The Role of Finance in Economic Development: Benefits, Risks and Politics Thorsten Beck European Banking Center Discussion Paper No. 2011-038, 2011.

The Role of Finance in Economic Development:Benefits, Risks and Politics

Thorsten BeckEuropean Banking Center Discussion Paper

No. 2011-038, 2011

Introduction:• Alexander Hamilton (1781): « banks were the

happiest engines that ever were invented »• However, the financial sector is also a major source of

risk and fragility• Moreover, « the financial sector is often at the top of

the policy agenda »

• In this article: investigation about the role of the financial sector for growth, the causes and consequences of financial fragility and the politics behind financial deepening and fragility

• Nb: the 2008 crisis put these issues to the forefront of the academic and political debates

Outline of the paper:• Comprehensive survey of the theoretical and

empirical literature on:

1) Finance and Economic Development

2) Financial Fragility: Causes and Policies

3) The Politics of Financial Development

• Nb: this article seeks to bring together these three strands of the literature and to relate them to the 2008 crisis

I.Finance and Economic Development

1. FINANCE AND GROWTH : THEORY

WHY DO FINANCIAL MARKETS AND INSTITUTIONS EXIST?

• Market frictions : asymmetric information (agency pbs, risks of liquidity, default).

• Stiglitz&Weiss (83) : economize screening & monitoring costs, diversify risk.

• Pool Savings : people with different time liquidity needs.

BUT EXISTS AMBIGUITIES

• Aghion, Howitt and Mayer-Foulkes (05) : low and middle income-per-capita most important

• Financial sector attracts too many resources relative to real sector : bad for growth.

• Better resource allocation ; depress saving rates ; overall growth decreases.

2. FINANCE AND GROWTH : FROM CORRELATION TO CAUSALITY

TRYING TO EXPLAIN THE RELATIONSHIP:

• More micro-data : channels through which dvt is associated with eco growth.

• Goldsmith (69) : first to show empirically positive correlation between financial dvt and GDP/capita.

• Levine, Loyaza and Beck (2000) : IV (reverse causation, omitted variables).

• Arcand, Berkes and Panizza (2011) : relationship turns negative for high-income countries.

• With (private credit/GDP) ratio

• 110% is turning point

• 150% turns significant (level reached by some countries in early 2000s.

CRITICS OF GROWTH AND FINANCE RELATIONSHIP.

• Johnson, McMillan and Woodruff (2002) : property rights rather than credit, encourages reinvestment of profits.

• Cull and Xu (2005) : quality of contractual institutions matters

• Acemoglu and Johnson (2005) : prop rights from expropriation by governments more important.

3. BANK VS MARKETS : DOES FINANCIAL STRUCTURE MATTER?

BECK AND LEVINE (2002) :

• What is better? More bank-based or market-based financial systems?

• Overall level of dvt,not structure that plays an important role.

• Not so important of who delivers financial services

4. INTERNATIONAL DIMENSION : FINANCE AND TRADE PATTERNS.

EFFECT OF FINANCE ON TRADE BALANCE:

• Kletzer&Bardhan (87) , Beck (2002), Matsuyama (2005) : financial dvt turns into a comparative advantage for countries with higher needs for external finance.

• Becker&Greenberg (2007) : total exports in financially more developed countries, more sensitive to exchange rate movements.

5. ACCESS TO FINANCIAL SERVICES.

DISTRIBUTIONAL EFFECTS OF FINANCE :

• Benefits different groups of households or firms differently : small enterprises and the poor suffer the most.

• Beck and al. (2009) : positive effect of financial deepening comes mostly through enerprise credit. No significant importance of HH credit.

6. DISTRIBUTIONAL EFFECTS : THEORY AND EVIDENCE.

AMBIGUOUS PREDICTIONS :

• Pro-poor : efficient K allocation, growth accelerator, relax credit constraints (heavier on the poor), reduces income inequality.

• Pro-rich : poor rely more on family connections for K, at early stages of K dvt only the rich can access financial markets.

• Broaden finance beyond micro-credit : have better savings services, payments services (remittances) and insurance services.

CONCLUSIONS AND LOOKING FORWARD.

• Historically, theoretically and Empirically : a lot of evidence for positive role of financial deepening.

• But, cross-country heterogeneity and non-linearity in relationship poses new challenges.

• Therefore importance on the nex section.

II. Financial Fragility: Causes and Consequences

1.FRAGILITY : CAUSES AND POLICIES.

TWO TYPES OF FRAGILITIES.

• Liability risk : maturity mismatch, depositors withdraw funds prematurely and unexpectedly (can be information-based or irrational). Can lead to bank runs and collapses.

