Thorsten Becks Slides Maxwell Fry Lecture 2012 - Birmingham

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

0

.01

.02

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0 10000 20000 30000 40000GDP_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)

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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….