The effects of prudential regulation, financial development and financial openness on economic growth

Focus

This paper studies how prudential regulation, financial development and financial openness can affect economic growth. It adopts both a theoretical and an empirical perspective.

Contribution

The contribution of the paper is twofold. First, it provides an analytical overview of the various channels through which prudential regulation can affect economic growth. Second, it conducts an econometric analysis, using data for 64 countries over the period 1990-2014. These cover the effects on economic growth of prudential policies, financial development, and the degree of financial openness, both separately and jointly. In doing so, the paper goes beyond existing studies, whose focus has been more narrowly defined in terms of the effects of prudential policies on growth, without accounting for the fact that financial development or financial openness could also significantly affect this relationship.

Findings

The results show that growth may be promoted by prudential policies that seek to mitigate financial risks to the economy. At the same time, financial openness tends to reduce the growth benefits of these policies. This may reflect either greater opportunities to borrow abroad or increased scope for cross-border leakages in regulation.

Abstract

This paper studies the effects of prudential regulation, financial development, and financial openness on economic growth. Using both existing models and a new OLG framework with banking and prudential regulation in the form of capital requirements, the first part presents an analytical review of the various channels through which prudential regulation can affect growth. The second part provides a reduced-form empirical analysis, based on panel regressions for a sample of 64 advanced and developing economies. The results show that growth may be promoted by prudential policies whose goal is to mitigate financial risks to the economy. At the same time, financial openness tends to reduce the growth benefits of these policies, possibly because of either greater opportunities to borrow abroad or increased scope for cross-border leakages in regulation.