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Asli Demirgüç-Kunt's blog

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?

Bank Capital Regulations: Learning the Right Lessons from the Crisis

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The recent financial crisis demonstrated that existing capital regulations—in design, implementation, or some combination of the two—were completely inadequate to prevent a panic in the financial sector. Needless to say, policymakers and pundits have been making widespread calls to reform bank regulation and supervision. But how best to redesign capital standards? Before joining the calls for reform, it’s important to look at how financial institutions performed through the crisis to see if we’re learning the right lessons from the crisis. Is capital regulation justified? What type of capital should banks hold to ensure that they can better withstand periods of stress? Should a simple leverage ratio be introduced to reduce regulatory arbitrage and improve transparency? These are some of the questions addressed in a recent paper I wrote with Enrica Detragiache and Ouarda Merrouche.


Since the first Basel capital accord in 1988, the prevailing approach to bank regulation has put capital front and center: banks that hold more capital should be better able to absorb losses with their own resources, without becoming insolvent or necessitating a bailout with public funds. In addition, by forcing bank owners to have some “skin in the game,” minimum capital requirements help counterbalance incentives for excessive risk-taking created by limited liability and amplified by deposit insurance and bailout expectations. However, many of the banks that were rescued in the latest turmoil appeared to be in compliance with minimum capital requirements shortly before and even during the crisis. In the ensuing debate over how to strengthen regulation, capital continues to play an important role. A consensus is being forged around a new set of capital standards (Basel III), with the goal of making capital requirements more stringent.  

The Global Financial Inclusion Indicators: An Important Step towards Measuring Access to Finance

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How inclusive are financial systems around the world? What proportion of the population uses which financial services? Despite all the work we have done so far, most of the figures cited by experts in this field are still just estimates (see, for example, here and here). But this is about to change—in a big way.

To help us understand the scope and breadth of financial activity by individuals around the world, the Bill & Melinda Gates Foundation today announced an $11 million, 10-year grant to the World Bank’s Development Research Group to build a new publicly accessible database of Global Financial Inclusion Indicators. The ultimate goal of the project is to improve access to finance; achieving this goal requires reliably measuring financial inclusion in a consistent manner over a broad range of countries and over time to provide a solid foundation of data for researchers and policymakers. We will carry out three rounds of data collection, starting with Gallup, Inc’s 2011 Gallup World Poll, which will survey at least 1,000 people per country in 150 countries about their access and use of financial services.

Islamic Banking: Can it Save Us from Crises?

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Pundits in the financial press have been asking an intriguing question: if too much debt and insufficient equity was partly responsible for the financial crisis, might Islamic banking be part of the solution? After all, Islamic principles require that financial transactions cannot include interest rate payments on debt, but rather have to rely on profit-loss risk-sharing arrangements (as in equity). For example, demand deposits that do not pay interest are fine, but savings deposits generally participate in the profits of the bank since these cannot accrue interest. Lending also generally follows a partnership model where the bank provides the resources and the client provides effort and expertise, and profits are shared at some agreed ratio. So can the heightened risk-sharing required by Sharia curb excess risk-taking by banks?

In practice Islamic scholars have also developed products that resemble those offered by conventional banks, replacing interest rate payments and discounting with fees and contingent payment structures. Nevertheless, Islamic banking still retains a strong element of equity participation. How does this affect bank risk-taking? Conceptually, the answer is not immediately clear. On the one hand, the equity-like nature of savings instruments may increase depositors’ incentives to monitor and discipline banks. On the other hand, if deposit instruments are equity-like, banks’ incentives to monitor and discipline borrowers may also be reduced since banks no longer face the threat of immediate withdrawal. Similarly, the equity-like nature of partnership loans can reduce the important discipline imposed on entrepreneurs by debt contracts.

Financial Access and the Crisis: Where Do We Stand?

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Do you wonder how the recent global crisis affected access to financial services? Well I do, and a report by the World Bank Group and CGAP just provided the answer: Data show that even as countries were suffering because of the financial crisis, access to formal financial services grew in 2009.  Indeed, the number of bank accounts grew world-wide, while at the same time the volume of loans and deposit accounts dropped. The physical outreach of financial systems— consisting of branch networks, automated teller machines (ATMs), and point-of-sale (POS) terminals—all expanded.

That’s a relief. Readers of this blog know by now that I am a strong believer in expanding access. Lack of access to finance is often the critical element underlying persistent income inequality as well as slower growth. But the recent global financial crisis has led us to question many of our beliefs and re-opened old debates. It also exposed an important tension between access and stability. Were we wrong to emphasize access in the light of what happened?

Corruption and Finance: Are Innovative Firms Victims or Perpetrators?

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Designing policies that promote innovation and growth is key to development. In many countries there is also considerable corruption, with government officials seeking bribes and many firms underreporting their revenues to the state to evade taxes. Might there be a set of reforms that allow policymakers to kill two birds with one stone, both reducing corruption and boosting innovation? New research suggests financial sector reform may be able to play this role.

In a recent paper with co-authors Meghana Ayyagari and Vojislav Maksimovic, we look at corruption—defined as both bribery of government officials and tax evasion—and how this is associated with firm innovation and financial development. Using firm-level data for over 25,000 firms in 57 countries, we investigate whether firms are victims, who pay more in bribes than they gain by underreporting revenues to tax authorities, or perpetrators, who gain more by avoiding taxes than they lose in paying bribes.

