Financial Development

8/7/2019 Financial Development

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DEVELOPMENT ECONOMICS


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FINANCIAL DEVELOPMENT

Financial intermediaries, in the circular flow model, receive savings from depositorsand allocate those savings to entrepreneurs to invest.

In practice, Financial Intermediaries have a number of beneficial roles:

Pool savings and mobilise them to finance promising projects across sectors.

Provide an efficient evaluation of projects.

Share and diversify the risks of innovation by pooling it and repackaging.

Monitor the use of loaned funds by entrepreneurs.

Create Liquidity by borrowing short-term and lending long-term.

Reduces transaction and information costs matching depositors and investors.

Further, can be divided into BANK financial intermediaries and NON-BANK financialintermediaries (such as equity/stock markets).

Gibson and Tskalotos (1994) notes that even in developed countries w/ developedequity markets, equity markets only account for a small proportion of total credit

allocation. Banks also have longer-term relationships with clients and therefore havegreater access to information.


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Financial Repression:

Before discussingfinancial developmentandfinancial liberalisation, we need tonote the initial conditions from which afinancial system is to be liberated, or

developed.

Financial repression is defined byGibson + Tsakolotos (1994): When theGovernment taxes or distorts domesticcapital markets.

Although they later suggest thatsuch a definition is too broad.

Lending rates are kept low to try andstimulate investment (which meansthat deposit rates have to be low aswell, as the bank cant finance higherones).

Taxes on the sector can be either director indirect (e.g., requiring a proportionof assets to be held as Government

bonds). There may also be an inflation

tax where the Government borrowsfrom the sector or prints money tofinance a deficit the resulting inflationreduces the efficiency of investment(the level of growth for a given level ofsavings).

The Government may also crowd outthe private sector by offering highyielding Government bonds.

Financial Repression leads to:

Proliferation ofInformal MoneyMarkets.

Distortions that make bank depositslook unattractive relative toinvesting in real assets, hurtingfinancial development.

Reduced savings, investment andgrowth, as well as CREDITRATIONING (McKinnon-Shawmodel).


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Why does the Government engage in Financial Repression?

Aside from attempting to:

Stimulate investment through lending rate ceilings,

Use the financial sector as a means to pay deficits,

The Government also uses the financial sector tofurther its developmentstrategy.

For example, Industry Substituting Industrialisation (ISI) requires thatresources be invested into industry.

The Government could facilitate this allocation of resources by forcing banksto lend to certain sectors either via direct control (nationalising banks) orusing preferential interest rates/refinancing schemes to skew creditallocation.

However, this can facilitate a culture ofcrony capitalism and rent-seeking,as investments may not be allocated to projects with the highest rate ofreturn.


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Is Financial Development important?

Financial development is an improvement in the quantity and quality of financialservices that households, firms and Governments receive.

Auerbach and Siddiki (2004) note that generally studies show a positive associationbetween Financial Development and Economic Growth.

Honohan (2004) supports this claim, noting that, when using Financial Deepening(the quantity of money/assets to which a firm/individual has access) as a proxy forfinancial development, the link between the two is significant and robust:

Moving from the lowest decile of financial depth to the highest is associated with arise in GDP per capita growth of ~4%.

Financial development is also associated with lower inequality (Li et al. (1998))

, inthat it reduces credit constraints and allows for investments in human capital. It is alsopossible that a healthy financial system is an effective anti-monopoly system,empowering small firms with credit.

Regarding poverty, financial development is important in that it increases access tocredit, which is more of a problem in developing countries than the cost of loans. Anexample is microfinance where firms loan credit to the very poorest in society atrelatively high rates of interest.


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The causality between financialdevelopment is more confused:

Calderon and Liu (2002) differentiatebetween three hypotheses of

causality:

Supply-Leading: Financial Dev Econ Growth (financialinstitutions provide financialservices which permits andfacilitates growth).

Demand-Following: Econ.Growth Financial Dev (real

economic growth raises thedemand for financial services).

Stage of Development: At earlystages of development, supply-leading. This creates self-sustaining growth whichinstigates demand-followingcausality.

