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Asli Demirgüç-Kunt's blog

Has the Global Banking System Become More Fragile Over Time?

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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.

Do We Need Deposit Insurance for Large Banks?

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I don’t think so. You may think this is an odd statement since nearly every country around the world has been busy either introducing or at least expanding its insurance coverage since the 2008 financial crisis. This is not surprising, considering that the U.S. was also in the midst of a banking crisis in 1933 when it first introduced deposit insurance.

But think of it this way. Deposit insurance is not meant to stop systemic crises; as we all know by now, governments do that. The purpose of deposit insurance is to protect individual banks from bank runs, mostly during normal times. Since large banks already have implicit protection because they are perceived to be “too-big-to-fail,” deposit insurance is really there to keep small banks in business. To the extent we believe small banks have an important role to play in supporting small, local businesses, this may be a worthy goal. But why do we still have deposit insurance for large banks?

Taxing financial transactions?

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With federal budget deficits soaring all over the world, policy makers are looking at every opportunity to find new sources of revenue. After the bailouts of the financial sector and public backlash against announcements of large profits and bonuses by banks, a financial transactions tax appears to be a popular proposal both in the U.S. and abroad to "recoup" costs from the financial services industry. But is it really a good idea?

Following James Tobin’s original proposal, governments would place a small tax on financial transactions to discourage speculators (who trade frequently) without putting an undue burden on investors who buy for the long haul. Such a national transaction tax, at a rate of 0.1% to 0.25% of the value of the trade, would be levied on all financial transactions such as stock trades, but not on consumer transactions like credit cards. Advocates in the U.S. argue that it would raise $100 billion to $150 billion a year. Many economists – including prominent figures like Paul Krugman, Joseph Stiglitz, and Jeffrey Sachs – have backed the tax.

Crisis Recovery and the Role of Credit: Do Phoenix Miracles Exist?

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One of the most hotly debated policy questions with respect to the 2008 global crisis is how to stimulate business recovery. Because the crisis started in and severely affected the financial sector, the conventional assumption is that the recovery of the financial sector is a precondition to recovery in the corporate sector. While this conjecture appears reasonable, some have challenged it, pointing to numerous crises across the world in recent years in which real sector recovery preceded that of the financial sector. Of particular interest are episodes characterized by Calvo et al. (2006) as Systemic Sudden Stops (3S episodes) where output declines are associated with sharp declines in the liquidity of a country’s financial sector. Subsequent credit-less recoveries—in which external credit collapses with output but fails to recover as output bounces back to full recovery—have been termed “Phoenix Miracles.”

Empirically, 3S episodes offer an unusual natural experiment since they provide an opportunity to observe how firms are affected in economies which have been subjected to a financial shock that precedes or is contemporaneous with a recession. To date there has been little evidence at the firm-level on how corporations respond to crises in general. In a recent paper, my co-authors Meghana Ayyagari, Vojislav Maksimovic and I use a database of listed firms in emerging markets to analyze the recovery process after a financing crisis. We try to see if recovery of the financial sector precedes or occurs at the same time as the recovery in output of the corporate sector. In other words, we ask: Do firms experience Phoenix Miracles where their sales recover without a recovery in external credit? We then compare and contrast the experience of emerging market firms to that of US firms during the 2008 US financial crisis and investigate if the recent US recovery process qualifies as a Phoenix Miracle.

Optimal Financial Structures for Development? Some New Results

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One of the interesting debates in the finance and development literature is on financial structures: does the mix of institutions and markets that make up the financial system have any impact on the development process? Last week we hosted an interesting conference on the topic at the World Bank (click here for the agenda and papers). Those of you who have been following this literature will know this is not the first time this topic has been discussed – we held a conference on financial structures over ten years ago.

