Syndicate content

March 2010

What Does the Financial Crisis Teach Us about the Feasibility of Different Banking Models?

Asli Demirgüç-Kunt's picture

The recent financial crisis has seen the demise of large investment banks in the U.S.  This major change in the financial landscape has also rekindled interest in discussion of optimal banking models.  All over the world, perceived costs and benefits of combining bank activities of various kinds have given rise to a wide variation in allowed bank activities.  Should banks operate as universal banks, a model which allows banks to combine a wide range of financial activities, including commercial banking, investment banking and insurance; or should their activities be restricted?

To some policymakers the universal banking model may appear to be a more desirable structure for a financial institution due to its resilience to adverse shocks, particularly after the crisis.  However, others have called for the separation of commercial and investment activities (along the lines of the Glass-Steagall Act of 1933 in U.S. which was repealed by Gramm-Leach-Bliley Act in 1999) to minimize the crisis-related costs imposed on taxpayers through the financial safety net.  So which model is more desirable?

Theory, as usual, provides conflicting predictions about the optimal asset and liability mix of an institution.  On the one hand, banks gain information on their customers in the provision of one financial service that may prove useful in the provision of other financial services to these same customers.  Hence, combining different types of activities – non-interesting earning, as well as interest-earning assets – may increase return as well as diversify risks, therefore boosting performance.  This argues for the merits of universal banks.

On the other hand, if a bank becomes too complex, bank managers may actually start taking advantage of this complexity for their own private benefit (what are sometimes known as “agency costs”) at the expense of the bank.  So, too much diversification may actually not be optimal, increasing bank fragility and reducing overall performance.  This tends to support the separation of commercial and investment activities. 

Measuring Access to Finance…One Step at a Time

Asli Demirgüç-Kunt's picture

How well do financial systems in different countries serve households and enterprises?  Who has access to which financial services – such as savings, loans, payments, insurance?  Just how limited is access?

Just a short while ago, we didn’t know the answer to these questions.  But modern development theories very much emphasize that broad financial access is the key to development.  Lack of access to finance is often the critical element underlying persistent income inequality as well as slower growth.  Without inclusive financial systems, poor individuals and small enterprises need to rely on their personal wealth or internal resources to invest in their education, become entrepreneurs, and make their businesses grow.  So it was disappointing that although data on the financial sector have been readily available, data on access simply were not.

Those of us who spend our days trying to find ways of influencing policy decisions know that one of the most effective ways of focusing policy attention on an issue is by measurement.  If you can measure something and “benchmark” it with useful comparisons, you are one step closer to identifying what needs to be done.  And if you can provide these measurements at regular intervals, you are more likely to capture the attention of policymakers, promote policy change, and track and evaluate the impact of such policies. A team at the World Bank began thinking about this issue in the beginning of this decade, so when the UN announced 2005 as the Year of Microcredit, we were more than ready to rise to the challenge. 

Microfinance: Dream vs. Reality

Asli Demirgüç-Kunt's picture

Microfinance started as a simple idea: to provide loans to poor entrepreneurs.  Today it is a much more diverse and dynamic sector, and includes institutions that provide savings and remittance services, sell insurance, and offer loans for a wide range of purposes.  The idea now is to focus on bringing a range of financial services to the underserved.  The institutions that focus on this mission vary in the income levels of the customers they serve, their use of subsidies, and the breadth and quality of services offered.  This diversity also presents microfinance providers new opportunities as well as trade-offs.

When Muhammad Yunus and Grameen Bank won the Nobel Peace Prize in 2006, the world community celebrated the ways that expanding financial access can improve the lives of the poor.  Many microfinance “insiders” have been working toward a second goal as well: to find ways to provide microfinance on a commercial basis, without long-term subsidies.  The argument that microfinance institutions should seek profits has an appealing “win-win” resonance, admitting little trade-off between social and commercial objectives.  Should institutions move up-market to provide larger loans and improve financial performance?  Is deposit-taking feasible at such scales?  Can socially-minded institutions survive commercial competition and regulation without re-defining their mission?

The Disastrous Consequences of Weak Financial Sector Policies

Asli Demirgüç-Kunt's picture

What is the role of the financial sector in development?  Does it really contribute, or does it merely respond to the demands of the real sector?  Are markets simply casinos for betting, or do they perform some productive role?  Shouldn’t the development community just focus its attention on more important issues, such as health, education, and the real sector?

I hear these questions all the time.  It is not surprising because prominent economists also hold conflicting views.  Many development economists do not even bother to discuss the role of the financial sector in development.  Joan Robinson famously stated “Where enterprise leads, finance follows,” and Robert Lucas has argued that the role of finance in the literature on growth has been “over-stressed.”

But at the other extreme, Joseph Schumpeter observed “The banker…authorizes people in the name of society…to innovate” and Merton Miller stated: “That financial markets contribute to economic growth is a proposition almost too obvious for serious discussion.”  This debate is crucial since it affects the decisions of policymakers to prioritize financial sector reforms, and the attention they pay to identifying and adopting appropriate financial sector policies.  Where do we come out?

Small and Medium Enterprises – What Works? What Doesn’t?

Asli Demirgüç-Kunt's picture

Development economists are obsessed with SMEs.  And for good reason: employment in SMEs – defined as enterprises with up to 250 employees – constitutes over 60 percent of total employment in manufacturing in many countries.  A large SME sector is also a characteristic of rapidly growing economies (although researchers are more skeptical of the claim that “SMEs are the engine of growth”).  Also, few disagree that SMEs face greater constraints to their growth than large firms. Not only does access to finance rank high among these constraints, but it also has a proportionally greater impact on SME growth.

Constraints

All these facts suggest SMEs deserve policymakers’ attention, but there are many questions about the efficacy of pro-SME policies in different areas. In reviewing research findings, I’ve grouped these areas roughly under four headings: institution building, financial development, interim solutions, and directed government interventions.