The failure of the investment banking giant Lehman Brothers on September 15, 2008 marked the onset of the largest global economic meltdown since the Great Depression. The crisis has prompted many people to reassess state interventions in financial systems, from regulation and supervision of financial institutions and markets, to competition policy, to state guarantees and state ownership of banks, and to enhancements in financial infrastructure. But the crisis does not necessarily negate the considerable body of evidence on these topics accumulated over the past few decades. It is important to use the crisis experience to examine what went wrong and how to fix it. This is the motivation of the World Bank’s Global Financial Development Report, released this week, on the fourth anniversary of the Lehman failure.
Asli Demirgüç-Kunt's blog
Today, Gallup hosted a conference on “Evidence and Impact: Closing the Gender Data Gap” where Secretary of State Hillary Clinton , World Bank President Jim Kim, and other leaders emphasized the importance and relative lack of gender-sensitive data to support policies for improving the lives of women and girls. Secretary Clinton remarked to a packed house that “data not only measures progress, it inspires it.” She asked participants, national governments, and the international community at large to invest in gender-sensitive data collection, use, and publication. Jim Clifton, the CEO of Gallup, spoke about the danger of creating policy simply based on our perceptions of what women want and need.
In today’s New York Times, Nicholas Kristof gives the example of a family in Malawi that improved their lives as the result of a village savings group. We know that access to banks, cooperatives, and microfinance institutions has allowed many adults like the Nasoni family to safely save for the future, invest in an education or insure against risk, but just how widespread is the use of formal financial products worldwide? How do the barriers to access vary across regions? And how do the unbanked manage their finances?
In the past, the view of financial inclusion around the world had been incomplete. With the release of the Global Financial Inclusion (Global Findex) Database we now have a comprehensive, individual-level, and publicly-available database that allows for comparisons across 148 economies of how adults around the world manage save, borrow, make payments and manage risk. As cited in the article, the Global Findex data shows that more than 2.5 billion adults around the world don’t have a bank account.
The facts are in. 50 percent of adults worldwide have an account at a formal financial institution. 21 percent of women save using a formal account. 16 percent of adults in Sub-Saharan Africa use mobile money. These are just a few of the thousands of data points now available in the Global Financial Inclusion (Global Findex) database, the first of its kind to measure people’s use of financial products across economies and over time.
Thankfully, researchers and policymakers no longer have to rely on a patchwork of incompatible household surveys and aggregated central bank data for a comprehensive view of the financial inclusion landscape. The publically accessible Global Findex provides comparable individual-level data that facilitate detailed analyses of how adults save, borrow, make payments, and manage risk in 148 economies. The data are based on more than 150,000 interviews with adults representing over 97 percent of the world’s population and was carried by Gallup Inc. as a component of its 2011 World Poll.
The global financial crisis reignited the interest of policymakers and academics in assessing the impact of bank competition on stability and rethinking the role of the state in shaping competition policies. Competition in the financial sector has a long list of obvious benefits: greater efficiency in the production of financial services, higher quality financial products and more innovation. When financial systems become more open and contestable, generally this results in greater product differentiation, a lowering of the cost of financial intermediation and more access to financial services. But when we turn to the issue of financial stability, it is no longer so obvious whether competition is beneficial or not, with a continuing debate among academics and policymakers alike. Some believe that increasing financial innovation and competition in certain markets like sub-prime lending contributed to the recent financial turmoil. Others worry that as a result of the crisis and the actions of governments in support of the largest banks, concentration in banking increased, reducing the competitiveness of the sector and potentially contributing to future instability as a result of moral hazard problems associated with “too big to fail” institutions.
More than three years after the onset of the global financial crisis, a plethora of regulatory reforms are being put in place. The Basel Committee has prepared new capital and liquidity requirements, and the Financial Stability Board has kicked off an impressive agenda of reform. But implementation has been far from straightforward, and domestic priorities have often been in conflict with attempts at regulatory convergence. Against this background, the International Centre for Financial Regulation (ICFR) and the Financial Times invited submissions for a research prize in financial regulation, calling for essays that would consider “what good regulation should look like”.
