This essay examines the assumption, that a large financial sector consistently benefits the real economy. It has been acknowledged that the financial sector, not to mention some of its components, may sometimes become too large. It can end up posing a threat to both economic and financial stability, so the essay develops our understanding of where the optimal threshold lies. The regulatory measures and addresses the problem best: namely, preventing the financial industry from becoming too large and taking excessive risks, leading to the emergence of bubbles, and to the production of complex and dense financial instruments. And we should avoid imposing restrictive measures that will prevent the financial sector from channelling resources towards productive opportunities. In doing so, we need to make sure that our measures target non-traditional financial markets as much as traditional banking, in order not to encourage regulatory arbitrage and a return to “business as usual” outside the auspices of regulators.

Financial innovation can impose a threat to both economic and financial stability, so we have to enhance our understanding of where the best possible threshold lies in determining the size of the financial systems. There is an emerging consent that while financial markets are generally conducive to economic growth, in the run-up to the recent crisis they were operating on an extreme scale. This essay will converse around four main points: firstly that efficient financial markets enhance growth, however, if they grow “too large,” then they may lead to a misallocation of resources and cause costly crises. Secondly, facts will be presented showing that in the build-up to the crisis, the size of the financial sector outgrew its trend. Thirdly, identification of some of the main reasons why this occurred and argued how to avoid that such imbalance again. To this end, regulation and supervision can play an important role. Lastly, while ensuring that the financial sector does not grow beyond its optimal size, the new regulatory framework should not reach the point of financial domination.

The knowledge from recent industrialised countries has relatively claim, that deeper financial markets improve economic efficiency, lead to a better allocation of productive capital, and increase long-term economic growth. However, the frequent financial shocks associated with dynamic financial industries, and in particular the recent economic crisis, also highlight the role large financial markets play in downside risk. This mutually shows that there is a trade-off between a highly vibrant financial sector and the overall stability of the financial system. (Ranciere, R., Tornell, A., and F. Westermann, 2008)