Empirically, they make 5 findings:

1. Financial development generallyleads to economic growth inboth developing and developedcountries.

2. Both supply-leading anddemand-following relationshipsoccur simultaneously at allstages of development.

3. Financial development has agreater effect in developingcountries.

4. It takes time for financialdeepening to impact upon thereal economy.

5. Financial developmentencourages more rapid capitalaccumulation and TFP growth,which enhances economicgrowth.


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Does financial liberalisation promote growth?

Neoclassical perspective: YES.

Financial Liberalisation entails:

Privatisation, deregulating interest rates, lowering reserverequirements and removing Government control over credit allocation.

Neoclassicists believe that financial liberalisation positively affects boththe quantity of savings and investmentand the quality of thatinvestment too. Hence,financial liberalisation positively affects

economic growth!

The typical model that is employed to show this, is the McKinnon-Shawmodel, shown on the next slide, where the level of savings is variant onthe interest rate and growth rate, and equilibrium is where I=S. Itconsiders financial repression where an interest rate ceiling (on lendingrates) has been imposed.


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Ceiling 1

Ceiling 2

I

S(g1)S(g2)

S(g3)

r1

r2

r*

r3

I1 I2 I* I3

E

A B

C

Investment

Interest

Rate

rII !0"

rI

grsS ,!

"r

0"gS


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Scenario 1: Assume the free marketequilibrium is at point E, with interest rater*. Assume further that the Governmentholds down DEPOSIT RATES at ceiling 1,and leaves LENDING RATES unregulated.

In this scenario, there is I1 level of savings and investment, and there isexcess demand for loans.

This excess demand is met by chargingr3 for the lending rate. There istherefore a spread between lendingand deposit rates, and this spread maybe used to finance non-pricecompetition (such as establishing

branches in prestigious locations).

Scenario 2: assume the Government nowmakes ceiling 1 apply to BOTH deposit andlending rates, which is more realistic.

Here, there are still I1 levels of savings in the economy, howeverthere is CREDIT RATIONING of I3 I1due to excess demand for investmentat the prevailing lending rate.

Lending is likely to be of low-quality;depositors will be more likely to investin low-yielding projects than deposit inthe bank, and investors with lowyielding projects that wouldnt occurunder equilibrium, do go aheadbecause the low interest rate gives

them a positive rate of return.

Low interest rates also change therelative prices of labour and capital ,distorting the input-mix.

Financial Liberalisation implies a rise inthe ceiling from ceiling 1 ceiling 2.

As savings are a function of theinterest rate, the savings functionshifts outwards and we have I2 level ofsavings, although there is still creditrationing.

However, higher yielding projects nowgo ahead and therefore efficiency isincreased.


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Galbis (1977) offers a two-sector model where the efficacy of investment increases due toliberalisation:

Traditional sector (with low rate of return on investments, and investments are self-financed), and Modern sector (with high rate of return and relies on loans from a bank hence, relies on savings from the traditional sector).

Financial repression keeps deposit rates low (low incentive to deposit money in a bankrather than invest it) and leads to scarce credit for the modern sector.

Financial liberalisation raises deposit rates, raising savings in the traditional sector andalleviating the credit scarcity in the modern sector.

Liberalisation also entails capital inflows due to high real interest rates and a highermarginal productivity of capital in recently liberalised countries.

Empirical evidence is MIXED for the predictions of the McKinnon-Shaw model, as Gibsonand Tsakalotos (1994) conclude, due to difficulty in obtaining reliable data andmethodological problems.

McKinnon (1991) argues that there are two pre-requisites for Financial liberalisation:

Fiscal Control (bank taxes are no longer a revenue source, the Gov. Must develop the taxsystem to compensate).

Control over domestic banks for monetary policy purposes.


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Macroeconomic criticisms:

Can be divided into two camps: the POST-KEYNESIANS (who focus on aggregatedemand) and the NEO-STRUCTURALISTS (who focus on supply of credit).

Post-Keynesian critique:

After liberalisation, AD can fall for the following reasons:

Liberalisation leads to a rise in the marginal propensity to save, whichadversely impacts on AD and therefore current and expected investment.

Real exchange rate overvaluation (high capital inflows).

Increasing interest payments on Government debt.

Bank losses due to lending long term and borrowing short term (higherdeposit rates w/ still low lending rates).

Upward Financial Repression where equilibrium interest rates are very low(perhaps negative in real terms). This means that the bank faces high levels ofuncertainty when lending, however withholding funds reduces profits as thebank becomes excessively liquid.