The call resulted in an interesting set of ten top-rated essays. One of them is a new paper that we co-authored with R. Barry Johnston, based on some of the background work for the World Bank’s upcoming 2013 Global Financial Development Report. In our piece (which of course represents only our views and not necessarily those of the World Bank), we answer the organizers’ question by saying that “good regulation needs to fix the broken incentives.” Or, to paraphrase a 1990s campaign slogan, “it’s the incentives, stupid.”
The Question: Has executive compensation contributed to the financial crisis?
In the aftermath of the financial crisis there has been no shortage of finger-pointing in the attempt to identify its underlying causes. The list of potential culprits is long and ranges from bank deregulation to the “alchemy” of credit ratings and structured finance. This debate focuses on one factor that has allegedly contributed to the crisis: greedy bankers and the executive compensation packages that tempted them to, quite literally, bet the bank.
The spectacular collapse of banks whose executives were allegedly paid for performance clearly raises many questions about the link between executive pay and risk-taking. In a recent paper, Thomas Philippon and Ariell Reshef of New York University show that while in 1980 bankers made no more than their counterparts in other parts of the economy, by 2000 wages in the financial sector were 40% higher for employees with the same formal qualifications. The last time such a discrepancy was observed was just prior to the Great Depression—an irony which has not been lost on critics of bank compensation, ranging from regulators to the Occupy Wall Street protesters. But the level of compensation alone may not be the real problem. Many leading economists (see, for instance, op-eds from Alan Blinder and Raghuram Rajan) have emphasized that a much more important (and difficult) question to answer is how the structure of performance pay may encourage excessive risk-taking at all levels of the institution, from traders and underwriters right up to the firm’s CEO.
How should the relative importance of banks and stock markets change as countries develop? Is there an optimal financial structure—in other words, should the mixture of financial institutions and markets change to reflect the evolving needs of economies as they develop?
Previous research has found that both the operation of banks and the functioning of securities markets influence economic development (Demirguc-Kunt and Maksimovic, 1998; Levine and Zervos, 1998), suggesting that banks provide different services to the economy from those provided by securities markets. Indeed, banks generally have a comparative advantage in financing shorter term, lower risk, well collateralized investments, while arms length markets are relatively better suited in designing custom financing for more novel, longer run and higher risk projects.
However, economic theory also emphasizes the importance of financial structure, i.e., the mixture of financial institutions and markets operating in an economy. For example, Allen and Gale’s (2000) theory of financial structure and their comparative analyses of Germany, Japan, the United Kingdom, and the United States suggest that (1) banks and markets provide different financial services; (2) economies at different stages of economic development require different mixtures of these financial services to operate effectively; and (3) if an economy’s actual mixture of banks and markets differs from the “optimal” structure, the financial system will not provide the appropriate blend of financial services, with adverse effects on economic activity.
The last decade has seen a tremendous transformation in the global financial sector. Globalization, innovations in communications technology and de-regulation have led to significant growth of financial institutions around the world. These trends had positive economic benefits in the form of increased productivity, increased capital flows, lower borrowing costs, and better price discovery and risk diversification. But the same trends have also lead to greater linkages across financial institutions around the world as well as an increase in exposure of these institutions to common sources of risk. The recent financial crisis has demonstrated that financial institutions around the world are highly inter-connected and that vulnerabilities in one market can easily spread to other markets outside of national boundaries.
In a recent paper my co-author Deniz Anginer and I examine whether the global trends described above have led to an increase in co-dependence in default risk of commercial banks around the world. The growing expansion of financial institutions beyond national boundaries over the past decade has resulted in these institutions competing in increasingly similar markets, exposing them to common sources of market and credit risk. During the same period, rapid development of new financial instruments has created new channels of inter-dependency across these institutions. Both increased interconnections and common exposure to risk makes the banking sector more vulnerable to economic, liquidity and information shocks.