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Financial Sector

Should Development Organizations be Hunting Gazelles?

David McKenzie's picture

Last week I presented some early findings from ongoing work at the IADB, at Innovations for Poverty Action’s SME initiative inaugural conference. There was a lot of interesting discussion about early results from efforts to improve management and skills in small and medium firms, discussion of the most appropriate ways of financing these firms and the extent to which a personal vs automated approach to determining creditworthiness can be used, and an interesting panel on policies towards the missing middle. However, the one theme that has got me thinking the most is something that seems to come up a lot in discussions of microenterprise development and SME programs recently, namely should development institutions and policymakers be directing fewer resources at microfirms and more at high-growth-potential enterprises or gazelles?

Gazelles are defined by the OECD to be all enterprises up to 5 years old with average annualised growth greater than 20% per annum, over a three year period, and which have 10 or more workers. Recent work in the US, and looking at firms around the world have emphasized the role of a subset of dynamic, fast-growing young firms in net job creation, leading to policymakers and practioners focused on job creation to think we should be devoting more effort to identifying and supporting these gazelles, and decrying the lack of venture capital markets in developing countries. For example, see this scoping note by Tom Gibson and Hugh Stevenson at the IFC.

Informal Networks and Shadow Banking: Policy Implications

Robert Townsend's picture

Panel data can be used to measure directly or infer indirectly the presence and role of informal financial networks. In the Townsend Thai data (a collection of over 12 years of annual panel data for 900 households in 64 Thai) villages, networks are shown to play a beneficial role in smoothing consumption and investment against income and cash flow fluctuations. Villagers who lack formal financial access but are indirectly connected through networks receive the benefits of the formal financial system. Surveys of financial access  that ignore these networks can understate the reach of financial access while hiding the needs of the truly vulnerable (e.g., poor households without any kin in their village). Complementarities between the formal financial system and informal networks show up in bridge loans for repayment and the transactions demand for cash, revealing highly active informal money markets.

The same logic and data make labor supply and hours data conform with those of a sophisticated risk syndicate and make the rate of returns on investment/occupations conform with the theory of modern finance—in particular a capital asset pricing model applied to technologies/occupations with common market/village risk. We found that families engaged in occupations like rice farming require a higher expected return because this activity does well only when the village as a whole is doing well, and conversely occupations which are not covariate with market risk are recognized as particularly valuable. However, heterogeneous risk preferences creates a policy warning: outside insurance targeting village/market risk can actually make some in a village worse off, those had been providing insurance to others.

Has the Global Banking System Become More Fragile Over Time?

Asli Demirgüç-Kunt's picture

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.

Credit Reporting: An Essential Building Block of Financial Access at the Base of the Pyramid

Margaret Miller's picture

Credit information and credit reporting systems are critical to a modern financial sector’s infrastructure. Since past behavior is one of the most powerful indicators of future behavior, credit reports which detail payment histories provide lenders with a valuable tool to classify the risk posed by different borrowers. Credit reporting systems reduce the impact of asymmetric information on credit markets, both by helping lenders to more effectively screen borrowers and avoid adverse selection and by providing an incentive for borrowers to repay their loans—thus reducing moral hazard.

These systems are very well developed in North America and parts of Western Europe but are relatively new in most of the world. As data from the World Bank’s Doing Business database shows (see Figure 1 below), only a small fraction of adults are covered even where credit bureaus do operate. Even in Latin America, which has the best coverage of any emerging market region, only about one third of adults are covered. In many other regions, significantly fewer than 10% of adults have a credit report, and those who are in the system are likely to be high-income consumers with bank loans, not customers of microfinance lenders or retail credit providers.

Conflict Between an International Financial Agreement and the Borrower’s Domestic Law: Which One Prevails?

Ryan Hahn's picture

AAF blog readers who are in Washington, DC this week may be interested in attending an event this Wednesday on Conflict Between an International Financial Agreement and the Borrower’s Domestic Law: Which One Prevails?. The event is part of the World Bank Group's annual Law, Justice and Development week. More details on the event are here, and full details on the LJD week are here.