What do financial structures look like? How do they evolve with economic development? What are the determinants and impact of financial structures? Years ago Ross Levine and I, along with many others, tried to answer these questions and saw clear patterns in the data. One stylized fact: Financial systems become more complex as countries become richer with both banks and markets getting larger, more active, and more efficient. But comparatively speaking, the structure becomes more market-based in higher-income countries. We also saw that countries did not get to B from A in a single, identical path. You didn’t have any market-based financial structures in the lowest-income countries, but as soon as you got to lower-middle income, financial structures became very diverse: Costa Rica was bank-based, whereas Jamaica was much more market-based; Jordan was bank-based, Turkey was market-based etc. etc. So countries were all over the place and the correlation between GDP per capita and financial structure was less than 30 percent.

Generating Jobs in Developing Countries: A Big Role for Small Firms

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These days, job creation is a top priority for policymakers. What role do small and medium enterprises (SMEs) play in employment generation and economic recovery? Multi-billion dollar aid portfolios across countries are directed at fostering the growth of SMEs. However, there is little systematic research or data informing the various policies in support of SMEs, especially in developing countries. Moreover, the empirical evidence on the firm-size growth relationship has been mixed. Recent work of Haltiwanger, Jarmin, and Miranda (2010) in the U.S., suggests that (1) Startups and surviving young businesses are critical for job creation and contribute disproportionately to net growth and (2) There is no systematic relationship between firm size and growth after controlling for firm age. It is not clear whether these findings apply in developing countries where there are greater barriers to entrepreneurship, and where venture capital markets that finance young firms are not as well developed as in the US.

In a recent paper Meghana Ayyagari, Vojislav Maksimovic and I put together a database that presents consistent and comparable information on the contribution of SMEs and young firms to total employment, job creation, and growth across 99 developing economies. Our sample consists of 47,745 firms surveyed in the period 2006-2010. We then examine the relationship between firm size, age, employment, and productivity growth and how this varies with country income and find the following:

Do We Need Big Banks?

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In the past several decades banks have grown relentlessly. Many have become very large—both in absolute terms and relative to their economies. During the recent financial crisis it became apparent that large bank size can imply large risks to a country’s public finances. In Iceland failures of large banks in 2008 triggered a national bankruptcy. In Ireland the distress of large banks forced the country to seek financial assistance from the European Union and International Monetary Fund in 2010.

An obvious solution to the public finance risks posed by large banks is to force them to downsize or split up. In the aftermath of the EU bailout Ireland will probably be required to considerably downsize its banks, reflecting its relatively small national economy. In the United Kingdom the Bank of England has been active in a debate on whether major U.K. banks need to be split up to reduce risks to the British treasury. In the United States the Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) passed in July 2010 prohibits bank mergers that result in a bank with total liabilities exceeding 10 percent of the aggregate consolidated liabilities of all financial companies, to prevent the emergence of an oversized bank.

So public finance risks of systemically large banks are obvious. But what are some of the other costs (and benefits) associated with bank size? This is the question Harry Huizinga and I try to address in a recent paper. Specifically, we look at how large banks are different in three key areas:

Bank Lending to SMEs: How Much Does Type of Bank Ownership Matter?

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Small and medium-size enterprises (SMEs) account for close to 60 percent of global manufacturing employment. So it is no surprise that financing for SMEs has been a subject of great interest to both policymakers and researchers. More important, a number of studies using firm-level survey data have shown that SMEs perceive access to finance and the cost of credit to be greater obstacles than large firms do—and that these factors really do constrain the growth of SMEs.

In recent years a debate has emerged about the nature of bank financing for SMEs: Are small domestic private banks more likely to finance SMEs because they are better suited to engage in “relationship lending,” which requires continual, personalized, direct contact with SMEs in the local community in which they operate? Or can large foreign banks with centralized organizational structures be as effective in lending to SMEs through arm’s-length approaches (such as asset-based lending, factoring, leasing, fixed-asset lending, and credit scoring)? And how well do state-owned banks—for which expanding access to finance is often among their top objectives—serve SMEs?