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Neo-Structuralist critique:

Financial liberalisation can lead to STAGFLATION (declining growth and inflation):

Higher real interest rates raise the cost of capital, so aggregate supply declines. Assuming

supply falls faster than demand, then excess capacity is throttledsuggesting a rise ininflation.

Financial liberalisation may also lead to a fall in available credit:

In developing countries, there is an unregulated informal banking sector which does nothave reserve requirements, but has very large spreads between lending and deposit rates(suggesting inefficiency) and also very high lending rates (due to high uncertainty).

Assume an individual can store wealth either in non-productive assets (like Gold), or inthe informal market, OR they can deposit in formal sector banks.

A rise in the deposit rate due to liberalisation leads to a substitution away from the prior 2stores of wealth non-productive asset wealth is transferred into deposits (thus creatingcredit) and informal sector deposits are transferred to the formal sector.

The latter effect reduces credit! This is because formal sector banks have to have areserve requirement; neo-structuralists believe that this effect dominates in developingcountries with large informal money markets.


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Microeconomic Problems:

The most significant market failures in the financialsector are MoralHazardandAdverse Selection.

Adverse selection arises because of the presence ofbad lending risks in the marketplace and theinability of the bank to differentiate between

riskiness of investors.

Moral hazard arises because monitoring the use ofloaned funds is often costly and difficult toimplement.

Both lead to less lending and therefore reducefinancial development.

Mishkin (1999) outlines how A.S and M.H problemscan create financial instability and perpetuate crises:

Emerging market debt is likely to be: SHORT TERM &FOREIGN CURRENCY-DENOMINATED.

Therefore, an FX crisis is likely to lead to a financial crisis, aided by information asymmetries:

1. When debt is foreign-denominated, a devaluationmust raise the value of the debt.

2. With assets still in domestic currency, asset valuedoes not also rise therefore there is adepreciation the firms NET WORTH.

3. Net worth acts as collateral; lower NW means thatadverse selection rises (banks are unable todifferentiate between good and bad risks) andmoral hazard rises (firms can undertake riskierbehaviour as they have less to lose).

4. The resulting defaults then adversely impact onbanks balance sheets, creating a BANKING CRISIS.

5. The usual response to such a crisis is to restrictlending to increase capital stocks; however, banksplay a key role in emerging markets due to theirlong-term relationships allowing them access toinformation curtailing adverse selection, and theircredible threats to cut off lending preventing moral

hazard.

Thus, the lending restriction has a significantcontractionary effect

Therefore, FX crises and Economic crises bothadversely affect the balance sheets of banks andfirms, which exacerbate information asymmetriesand the problems they cause.


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Mishkin therefore recommends that itis important to have strong screeningand monitoring facilities that prevent alending boom (due to high interestrates or capital inflows) from allowing

banks loading up on too much risk.

Cho (1986) suggests developing equitymarkets as another measure for dealingwith adverse selection, however equitymarkets are focused on short-termprofits (high-frequency trading) andneglect the establishment of long-termhigh-trust relationships.

Even in developed markets, only asmall proportion of total finance iscreated by equity markets.

Financial liberalisation, therefore, maynot only instigate financial instability(higher interest rates and lendingbooms due to capital inflows), but also

may not impact greatly on actualinvestment levels due to adverse

selection and moral hazard problems.

The Government has a role incircumventing informationasymmetries:

Promote full informationdisclosures, and enforce monitoringand screening agencies (Levine etal. (2002) find that a lessdiscretionary intervention in thisrole is more beneficial for growth).

Protect Insiders (managers,

controlling shareholders) againstoutsiders (creditors) with strongershareholders rights (allocates theshare of risk between the twogroups).

Establishing an independentregulatory agency that engages inprompt corrective action, shutsdown insolvent institutions and

holds executives accountable.


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Increased competition via privatizationand liberalisation has two effects:

Auerbach and Siddiki (2002) note that itacts as a motivation for lenders andborrowers to act efficiently, generatesinformational signals and expands therange of financial services, improving theefficiency of investment. It also reducesthe deposit/lending rate spread.

However, Gibson and Tskalotos (1994)caution that the presence of marketfailures (information asymmetries,externalities (investment creates jobs)and the public good nature of

information) facilitates instability, even ifit increases operational efficiency.

