Productivity and the Financial Sector--What's Missing?

Author:Kronick, Jeremy
 
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Canada's financial sector over the last 15 years has lagged behind other OECD countries in its contribution to productivity growth. Improving the financial sector's productivity would boost not only the sector's performance but also the economy as a whole.

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THE STUDY IN BRIEF

Productivity improvement is considered the primary driver of economic growth in advanced countries because labour and capital are finite resources generating diminishing returns as their utilization increases. The financial services sector contributes to productivity growth in two ways: first, by improving its own output per worker and capital input (internal productivity) and, second, as a byproduct of the financial intermediation services it provides to the rest of economy (external productivity).

Using OECD aggregate and sectoral productivity data, and performing a series of novel calculations, my analysis indicates that Canada's financial sector over the last 15 years has lagged behind other OECD countries in its contribution to productivity growth. As well, Canada has experienced low aggregate productivity levels and growth rates over the same time period. Improving the financial sector's productivity would boost not only the sector's performance but also the economy as a whole.

This Commentary shows that part of the explanation for these relatively poor results include a policy approach that does not properly evaluate the link between competition and productivity, a regulatory structure that does not always reflect international best practices, and less efficient allocation of capital.

As a result, this Commentary recommends the following:

Remove barriers to the development of fintechs through a functional approach to regulation;

* Implement regulatory oversight that is proportionate to functional risk;

* Consider whether a more explicit productivity mandate is useful for Canadian regulators, in part based on the innovative ideas coming out of the UK's Financial Conduct Authority's focus on competition and productivity;

* Revise the Bank Act and Insurance Companies Act to allow more flexibility for banks and insurance companies to make substantial investments in fintechs and insuretechs;

* Since it is unlikely politically to have one (or twin) national financial-sector regulator(s) with legislative/ statutory powers, focus on achievable goals such as making clear what arrangements are in place between federal and provincial regulators for the sharing of market data related to, for example, the analysis of financial stability in capital markets, and strengthen links between market-conduct regulators across provinces and functions; and

* Reduce incentives for banks to lend to less productive residential mortgages by charging lenders mortgage-insurance premiums that reflect idiosyncratic risk beyond just loan-to-value ratios.

Canada's productivity growth lags behind many OECD countries--and this cannot be chalked up simply to a lower starting level. Given the financial services sector s importance to the Canadian economy, it is crucial to maximize its contribution to aggregate productivity growth. This Commentary explores how regulatory and policy changes could boost the financial services sector s contribution to productivity growth.

Productivity improvement is considered the primary driver of economic growth in advanced countries because labour and capital are finite resources generating diminishing returns as their utilization increases. (1) The financial services sector contributes to productivity growth in two ways: first, by improving its own output per worker and capital input (internal productivity) and, second, as a byproduct of the financial intermediation services it provides to the rest of economy (external productivity).

Using OECD aggregate and sectoral productivity data, and performing a series of novel calculations, my analysis indicates that Canada's financial sector over the last 15 years has lagged behind other OECD countries in its contribution to productivity growth. As well, Canada has experienced low aggregate productivity levels and growth rates over the same time period. Improving the financial sector s productivity would boost not only the sector's performance but also the economy as a whole.

So what can be done? Empirical literature suggests a clear link between productivity and government policy or regulation (see Levine 1997, 2005; De Serres et al. 2007; Lumpkin 2009; Competition Bureau 2017 and Heil 2017, who does a full literature review). Restrictive regulation and policy hinder productivity growth by leading to less competition for the delivery of financial services, a less attractive environment for foreign capital and distortions to the allocation of credit. So what can be said regarding these three areas in Canada?

On Canada's financial services competitiveness, the evidence is mixed. However, Canada lags behind other OECD countries with respect to the development and growth of technology and so-called fintechs and insuretechs in particular. In a 2017 study, the Competition Bureau points to barriers to entry in explaining low financial services technological innovation. Two related examples from this study stand out. First, regulatory uncertainty in the retail-payment space increases the risks and costs to nascent, unregulated firms trying to enter the market. Second, regarding lending, technology-based financing platforms are regulated the same way as established bricks-and-mortar institutions, despite posing very different risks to the financial system.

When it comes to attracting foreign capital, data on foreign direct-investment net inflows show that Canada and many other small open-economy OECD members are consistently losing out to the larger US and UK economies, as well as to the Netherlands. Among other things, Canada needs to ensure its policies and regulatory structures create an attractive environment for foreign capital. In this way, Brexit and the uncertainty surrounding the future US role in global markets present an opportunity for Canada.

Lastly, on efficient allocation of capital, data at the sub-sectoral level suggest that banks--by far our largest lenders--lag behind our developed world peers in business lending as a percent of GDP. Demand and supply reasons both help explain why this might be true, but lagging productivity numbers suggest we should look at the underlying regulatory and policy environment.

So what can be done to improve these three areas?

More Competition

Removing barriers to entry would help increase competition in the financial sector. One important suggestion coming out of the Competition Bureau's study is that the regulatory burden should focus on the function of the entity, and not the entity itself, with rules varying accordingly. If a particular function's failure is unlikely to pose a risk to the system, oversight need not be as strict as in the case where failure puts the system in jeopardy. The idea here is to ensure a level playing field for smaller players to innovate.

Also critical for the competition and productivity link is an evaluation of what other jurisdictions are already doing. The UK's Financial Conduct Authority (FCA) has put in motion some ideas worth following. For example, its mobilization program for prospective entrants into the banking sector separates essential regulatory requirements from the non-essential, thereby providing new entrants with operational authorization with restrictions on certain activities while the regulator performs a further evaluation. Other interesting ideas worth following include the UK's Innovation Hub, which incorporates an evaluation of how to adapt the regulatory framework to generate continued innovation while protecting customer interests.

Lastly, legislative restrictions can also hinder scaling up the usage of new technologies. Canada's Bank Act and Insurance Companies Act restricts banks and insurance companies from making substantial investments in fintechs that--even if they have financial services as their core functions--perform operations outside the financial-services space. (2) Consideration should be given as to whether more flexibility is required as long as the fintechs core function is delivering financial services. (3)

Attracting Foreign Direct Investment

Since the 2008 global recession, many countries have agreed on the need to establish international best practices in financial regulation. These best practices create a more efficient, and less costly, set of rules and...

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