Effects of Financial System Size and Structure on the Real Economy: What do we know and what do we not know?

United Nations Environment Programme (2015)

This paper reviews the banking and finance literature and seeks to summarize the current state of knowledge on the relationship between financial system characteristics and real economic outcomes.1 A particular focus is the influence that these characteristics (financial system size, financial market concentration, system diversity, size of institutions, 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 . Financial system structures and cultures evolve over decades and are path-dependent. They cannot be changed overnight, but are shaped by policies and regulations. The Glass-Steagall Act of 1933, which separated the activities of commercial banks, investment banks, securities firms and insurance companies in the US, as well as its repeal through the Gramm-Leach-Bliley Act of 1999 are prime examples of how legislation can profoundly change the structure of financial systems – for the better or worse. Steps taken to address financial stability concerns over global systemically important banking organizations by requiring capital surcharges, among others, are another example of public intervention that may shape market structures Questions over the optimum shape and size of the financial system are therefore of real and practical importance. Given that the findings of the literature are partly ambiguous and sometimes contradictory, many questions remain open and await further empirical investigation. The paper hence tries to take a balanced and cautious approach to adequately summarize what can be learned from the existing literature, and highlight where the evidence remains patchy or vague.