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4/2007 |
| Recent financial market turbulence has once again given rise to intensive discussions and exchange of opinions on various aspects of financial market behaviour. This has covered, in particular, the optimality of existing regulatory frameworks to provide the appropriate incentives for financial market participants to behave prudentially and to monitor their risk exposures in ways that do not compromise the stability of the financial system. Interesting and fundamental as these questions related to incentives for excessive risk taking are, a related and equally fundamental issue is how resilient the financial system is to extreme, particularly adverse macroeconomic shocks. Interestingly, recent research suggests that there is potentially a very close link between economic growth and financial fragility, where the latter manifests itself in the form of greater incidence of financial crises. |
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| The key to understanding this relationship ties in with credit market imperfections, which, in turn, originate from informational asymmetries in credit market relationships. More specifically, the underlying credit market imperfection, for example contract enforceability, generates borrowing constraints, bottlenecks and low growth. Measures taken to mitigate or even to overcome these imperfections may encourage systemic risk taking and increase investment. This results not only in higher growth but also greater incidence of crises. This is a very interesting line of thought, which, however, should not be taken to mean that financial liberalization necessarily results in crises or that financial crises are good for growth. Nevertheless, it does suggest that high growth paths are associated with the undertaking of systemic risk and with the occurrence of occasional crises, at least in countries with weak institutions. Furthermore, in this context it is often argued that the type of financial environment having the potential of generating risky growth path can be found in middle income economies that do not operate sufficiently strong institutions to manage or solve the informational frictions that characterize financial market behaviour. |
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| However, although the contribution of insufficient firm net worth to severely binding borrowing constraints seems to be less of a problem in more mature and richer economies, informational frictions intervening financial market relationships are not non-existent there either. Risky growth paths, hence financial fragility, can conceivably be an outcome of a different type of mechanism. Most interestingly, the combination of expectational biases, in the form of either optimism or favourable news shocks related to future productivity and income prospects, and informational asymmetries in credit relationships could in principle involve agents taking insolvency risk and place the economy on a risky growth path increasing the likelihood of an adverse future systemic event in the financial market. This possibility brings us back to the question of the resilience of the financial system to extreme adverse shifts in macroeconomic fundamentals generated by pessimistic shifts in agents' expectations. We have too little general equilibrium knowledge of the possibility of such scenarios, which, by itself, should motivate researchers to put more effort on this issues in their future research efforts. |
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| Jouko Vilmunen |