Competition reduces risk premia andprofits, relaxes credit constraints(facilitating a lending boom) andnote that it is associated with a risein speculative activity.

In net, competition could lead to

increased fragility in the financialsystem and have an adverse impact

on the real economy via fixation onshort-term profits and neglect oflong term investments.

This reinforces the need for soundmonitoring + screening processes, and asatisfactory legal framework.

Capital inflows may be a source ofinstability insomuch that they causelending booms (see case study on the2007+ crisis), however, the underlyingfundamental problem is POORREGULATORY INFRASTRUCTUREIN THEHOST COUNTRY. With goodinfrastructure, a lending boom need not

occur, or at least bad debt need not betaken on in large quantities.

However, external financialliberalisation should come afterdomestic liberalisation due to itsadverse impact on themacroeconomic stability of thecountry; if before, then there will becapital flight due to low real interest

rates and domestic banks will beuncompetitive internationally.


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Conclusion:

Financial development causes growth (and growth causes financialdevelopment).

Financial repression may also cause growth if used properly (see SouthKorea), but also has the potential for Government failure and a stagnanteconomy (see Chile/Mexico pre-reforms).

Financial liberalisation can cause economic growth by facilitating financialdevelopment, however it can also act as a source of instability thatundermines the economy as a whole.

Some degree of Financial liberalisation is a necessary, but not sufficientcondition for economic growth tooccur; there needs to be a Governmentpresence to deal with market failures and potential adverse impacts ofcompetition. There also needs to be a stable macroeconomic environment, ashrinking informal money market, and correct sequencing of liberalisationreforms and introduction of equity markets.


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CASE STUDY: CHILE


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CHILE (KALTER, 2004)

What structural weaknesses wererevealed?

Generous deposit insurance:

Effectively 100 .

Deposit insurance removesincentives for depositors to use allavailable information to monitorbanks and punish excessively riskybehaviour.

Hence, overly-generous depositinsurance encourages moral hazard.

Excessive risk-taking by banks:

Due to the likelihood that theywould be bailed out in a crisis duetobeing toobig to fail.

With this backing, they loaded upon risky assets; generous depositinsurance meant that depositorswouldnt have punished thisbehaviour even if they had the

information.

Large conglomerates (Grupos) wereformed due to the widespreadliberalisation policies and lack ofanti-monopoly regulation, and theyindulged in self-financing; banks

under their control would provideliquidity to firm under the samegrupo.

Lack of prudential regulation:

Allowed adverse selection andmoral hazard to result in banksbeing unable to differentiate

between risks and loading up onrisky assets.

A regulator, the Superintendency ofBanks and Financial Institutions(SBIF) did exist, but its powers werenot sufficient to enforce substantialregulation that was needed toprevent moral hazard and adverseselection problems.


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CHILE

What happe e ri g?

The financial li eralisation that wasimplementedwas roadly rolled ack;

preferential exchange rate fordollar de tors was executed, andthe central ank ought anks adportfolios at face value.

Large ailouts andnationalisationof anks y the overnment andCentral ank, leading to asubstantial uasi-fiscal deficit.

The stock market ceased to trade.

What happe e after?

Therewas an attempt to revert todiscretionary policies, but that simply

exacerbated the downturn, leading topoor growth and growing inflation.

Pinochet eventually settledon arestructured formofmarket-basedpolicies, focusedon:

I. Active acroeco o ic policies toensure stability.

II. Co soli atio of the arket-orie tate str ct ral refor sstarted in the 70s.

III. Innovative ebt anage entpolicies (debt-for e uity swaps).

As part of the consolidation, there wasa need to rebuild the financial sector .


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CHILE (KALTER, 2004)

Institutional reforms in the Chileanfinancial sector:

SBIF powers (adverse selection, moralhazard):

The SBIF was granted withsubstantially more power to limit risk-taking activities by banks, rate qualityof investments and enforce capitalrequirements.

The SBIF was also charged withprotecting the property rights of bankcreditors and debtors.

SBIF regulated that banks must publish

detailed compliance reports threetimes a year, allowing depositors toaccess information that would let themdiscern the riskiness of a bank. If abank is being excessively risky, thenthey may punish it by withdrawingdeposits.

