Finance, Growth and Fragility: The Role of Government Thorsten Beck - - PowerPoint PPT Presentation

Thorsten Beck Maxwell Fry Lecture 2012

Finance, Growth and Fragility: The Role of Government

Finance is pro-growth

…and pro-poor

…but also fragile

Output losses relative to potential output; Source: Laeven and Valencia (2010)

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

How much “bank” for the buck?

• .01

.01 .02 .03 10000 20000 30000 40000 GDP_pc

Who gets credit?

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

Too much finance?

Arcand, Berkes and Panizza, 2012

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

Graphical illustration

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

Bank deposits across regions

Private Credit to GDP:

Expected Versus Actual across Africa

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)

• 10
• 5

5 10

5-10 years crisis at end 5-10 years no crisis at end >10 years

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….