Finance, Growth and Fragility:
The Role of Government
Finance and growth – non-linearities and channels
The financial depth frontier
What explains cross-country variation in financial
development?
Policies
Politics
History
What do we learn from this
Some words on the banking union
Who gets credit? And does it matter? Only enterprise component of bank lending robustly linked to
economic growth
Lending to households has no significant effect on growth (consistent with ambiguous effect predicted by theory)
Increasing importance of household credit in total credit in high-income countries explains partly why the impact of overall bank lending in these countries is insignificant.
Credit to enterprises, but not to households explains pro-poor effect of finance
Beck et al. (2012)
Channels of pro-growth and pro-poor finance
Productivity growth more than capital accumulation
Pro-poor effects: Access to credit? Not necessarily –
differential effects across different groups (recent work by
Banerjee et al.)
Pro-poor effects: important indirect effects
Allocation effects
Labor market and migration effects
Evidence from Thailand, U.S. and India
What kind of financial sector – financial
intermediation vs. financial center view
Financial intermediation or facilitator view
Finance as “meta-sector” supporting rest of economy
Financial center view
One of many sectors
Nationally centered financial center stronghold based on
relative comparative advantages such as skill base, favorable
regulatory policies, subsidies, etc.
What kind of financial sector – financial
intermediation vs. financial center view
Private Credit to GDP vs. Value added of financial sector in GDP
Long-term: intermediation matters, not sector size
Higher growth and lower volatility
Short-term: size is associated with higher volatility in high income countries, intermediation with higher growth in low-income countries
Kneer (2012): evidence for brain drain from skill-intensive industries to financial sector
Implications for post-crisis regulatory reform
Back to basics!
Focus on intermediation
It’s about services, not specific institutions
Over-reaching of financial sector due to financial safety net
subsidy
Financial safety net reform
Start with resolution
But what explains cross-country
variation in financial development?
Policies: cross-country variation in macroeconomic policies and
institutional framework explains cross-country variation in
financial depth and penetration
Politics: Conflicts between different stakeholder groups
determines structure and development of financial sector
History: political history and colonial heritage determines
institutional framework underpinning financial system
development
All of the above?
Financial possibility frontier – a framework
Market frictions
Transaction costs
Idiosyncratic and systemic risk
State variables:
Invariant in the short-run and impose an upper limit on financial deepening
Socio-economic factors (income, market size, population density, age dependency ratio, conflict)
Macroeconomic management and credibility
Contractual and information frameworks
Available technology and infrastructure
Taxonomy of challenges Frontier too low
Structural variables
Institutional variables
Market-developing policies
Financial system below frontier Lack of competition
Regulatory constraints
Demand-side constraints
Market-enabling policies
Financial system beyond frontier Incentive compatible regulatory framework
Also on demand-side
Market-harnessing policies
Benchmarking model FDi,t = Xi,t+ i,t
X = log of GDP per capita and its square
log of population
population density
age dependency ratio
Offshore center dummy
Transition economy dummy
Oil-exporting country dummy
No financial sector policy variables included
A positive role of government
Market-developing policies: focus on state variables macroeconomic stability improvements in contractual and informational framework institution building long-term process
Market-enabling policies: help maximize access given state variables Competition Regulation Coordination failures, first-mover disincentives
Market-harnessing policies: prevent financial system from moving to imprudent outcome beyond frontier Incentive compatible financial safety net that minimizes moral hazard risk Disclosure requirement, predatory lending regulation and education to prevent
individual overborrowing
This is the “policy-view” of financial deepening
Conflict between interest groups
Example: financial safety net
Bankers Equity as put option; participate more in up-side risk; tend to aggressive
risk taking
Depositors Care about safety of their savings Large depositors might exert market discipline
Safety net managers (regulators) Have “official” task to avoid aggressive risk-taking Risk of political or regulatory capture
Safety net owners (ultimately tax payers) Care about costs Have often no say
Bank resolution – feasibility vs. interest groups
Market Discipline
Minimizing
externalities Bail-out
Open bank assistance
Liquidation
Resolution possibilities frontier
Preferences
Purchase &acquisition
Examples for political influence Credit registries….
How long does it take to construct one?
Negative vs. positive information (guess what the bankers want)
How much competition?