The Future of Banking

Thorsten Beck's picture

For better or worse, banking is back in the headlines. From the desperate efforts of crisis-struck Eurozone governments to the Occupy Wall Street movement currently spreading across the globe, the future of banking is hotly debated. A new compilation of short essays by leading financial economists from the U.S. and Europe analyzes the short-term challenges in addressing the Euro-crisis as well as the medium- to long-term regulatory issues. The essays cover a wide variety of topics, ranging from Eurobonds to ring-fencing and taxation, but there are several themes that come through across the chapters. First, many reforms have been initiated or are under preparation, but they are often only the first step towards a safer financial system. Second, there is a need to change banks’ incentive structure in order to reduce aggressive risk-taking. Third, there is an urgent – also political – need to move away from privatizing gains and nationalizing losses, thus from bailing out to bailing in bank equity and junior debt holders.

I will not be able to touch on all the topics discussed in the book, so let me discuss some of the main messages in more detail. Ring fencing – the separation of banks’ commercial and trading activities, known as the Volcker Rule but also recommended by the Vickers Commission in the UK – continues to be heavily discussed among economists. While Arnoud Boot thinks that “heavy-handed intervention in the structure of the banking industry … is an inevitable part of the restructuring of the industry”, Viral Acharya insists that it is not a panacea as long as incentive problems are not addressed. Banks might still undertake risky activities within the ring or might even have incentives to take more aggressive risk. Capital regulations have to be an important part of the equation.

Do We Need Deposit Insurance for Large Banks?

Asli Demirgüç-Kunt's picture

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?

Addressing the Too-Big-to-Fail Problem before the Banks Become Too-Big-to-Save

Inci Otker-Robe's picture

The unprecedented scope and intensity of the ongoing global financial crisis has underscored the too-important-to-fail (TITF) problem associated with systemically important financial institutions (SIFIs). Ahead of the crisis, implicit government backing permitted these institutions to take on greater risks without being adequately subjected to market discipline, and to enjoy a competitive funding advantage over systemically less important institutions. When the crisis broke, their scale, complexity, and interconnectedness, which had made them difficult to manage and supervise, also proved too significant to permit them to fail. The large-scale public support provided during the crisis has reinforced the moral hazard problem and allowed SIFIs to grow even more complex and larger.

In a recent IMF Staff Position Note with my coauthors, Aditya Narain, Anna Ilyina, Jay Surti, and other IMF colleagues, we found that a regionally diverse group of 84 banks, which are sufficiently large or interconnected to be considered systemic at national, regional, or global levels, doubled their share of total global financial assets over the period 2000-09, to about a quarter (Figure 1). The assets of some of these banks exceed multiples of the size of their home economies (Figure 2). This importance, in turn, gives such banks greater influence over the regulatory and legislative process and a competitive advantage over systemically less important institutions, while making the rescue of such institutions, when they get into trouble, a very costly affair. In countries affected by the recent financial crisis, governments protected many of these institutions from failure by providing direct and indirect support to contain the damage to the broader economy (the direct support, excluding guarantees, is estimated at 6.4 percent of GDP on average in the most crisis-affected countries in end-2010).

Cross-Border Banking Linkages: Good or Bad for Banking Stability?

Martin Cihak's picture

When a country’s banking sector becomes more linked to banks abroad, does it get more or less prone to a banking crisis? In other words, should cross-border banking linkages be welcomed? Or should they be approached with caution or perhaps even suppressed in some way?

The recent global financial crisis has illustrated quite dramatically that increased financial linkages across borders can have a ‘dark side’: they can make it easier for disruptions in one country to be transmitted to other countries and to mutate into systemic problems with global implications. 

But financial cross-border linkages may also benefit economies in various ways. They can provide new funding and investment opportunities, contributing to rapid economic growth, as witnessed in many countries in the early part of the 2000s. The more ‘dense’ linkages also provide a greater diversity of funding options, so when there are funding problems in one jurisdiction, there are potentially many ‘safety valves’ in terms of alternative funding.

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