• Asset risk : Principal-Agent problem : asymmetric information

POSSIBLE SOLUTIONS.

Diamond and Dibvig (83) : deposit insurance ; reduce likelihood of bank runs.

Bagehot (73) : Liquidity support by a lender-of-last-resort ; solves pbs of ST liquidity.

Capital requirements and lending restrictions.

Strong supervisors.

2. THE TRANSMISSION OF IDIOSYNCRATIC SHOCKS TO SYSTEMIC DISTRESS.

Idiosyncratic : a structural or behavioral characteristic peculiar to an individual (incentive misalignment and inherent fragility)

Systemic : refers to something that is spread system-wide, affecting a system as a whole.

SYMPTOMS

Bank credit and assets inherently cyclical and volatile.

Systemic fragility related to financial liberalization : credit and asset booms, aggressive risk taking (importance of regulatory reforms)

Fragility related to currency crises : rapid real exchange rate movements undermine banks solvency , can affect exchange rate stability.

MACRO SIGNALS OF SYSTEMIC CRISES

Real exchange rate appreciation

Low growth

High interest rates

inflation

TRADE-OFF?

Rancière, Tornell and Westerman (2006) : benefits of financial deepening outweigh the costs of systemic banking distress.

Conclusions tend to support idea that finance is, in the end, good for growth.

III. The Politics of Financial Development

Finance and politics:

• Different theories to explain why financial institutions/markets are on the top of agendas:

• The « public interest view »: maximize the social welfare (normative public economics)

• The « private interest view »: maximize the private interest of politicians/bankers/elites (positive public economics)

The public interest view:

• The policy makers act in the best interest of the society:

• Market failures in financial markets require public interventions

• Production of information, regulation and supervision

The private interest view :• Access to finance can be used:• As barriers to entry into the real

economy (small entrepreneurs suffer, Feijen and Perrotti, 2005)

• To protect rents and dominant positions

• Evidences from the US history:• Benmelech and Moskowitz (2010): when

low voting suffrage, the ruling elites use interest rate ceilings into banking to prevent competitors from gaining market shares.

From Government banking to Activist Policies

• Government ownership: Government intervention in the financial sector has been strong throughout history

• It can lead to misallocation of resources and political capture:• Firms with political connections have easier

access to state banks and receive larger loans but are less likely to repay (Faccio 2006)

• Public ownership is associated with with lower financial development and economic growth (La Porta et al., 2002)

• Public intervention can take many forms: reserve requirements, credit quotas, rate ceilings and floors (« financial repression », Fry, 1988)

• Most of these policies benefited the elites rather than marginal groups: markups on smaller loans, unadequate risk premiums for big firms, lack of incentive for financial services to become more efficient

• Consequence: reforms towards privatization, more market-based financial systems

From Government banking to Activist Policies

Finance liberalization is not a panacea:

• The success of reforms is discussed (Clarke et al. 2006)

• It can lead to financial fragility: • Mexico (1988), privatization of banks but

the domestic shareholders lacked experience, public recapitalization was required (after a boom-and-bust period)

• Some conclusive cases in Central Europe (90’): • In order to impose hard budget constraints

to state owned firms/government, banks were sold to foreign institutions

Political structure as basic factor:

• Why have some countries political structures consistent with financial developement ?

• Basic condition : constraints on political power and protection of individual property rights

• Several studies highlight that autocratic/corrupt government inhibit the financial development (Barth and al.,2006) and more restrictions on political power are more conducive to financial development (Bordo and Rousseau, 2006)

• History of Europe independent cities (North Italy, the Netherlands)

• Two main theories can be mobilized

Legal origins:

• Historical events in Europe shape the legal and regulatory framework accross the globe today

• Spread of these models accross Europe/the world with Napoleonic wars/colonization

• Napoleonic legal tradition = less independent justice, weaker property rights protection and contractual institutions = less conducive to external finance through weaker protection for minority shareholders by instance (see La Porta et al. 2004, Beck et al. 2003)

Mode of colonization:

• Settler and extractive colonies (Acemoglu et al. 2001, 2002), with stronger property rights protection in the former (links with diseases and native population)

• Countries colonized for extractive purposes have less developped financial markets today (Beck et al. 2003)

• Conclusion: importance and persistence of political structures in finance systems development (« path dependency »)

Conclusion:

• The three strands of literature are closely linked:• Growth benefits of finance and financial

fragility are two sides of maturity transformation

• Financial institutions reduce agency problems between investors and entrepreneurs (growth) but face these problems with depositors (fragility)

• Underlying both growth and fragility are political constraints, historically determined

• Current crisis and developement of financial markets in the US is an interesting background on which to bring these 3 themes