Franchise view – competition-fragility
Or: incumbents protecting rents
Housing finance
My house, my castle
Or: short-cut to reduce inequality
Political and regulatory capture
Different views of government’s role Public interest view
Focus on market failures to help overcome two main agency problems Borrowers vs. banks
Depositors vs. banks
Critical assumption: government is competent and maximizes society’s welfare
Need government for “financial infrastructure”: macroeconomic stability, institutions etc.
Role for government beyond that?
Private interest view Government is arbiter and interested party – conflict of interest Conflicts between different coalitions of stakeholders Implements policies favoring incumbents, against new entrants Third agency conflict in banking: bank stakeholders vs. government
All about politics?
Source: Quintyn and Verdier (2012)
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Politics and finance Important variation over time:
Relative power of stakeholders change
Technology
Outside shocks
“Outside shock” Argentina, Brazil – macroeconomic stability required closing state bank leak
But: other constraints continue
Transition economies: Banking crises in 1990s forced countries to look outside their countries for bank
capital
Foreign bank entry
Helped cut links between banks and incumbent, (former) state-owned enterprises
Technology: Invention of ATM triggered end of branch banking in US
Cell phone banking – M-Pesa – changed banking landscape in Kenya
Legal institutions and finance
Property right protection and contract enforcement at the
core of finance
Inter-temporal contracts – jump into uncertain future.
Countries with more effective legal institutions have higher
levels of financial deepening
Also holds within countries after legal reform – e.g., Brazil,
India
Law and finance view
Napoleonic Code
colonies
• State power
• Rigidity
Common law colonies
• Private property
• Adaptability
European
colonization
Legal institutions
supporting private
property rights
Legal institutions
thwarting private
property rights
Legal institutions
preventing
flexibility
Legal institutions
enhancing
flexibility
Law and finance view
Higher state ownership in Napoleonic Code countries
Common law countries more likely to be market-based
Different legal traditions might also affect regulatory
approach
Example:
Pre-approved borrowers in West Africa
M-Pesa in Kenya
The historic determinants of
financial deepening Endowment hypothesis
Directly linked to historic power struggles Power of incumbents and contestability of system determines financial
sector development Self-reinforcing structure, unless disturbed from outside
Legal origin Political channel (see above) Adaptability channel
Link to regulatory flexibility: compare East to West Africa
Alternative views Ethnic fractionalization Religion
In common: historic factors explain institutional development and thus necessary infrastructure for financial sector development
Implications of the three views
Policy view: just implement reforms! Standard setters of the
world, unite!
Build capacity!
Politics view: political economy of financial sector reform
critical. Look for windows of opportunity
Historic view: reforms only in context of historic structures;
look out for exogenous shocks and use them
Where does that leave us?
The big trade-off Need government to help overcome market frictions, but:
Cannot trust government
The conundrum of financial sector reform
“Solutions”:
Focus on independent regulators, but: regulatory capture, regulatory inertia
Take into account political economy when designing financial sector reform programs
All financial sector reform is local!
Define role of government in financial sector deepening according to
Political structure
Country factors
Broader implications
Focus on competition and openness rather than subsidies
Focus on services rather than specific institutions
Use globalization as outside force – but manage the risks
Incentive audits instead of box ticking approaches
How to take account of history?
Work within rather than “against” system
E.g., legal tradition
Research questions going forward
Operationalize concept of financial possibility frontier
Benchmarking exercise, micro-data
What is the bottleneck for further deepening and broadening
Better understand the politics of financial sector reform
How to create constituencies for financial sector reform
Entry points through new products, services
Financial literacy
Media
Substitutability vs. complementarity of reforms
…moving from national to supra-
national level
Reduce risk of political capture
Example: EADB vs. national DFI in EAC
Cross-border banking
Lower likelihood of cozy relationships between bankers,
borrowers and regulators
Supranational supervisors?
Help overcome mis-match between banks’ geographic footprint
and regulatory perimeter
Less political capture
Banking union for Europe:
Policy vs. politics Historical example U.S.: banking union and sovereign debt
mutualization
Euro: currency union without fiscal or banking union Tragedy of Commons
Different narratives on Eurozone crisis (Underhill, 2012) Feckless spendthrifts Avanti integration Out of the blue
Crisis resolution hampered by distributional conflicts
Differentiation between crisis resolution and long-term reform
Supra-national bank supervision and resolution – but please not for my state-owned savings bank, caja, cooperative….