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April 2010

Thoughts on the Financial Crisis and Improving Financial Regulation

Editor’s Note: The following post was contributed by Ross Levine, the James and Merryl Tisch Professor of Economics at Brown University.  This post summarizes a presentation Professor Levine gave at the World Bank on April 28 entitled An Autopsy of the Financial System: Suicide, Accident, or Negligent Homicide?  The presentation from the event is available here and video of the event will be made available soon on the All About Finance blog.  

In this blog entry, I address three issues: (1) The causes of the cause of the financial crisis, (2) Core approaches to financial regulation, and (3) Systemic improvements.  I also direct readers to longer treatments of each of these issues.

Causes

In a recent paper, An Autopsy of the U.S. Financial System: Accident, Suicide, or Negligent Homicide, I show that the design, implementation, and maintenance of financial policies by U.S. policymakers and regulators during the period from 1996 through 2006 were the primary causes of the financial system’s collapse.  I study five important policies (1) Securities and Exchange Commission (SEC) policies toward credit rating agencies, (2) Federal Reserve policies that allowed banks to reduce their capital cushions through the use of credit default swaps, (3) SEC and Federal Reserve policies concerning over-the-counter derivatives, (4) SEC policies toward the consolidated supervision of major investment banks, and (5) government policies toward the housing-finance giants, Fannie Mae and Freddie Mac.

Let me be blunt—time and again, U.S. regulatory authorities and policymakers (1) were acutely aware of the growing fragility of the financial system caused by their policies during the decade before the crisis, (2) had ample power to fix the problems, and (3) chose not to.  This crisis did not just fall from the sky on the heads of policymakers; policymakers helped cause this crisis.  While Alan Greenspan (former Chairman of the U.S. Federal Reserve) depicts the financial crisis as a once in a “hundred years flood” and a “classic euphoric bubble,” the evidence is inconsistent with these overly simple characterizations.  More importantly, this focus on “irrational exuberance” self-servingly deflects attention from the policy determinants of the crisis.

Regulators were not simply victims of limited information or a lack of regulatory power. Rather, the role of regulators in the five policies I mention above demonstrates that the crisis represents the selection—and most importantly the maintenance—of policies that increased financial fragility.  The financial regulatory system failed systemically.  To fix it, we need more than tinkering, we need systemic change. 

What Do We Know about the Consequences of Foreign Bank Participation in Developing Countries?

Maria Soledad Martinez Peria's picture

The process of financial globalization that accelerated in the 1990s has brought many changes to the financial sectors of developing countries.*  Countries have opened up their stock markets to foreign investors, allowed domestic firms to cross-list and issue debt overseas, and welcomed foreign direct investment into their local financial sectors.  When it comes to the banking sector, arguably no change has been as transformative as the increase in foreign bank participation in developing countries.  On average, across developing countries, the share of bank assets held by foreign banks has risen from 22 percent in 1996 to 39 in 2005.  At the same time, foreign bank claims on developing countries, which together with the loans extended by foreign bank branches and subsidiaries include cross-border loans, increased from 10 percent of GDP in 1996 to 26 percent in 2008 (see Figure 1).

Total foreign claims

What Explains Firm Innovation in Developing Countries?

Asli Demirgüç-Kunt's picture

Many economists agree that innovation is essential for economic growth.  But the little we know about firm innovation is based on the study of large, publicly-traded firms in developed countries.  As Moisés Naím, editor-in-chief of Foreign Policy magazine, pointed out at the recent Financial and Private Sector Development Forum, large, publicly-traded firms have served as the basis for a lot of formal economic analysis, but they are much less typical of developing countries.  This is a problem, since we know from existing studies that small and medium size firms play an important role in developing countries.

What might explain the likelihood of these firms to innovate?   Here are some of the key issues that deserve closer scrutiny:

  • Are certain types of firms more innovative than others?
  • What is the role of finance, governance and competition?
  • Is ownership or corporate form important?
  • Does foreign competition or trade openness matter?
  • And what about the education and experience of managers and workers?
     

How Do Firms Finance Investment?

Asli Demirgüç-Kunt's picture

A large body of literature has found that in countries with weak institutions firms are able to obtain less external financing, resulting in lower growth.  Indeed, even simple cross-country comparisons of firm financing patterns can be quite revealing.  In a paper co-authored with Thorsten Beck and Vojislav Maksimovic, this is exactly what we do.  Using data from the World Bank’s Enterprise Surveys dataset (WBES) for 48 countries, we investigate what proportion of firm investment is financed externally, and, of this external finance, how much of it comes from different sources, such as bank and equity finance, leasing, supplier credit, development banks, and informal sources such as money lenders.

In our sample of firms, on average just over 40 percent of firm investment is externally financed.  Breaking external financing down into its parts, about 19 percent of all financing comes from commercial banks and 3 percent from development banks.  Another 7 percent is provided by suppliers and 6 percent through equity investment.  Leasing is another 3 percent, and less than 2 percent comes from informal sources.  More recent enterprise survey data for an expanded sample of countries and firms also suggest similar patterns (Figure 1).

Sources
Source: Enterprise Surveys, covering 71 countries