworks can facilitate financial deepening;
• Existence of potential and emerging stability threats can be monitored if policymakers implement appropriate market-harnessing policies;
• General equilibrium models with financial intermediaries can be developed to serve the important role of quantifying the impact of policies and for evaluating the underlying trade-offs.