While finance is an integral part of the world’s economies, too much finance may hamper economic growth and worsen income inequality, according to the report, “Finance and inclusive growth: How to restore a healthy financial sector that supports long-lasting, inclusive growth?” released Wednesday by the Organisation for Economic Cooperation and Development.

“The global financial crisis has raised deep questions about the influence of finance on economic activity and the distribution of income,” OECD chief economist Catherine L. Mann said in a press release. “What our research has shown is that avoiding credit over-expansion and improving the structure of finance can lead to improvements in both economic and social well-being.”

An over-reliance on bank lending — versus other types of market-based finance, such as bonds and equities — can stymie long-term growth because financial institutions tend to misallocate capital and fund investments with low profitability, the authors wrote.

Moreover, too much lending can magnify the cost of implicit guarantees for too-big-to-fail banks; draw highly-talented workers away from sectors with greater productive potential; and generate boom-bust cycles.

A rise of bank credit by 10% of gross domestic product translates into a GDP growth rate that is 0.3 percentage points less than would otherwise be the case, according to the OECD. Greater levels of stock market financing, on the other hand, are still seen to boost growth. An increase in stock market capitalization by 10% of GDP is, on average across OECD and G20 countries, associated with a 0.2% rise in GDP growth.

The biggest drag on economic growth are institutions financing too many residential mortgages.

“Whereas financial expansion can help low-income individuals fund their projects and home ownership, it tends more to drive inequality,” the authors wrote. “People with higher incomes can and do borrow more than those on lower incomes, and the benefits from growth in stock markets accrue more to high-income households who tend to have more wealth in equity.”

Income inequality is further exacerbated because the financial sector pays high wages, which are above what employees with similar profiles earn in the rest of the economy, the OECD contended. In Europe, financial sector employees make up 20% of the top 1% earners, but are only 4% of overall employment.

Reforms suggested by the OECD include:

  • Greater use of “macro-prudential” instruments to prevent credit over-expansion, and the supervision of banks to maintain sufficient capital buffers.
  • Measures to reduce explicit and implicit subsidies to too-big-to-fail financial institutions, through break-ups, structural separation, capital surcharges, or credible resolution plans.
  • Reforms to reduce the tax bias against equity financing.

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