The Proposition: "Can state-owned banks play an important role in promoting financial stability and access?"
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?
Editor's Note: Raju Jan Singh recently presented the findings of the paper discussed in the following blog post at a session of the FPD Academy. Please see the FPD Academy page on the All About Finance blog for more information on this monthly World Bank event.
The recent financial crisis has renewed concerns about the merits of financial development, especially for the most vulnerable parts of the population. While financial development and its effects on economic growth have attracted much attention in the literature, far less work has been done on the relationship between financial deepening and poverty. Yet some economists have argued that lack of access to finance is among the main causes of persistent poverty.
Studies on the relationship between financial development and income distribution have been inconclusive. Some claim that by allowing more entrepreneurs to obtain financing, financial development improves the allocation of capital, which has a particularly large impact on the poor. Others argue that it is primarily the rich and politically connected who benefit from improvements in the financial system.
Ask small farmers in semiarid areas of Africa or India about the most important risk they face and they will tell you that it is drought. In 2003 an Indian insurance company and World Bank experts designed a potential hedging instrument for this type of risk—an insurance contract that pays off on the basis of the rainfall recorded at a local weather station.
The idea of using an index (in this case rainfall) to proxy for losses is not new. In the 1940s Harold Halcrow, then a PhD student at the University of Chicago, wrote his thesis on the use of area yield to insure against crop yield losses. In the past two decades the market to hedge against weather risk has grown, especially in developed economies: citrus farmers can insure against frost, gas companies against warm winters, ski resorts against lack of snow, and couples against rain on their wedding day.
Rainfall insurance in developing countries is typically sold commercially before the start of the growing season in unit sizes as small as $1. To qualify for a payout, there is no need to file a claim: policyholders automatically qualify if the accumulated rainfall by a certain date is below a certain threshold. Figure 1 shows an example of a payout schedule for an insurance policy against drought, with accumulated rainfall on the x-axis and payouts on the y-axis. If rainfall is above the first trigger, the crop has received enough rain; if it is between the first and second triggers, the policyholder receives a payout, the size of which increases with the deficit in rainfall; and if it is below the second trigger, which corresponds to crop failure, the policyholder gets the maximum payout. This product has inspired development agencies around the world, and today at least 36 pilot projects are introducing index insurance in developing countries.
Editor's Note: The following post was submitted jointly by Jake Kendall and Ignacio Mas of the Bill and Melinda Gates Foundation.
At the Financial Services for the Poor team at the Bill & Melinda Gates Foundation we have made a deliberate choice to focus on promoting savings (you can read about our strategy here). We think that saving in a formal, prudentially regulated financial institution is a basic option that everyone should have. Having a safe place to save allows people to manage what little they have more effectively and to self-fund life-improving or productivity-enhancing investments without paying the high interest rates associated with small loans. Accessing other people’s money through credit may not be right for everyone, but making the most out of your own income surely is. From a donor perspective, we need to move beyond microcredit and support the development of broader markets. In fact, too much focus on microcredit risks tilting the incentives of local financial intermediaries to funding their credit portfolio from external soft funds rather than via mobilizing local deposits.
As I go around the world talking up these issues, I am struck by how often I need to justify the value of savings for poor people intellectually. Sure, we should do more to demonstrate these benefits with actual data, and we are funding a bunch of studies in this regard. But why is the notion so counter-intuitive for many people? I would trace that to two misconceptions and two fears.
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.
Lack of competition in the banking sector has detrimental effects. Studies have found that it can result in higher prices for financial products and less access to finance, especially for smaller firms. Others have shown that it can lead to the entry of fewer new firms, less growth for younger firms, and delayed exit for older firms. Moreover, while a debate is still under way, new evidence suggests that lack of competition can undermine the stability of the banking sector, especially if some banks become too big to fail.
How to measure bank competition? In a recent paper Asli Demirgüç-Kunt and I propose a multipronged approach. While we apply this framework to Jordan, it can be used to analyze bank competition in any country. In fact, the approach developed in this paper has been used to analyze competition in China, the Middle East and North Africa, and Russia.
Ask most people to name the most effective means of raising incomes of people in poor countries, and what would they say?
Deworming? It increased primary school participation and improved health, but in the short-term at least seems unlikely to raise household income.
Conditional cash transfers? This might be a popular answer, with evidence from a number of countries that they have increased household expenditure , schooling, and health outcomes. But even though Governments devote significant resources to such programs, the absolute annual increases in household income and expenditure are still at most US$20-40 per capita for participating households.
I bet that facilitating international migration is not very high up the list of interventions people think of. But it should be. In a new working paper, John Gibson and I evaluate the development impacts of New Zealand’s new seasonal worker program, the RSE. The figure below compares the per-capita income gain we estimate to those from microfinance, CCTs, and from my previous research giving grants of $100-200 to microenterprises. It is simply no contest!
To promote the registration of new firms, many countries have been undertaking reforms to reduce the costs, days or procedures required to register a business. For example, the World Bank Doing Business report each year identifies the 10 most improved countries on the overall Doing Business index (comprised of 9 subindicators). One of these subindicators measures reforms related to starting a business, with 30-65 countries reforming in this area each year. A still unanswered question is whether some reforms are more important than others. A priori, it is not clear what magnitude of reduction in costs (or days or procedures) is necessary to create a significant impact on firm registration. In other words, what exactly constitutes a reform? Is a 20% reduction in the costs of registration sufficient, or is a 50% reduction necessary to get a substantial number of firms to register?
In a recent paper Leora Klapper and I empirically investigate the magnitude of reform required for a significant impact on the number of new registrations. We use a new dataset that is uniquely suited for this purpose: the World Bank Group Entrepreneurship Snapshots (WBGES), a cross-country, time-series panel dataset on the number of newly registered companies. We supplement it with data from Doing Business reports that contain the cost, time and procedures required for registration of new companies. Importantly, both datasets focus on limited liability companies. In an earlier paper, we used the same dataset to investigate the impact of the global financial crisis on new firm registrations.
Several economists have argued that cross-country differences in economic development today have their roots in the colonial era. For example, Engerman and Sokoloff (1997, 2002)—henceforth referred to as ES—argue that different types of economic activities that the colonizers engaged in led to different growth paths. They claim that the link between colonial activities and current-day levels of economic development is as follows. In many areas, colonial society was very unequal, giving political rights only to a few landowners, while repressing most of the population through slavery or forced labor. Consequently, institutions that developed during colonial times were designed to protect the rights of only a few. These institutions persist until today and constrain economic development. To give one example, many Latin American banking systems developed primarily to serve a wealthy elite, restricting access to finance for the rest of the population.
In a paper I recently co-authored with Francisco Gallego, we test empirically whether areas with different types of colonial activities do indeed have different levels of economic development today. We use within-country data for 345 regions in seventeen countries in the Americas to do this. We rely on within-country data because colonial activities varied considerably even within countries (for example, the northeast of Brazil grew sugar, while many states in central and southern Brazil had large cattle ranches). Moreover, in our sample, levels of development vary almost as widely within countries (between regions) as they do between countries.