Safety nets (moral hazard):

Deposit insurance deposit insurance

was reduced from 100% of all funds (ineffect), to 100% of funds up to a setcap. This meant that whilst there wassome security, it was not so generousas to erode incentives for depositors topunish risky behaviour.

Deposit insurance is also compulsory

and privately financed.

Lender of last resort to be effective,firms and banks must perceive bailoutsto be both rare and at great personalcost. Also, the LOLR must not targetspecific firms, but lend aid to solvent,collateral rich banks suffering short-term liquidity problems.

The recent CORFO-Inverlinkaffairprecipitated a liquidity crisis in whichthe Central Bank acted in accordancewith the above.

Credibility has been built by theChilean Government not bailing outbanks that were in breach ofregulations in both 1988 and 1989; thislent credibility to the statement that it

would not it would not bailout banksas it did in 1982.


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ARGENTINA


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ARGENTINA

Perry and Serven (2003) note that a major problem during the build up to the Argentinefinancial crisis of 2001 was a structural weakness of the banking sector:

Surprising, since in 1998, the World Bank ranked Argentina second for regulatory structure;in the wake of the Tequila crisis (1994/5), the banking sector was legislated to have a largeliquidity buffer.

The liquidity buffer served well initially; it absorbed most of the initial liquidity and solvencyshocks in 1999, including the initial capital flight.

However, the hard peg encouraged increasing levels of dollar-denominated debt, whichraised the risk of financial collapse if the currency board collapsed.

Perry and Serven note three weaknesses in the regulatory framework:

Failure to recognize the special risk of loans to debtors in the tradable sector, which wouldappear when there was a deflationary policy to achieve the equilibrium RER. (AdverseSelection).

Inability to separate the solvency of the financial sector from the solvency of theGovernment (Government was running large deficits and had a high interest payments, soborrowed heavily from the financial sector).

General liquidity buffers do not adequately protect the system from a run on the banks,they help buy time, but ultimately, a credible lender of last resort is needed. Under a

currency board system, the Central Bank cant credibly commit to LOLR duties as its priorityis to keep the exchange rate fixed.


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MEXICO


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MEXICO Mishkins (1999) story of a FX crisis triggering a

financial crisis due to a high proportion of short-term,foreign denominated debt accurately describesMexicos 1994 Tequila crisis.

Indeed, it is more or less the same story as in Chile;after a set of market-based reforms (Washingtonconsensus), with a fixed-peg exchange rate system forstability, a combination of poor supervision, lending

booms and FX crisis served to create a financial crisis.

Mishkin notes the following policy lessons from thecrisis:

The dangers ofPegged exchange rate regimes:

Fixed regimes are susceptible to speculative attackswhich cause a FX crisis Financial crisis.

They also dont have a warning system; a floatingexchange rate will depreciate if Governmentborrowing is too high or inflation is too high, sendingsignals to policymakers.

Need for Prudential Supervision:

Poor supervision can foster a weak banking sectorwhich can also lead to FX crisis: a banking sectorwith high foreign-denominated debt limits theCentral Banks ability to stave off a speculative

attack via raising interest rates (as that raises thevalue of debtors debt). Speculators will then attackthe currency, triggering a FX crisis: BANKING CRISIS FXCRISIS BANKING CRISIS.

Managing Financial liberalization:

Although financial liberalization is necessary forfinancial development + therefore growth, it needstobe sequenced carefully to prevent lendingbooms.

Lending booms do increase financial depth (ameasure of financial development), due to thehigherMPK in emerging markets as well as moreopportunities in emerging markets. However, thisboom may outstrip the availability of information,increasing the portion of bad loans on banks balancesheets.

Need for recovery policies that are sensitive to thecountry context:

Instead of promoting the central bank to be a LOLRand pursuing expansionary monetary policies, usecontext-specific policies.

The problem w/ LOLR + Expansionary monetarypolicy is that it drives up inflation and thus

depreciates the currency (affecting firms net worthand prolonging the crisis).


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MEXICO

Kehoe and Ruhl (2010) also argue that Mexicohad poor bankruptcy laws and a poor rule of

law that precluded contract enforcement.

This exacerbated Adverse Selection problems,lead to misallocation of resources and acted as adrag on TFP growth.

Thus, in addition to specific financial sectorreforms that Mishkin stated,Mexico needs toshore up its legal institutions as well to reduceuncertainty (and transaction costs).

Financial Development

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