Countries with relatively large financial sectors, such as Canada, suffer a drag on growth as a result, suggests new research.

A new paper published Tuesday by two economists with the Bank for International Settlements (BIS) examines how financial development affects aggregate productivity growth, and concludes that financial development “is good only up to a point, after which it becomes a drag on growth”. And, it finds that a fast-growing financial sector is also detrimental to aggregate productivity growth.

The paper notes that the assumption that finance is good for growth has underpinned arguments for financial deregulation. Yet the financial crisis has recently led some academics and policymakers to question that assumption.

And, the BIS paper finds that, “… as is the case with many things in life, with finance you can have too much of a good thing.” While a growing financial sector helps growth at lower levels, at some point, more banking and more credit becomes are associated with lower growth.

“At first, these results may seem surprising. After all, a more developed financial system is supposed to reduce transaction costs, raising investment directly, as well as improving the distribution of capital and risk across the economy,” it says.

However, the paper notes that the financial industry competes for resources with the rest of the economy. “The result is that people who might have become scientists, who in another age dreamt of curing cancer or flying to Mars, today dream of becoming hedge fund managers,” it says. Only after the industry busts, does the size of the overinvestment and excess employment become obvious.

The research finds that when the financial sector represents more than 3.5% of total employment, further increases in financial sector size tend to be detrimental to growth. Canada, Switzerland, Ireland have all exceeded this point, it notes.

The gain in GDP-per-worker if the financial sector were to shrink back to the growth-maximizing point, is estimated at 1.3 percentage points for Canada, 0.7 for Switzerland, and 0.2 for Ireland.

“Financial booms are not, in general, growth enhancing. This evidence, together with recent experience during the financial crisis, leads us to conclude that there is a pressing need to reassess the relationship of finance and real growth in modern economic systems. More finance is definitely not always better,” it concludes.