Finance, Growth and Fragility: The Role of Government Thorsten Beck Maxwell Fry Lecture 2012
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? .03 .02 .01 0 -.01 0 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 FD i,t = X i,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 Minimizing externalities Bail-out Open bank assistance Purchase &acquisition Preferences Resolution possibilities frontier Liquidation Market Discipline
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? 5-10 years crisis at end 5-10 years no crisis at end >10 years 10 5 0 -5 -10 Source: Quintyn and Verdier (2012)
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 Legal institutions thwarting private Napoleonic Code property rights colonies Legal institutions • State power preventing • Rigidity flexibility European colonization Legal institutions Common law colonies enhancing • Private property flexibility • Adaptability Legal institutions supporting private property rights
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
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