EUROPE - The positive relationship between financial markets and economic growth has limits, the deputy governor of Norway's central bank has said.

Offering his views on a paper by the European Central Bank's (ECB) Frank Smets, head of its research department, Norges Bank deputy Jan Qvigstad said he broadly agreed with Smets' conclusions and that it fell to regulatory bodies to determine where these limits were.

Speaking at a conference on the welfare effects of financial innovation, he highlighted the importance of a strong regulatory system and pointed to a new committee launched at Norway's Pension Fund Global in the wake of the financial crisis.

"The committee must sanction every financial instrument before it can be used for investments," he said.

"As a result, the number of instruments available to the fund's managers has been significantly reduced, in particular fixed income and derivatives instruments, since the committee was established."

He said neither a higher credit volume nor all credit allocations made by investors were always "socially optimal" if they were made with the most profit for individual investors in mind.

"This is one basic reason why financial markets are and should be regulated," Qvigstad said.

"The interaction between asset prices and credit volumes may create a spiral where both asset prices and credit rise to unsustainable levels.

"The use of financial innovations to create more credit with the result that it fuels such a spiral is clearly not a socially desirable use."

The deputy governor pointed to stricter regulation introduced in the wake of Norway's banking crisis in the 1990s as proof that certain regulation can be beneficial, as it stopped the country's financial institutions from gaining exposure to sub-prime mortgages.

However, he said some smaller, local savings banks in Norway nonetheless sold sub-prime products to municipalities without fully understanding the instruments' risks.

Referencing the current chair of the UK's Financial Services Authority and the Bank of England's deputy governor for financial stability, he said: "Both Adair Turner and Paul Tucker have raised doubts about the social value of some of these new instruments. I quite agree - restrictive regulation of some of these instruments could contribute to stabilising financial markets."

He argued that regulators had the duty to guarantee that any instrument traded in "sufficient" quantities be transparent enough to serve as a useful risk-shifter.

Referring back to Smets' paper, he said: "In short, I agree with Frank that the positive relationship between financial markets and economic growth has its limits.

"The difficult question is naturally where these limits are. It will be hard for a regulator to draw the line. But there are few other candidates for doing it."