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).
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?
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).
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.
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 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?
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?
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.
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.
A couple of years ago, at a meeting of World Bank financial sector experts, one of the Vice Presidents at the time challenged me by saying, “You always talk about the importance of the financial sector for development, and emphasize we need to prioritize financial sector reforms, but just look at China. It is doing very well without a well functioning financial system.”
This struck a chord. I had also recently seen an academic paper making more or less the same point, that China is one of the fastest-growing economies in the world despite weaknesses in its formal banking system. Of course there is a large literature on finance which shows that development of formal financial institutions is associated with faster growth and better resource allocation. It has also long been recognized that informal financial systems play a complementary role in developing countries, typically consisting of small, unsecured, short-term loans restricted to rural areas, agricultural contracts, households, individuals, or small entrepreneurial ventures.
There is even a direct parallel in developed countries called angel finance, where high-net-worth individuals—“angel investors”—provide initial funding to young firms with modest capital needs until they are able to receive more formal venture capital financing. But informal finance substituting for formal finance? Conventional wisdom has always been that this is not likely since informal monitoring and enforcement mechanisms are generally ill equipped for scaling up and meeting the needs of the higher end of the market.
- Financial Sector
There are many who argue that the financial crisis proved that we have been wrong about most of our policy recommendations in the financial sector. I am not one of them. For example, consider the renewed fascination with development banks. Given the reluctance of private institutions to lend more during the crisis, many countries used their public banks to expand credit. (But others without such institutions used other innovative ways to do this – such as the US Federal Reserve.) Should we then conclude that government ownership of banks is desirable? Similarly, the crisis was so intense that many governments ended up as large shareholders in their banking systems (which is turning out to be temporary, as expected). Does this mean developing countries should abandon their bank privatization programs? Others interpret the crisis as a vivid example of market failure and wonder if much more aggressive regulation is a good idea.
You may have guessed already that my answer to these questions is no. Research is seldom conclusive, but in the area of state ownership of banking the evidence is as overwhelming as it gets. When it comes to lending, it appears that the state banks are the best at lending to cronies. Government officials face conflicts of interest that go against efficient allocation of resources – such as securing their political bases and rewarding supporters. Overall, greater state ownership of banking is associated with less financial sector development, lower growth, lower productivity and even less stability – and it is more damaging at lower per capita income levels where there are typically fewer checks and balances. So it is no wonder that many countries embarked on privatization programs and ought to continue with them. Surely this is a difficult process – but there is again plenty of evidence that well-designed privatization can significantly increase bank performance.