Of particular interest is the effect of corruption and tax evasion on innovative firms. Specifically, we explore the following questions:

Too Big to Fail, or Too Big to Save?

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Too big to fail has become a key issue in financial regulation. Indeed, in the recent crisis many institutions enjoyed subsidies precisely because they were deemed “too big to fail” by policymakers. The expectation that large institutions will be bailed out by taxpayers any time they get into trouble makes the job of regulators all the more difficult. After all, if someone else will pay for the downside risks, institutions are likely to take on more risk and get into trouble more often—what economists call moral hazard. This makes reaching too-big-to-fail status a goal in itself for financial institutions, given the many implicit and explicit benefits governments are willing to extend to their large institutions. Hence, all the proposed legislation to tax away some of these benefits.

But could it be that some banks have actually become too big to save? Particularly for small countries or those suffering from deteriorating public finances, this is a valid question. The prime example is Iceland, where the liabilities of the overall banking system reached around 9 times GDP at the end of 2007, before a spectacular collapse of the banking system in 2008. By the end of 2008, the liabilities of publicly listed banks in Switzerland and the United Kingdom had reached 6.3 and 5.5 times their GDP, respectively.

In a recent paper with Harry Huizinga, we try to see whether market valuation of banks is sensitive to government indebtedness and deficits. If countries are financially strapped, markets may doubt countries’ ability to save their largest banks. At the very least, governments in this position may be forced to resolve bank failures in a relatively cheap way, implying large losses to bank creditors.

Reforming Bank Regulations

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It is no surprise that the recent financial crisis has sparked a new round of regulatory reform all around the world. The crisis has certainly exposed significant weaknesses in the regulatory and supervisory framework and led to a debate about the role these weaknesses may have played in causing and propagating the crisis. As a result, reform of regulation and supervision is a top priority for policymakers, and many countries are working to upgrade their frameworks. But there are more questions than answers: What constitutes good regulation and supervision? Which elements are most important for ensuring bank soundness?  What should the reforms focus on?

The Basel Committee – a forum for bank supervisors from around the world – has been trying to answer these questions since 1997. The Committee first got together that year to issue the Core Principles for Effective Bank Supervision (BCPs), a document summarizing best practices in the field. Since then many countries have endorsed the BCPs and have undertaken to comply with them, making them an almost universal standard for bank regulation. Since 1999, the IMF and the World Bank have conducted evaluations of countries’ compliance with these principles, mainly within their joint Financial Sector Assessment Program (FSAP). Hence the international community has made significant investments in developing these principles, encouraging their wide-spread adoption, and assessing progress with their compliance.

In light of the recent crisis and the resulting skepticism about the effectiveness of existing approaches to regulation and supervision, it is natural to ask if compliance with this global standard of good regulation is associated with bank soundness. This is what I have tried to do with Enrica Detragiache and Thierry Tressel, two of my colleagues from the Fund. Specifically, we test whether better compliance with BCPs is associated with safer banks. We also look at whether compliance with different elements of the BCP framework is more closely associated with bank soundness to identify if there are specific areas that would help prioritize reform efforts to improve supervision.

Bank Competition and Access to Finance

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In a recent blog post, I talked about whether there are trade-offs between bank competition and financial stability.  But what about access to finance?  What does competition imply for access?

Theory supplies conflicting predictions, as usual.  According to standard economic theory, a banking system characterized by market power delivers a lower supply of funds to firms at higher cost; hence greater competition improves access.  However, several theoretical contributions have shown that when we take into account problems of information asymmetry, this relationship may not hold.  For example, banks with greater market power can have more of an incentive to establish long-term relationships with young firms and extend financing since the banks can share in future profits.  In competitive banking markets, however, borrower-specific information may become more dispersed and loan screening less effective, leading to higher interest rates. Indeed, while it has been shown that concentration may reduce the total amount of loanable funds, it may also increase the incentives to screen borrowers, thereby increasing the efficiency of lending.  However, all these models also assume a developed economy, with a high degree of enforcement of contracts and developed institutional environments in general. This is obviously not the case for most of the countries where the Bank works.

Bank Concentration, Competition and Financial Stability: What Are the Trade-offs?

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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, we generally see 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.  Is there a trade-off between increased competition and financial sector stability?

In one camp, there are some who stress the notion of charter value—the proposition that the financial sector is unlike other sectors of the economy and that too much competition may be harmful because it reduces margins and may foster excessive risk taking.  In a second camp are those who argue that a more concentrated banking system may exacerbate banking fragility.  This view holds that less competition leads to greater concentration and increased market power, with banks charging higher interest rates and obliging firms to assume greater risks.  Those in the second camp might also point to the recent crisis, arguing that if banks become “too big to fail” the implicit guarantees provided to them can distort their risk-taking incentives, leading to significantly higher fragility.

As usual, theory is conflicted, so we must turn to empirical evidence to help sort out these claims. In fact a substantial amount of empirical evidence supports the idea that competition per se is not detrimental to financial stability when adequate institutional frameworks are in place.  For example, using data for 69 developed and developing countries Thorsten Beck, Ross Levine and I study the impact of bank concentration and regulatory environment on a country’s likelihood of suffering a systemic banking crisis.  In short, we find that concentration makes banking systems more stable. At the same time, we find that the more competitive financial systems—those with lower barriers to bank entry, fewer restrictions on bank activities, greater economic freedoms and higher quality of regulations—tend to be more stable.  Hence, concentrated banking systems are not necessarily uncompetitive.