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Financial Sector

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.

Taxing financial transactions?

Asli Demirgüç-Kunt's picture

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.

Triplet Crises: Lessons European Leaders Can Learn From Emerging Markets

Maria Soledad Martinez Peria's picture

Much of the discussion surrounding the current European crisis focused initially on whether a default by Greece was inevitable and how that would impact bond holders. Over time, the attention has shifted to banks and the potential for a generalized run and failure of the financial system, not only in Greece but also in other countries. Unfortunately, the developments in Europe are awfully similar to those in emerging economies in the past. The lessons learned in emerging markets might have helped European policymakers lessen the spillovers from macroeconomic risk to the financial sector, and even at this stage may still be useful for understanding how to manage the on-going crisis.

Many emerging economies used to follow exchange rate pegs, had large degree of liability dollarization, and ran fiscal deficits financed by the banking sector, which led to “triplet crises” involving debt, currency, and banking collapses. The  crises in Argentina and Uruguay in 2000–02 are illustrative. In a recent paper co-authored with Levy Yeyati, we show that macroeconomic risks like exchange rate devaluations or sovereign debt defaults can quickly cause the collapse of banking systems. These macroeconomic events are not random or driven by contagion across banks. Macroeconomic factors that are largely irrelevant in explaining depositor behavior during tranquil times can rapidly become the main driver of market response during crisis episodes, even after controlling for standard bank-specific traits. Furthermore, a crisis in one country (Argentina) can contaminate the banking system of a neighboring country (Uruguay) in a matter of days.

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

Asli Demirgüç-Kunt's picture

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.

How to Deepen Financial Systems in Africa: All financial sector policy is local

Thorsten Beck's picture

Editor’s Note: This is the fifth and final contribution in a series of posts that preview the findings of the forthcoming Financing Africa: Through the Crisis and Beyond regional flagship report, a comprehensive review documenting current and new trends in Africa’s financial sectors and taking into account Africa’s many different experiences. The report was prepared by the African Development Bank, the German Federal Ministry for Economic Cooperation and Development and the World Bank. In this post, the authors argue that all financial sector reform has to start locally, taking into account political constraints, but also aiming to create a constituency for financial sector reform.

What has the recent crisis taught us about the role of finance in the growth process of countries? The global crisis and the ensuing Great Recession have put in doubt the paradigm that financial deepening is good for growth under any circumstance. For students of financial systems, the bright (growth-enhancing) and dark (instability) sides of financial development go hand in hand. The same mechanism through which finance helps growth also makes finance susceptible to shocks and, ultimately, fragility.

Lengthening Financial Contracts in Africa

Thorsten Beck's picture

Editor’s Note: This is the third in a series of posts that preview the findings of the forthcoming Financing Africa: Through the Crisis and Beyond regional flagship report, a comprehensive review documenting current and new trends in Africa’s financial sectors and taking into account Africa’s many different experiences. The report was prepared by the African Development Bank, the German Federal Ministry for Economic Cooperation and Development and the World Bank. In this post, the authors focus on the challenges and opportunities in providing long-term finance for enterprises, households and governments. Long-term finance is a critical element for financial systems to fulfill their growth-enhancing role.

Despite recent encouraging innovations in banks, contractual savings institutions, and the capital market, we find that lengthening financial contracts remains a challenge for financial systems across Africa. Figure 1 illustrates the short-term nature of African banking; more than 80% of deposits are sight deposits or with a maturity of less than one year and less than 50% percent of loans have a maturity of more than one year. Providers of long-term finance that are well developed in the industrialized world, such as insurance companies, pension and equity funds and venture capitalists are small in most African countries and inefficient in their operation. This goes hand in hand with a limited supply of long-term equity and debt instruments across the continent.

Is Infrastructure Capital Productive?

From a theoretical and empirical standpoint, the contribution of infrastructure capital to aggregate productivity and output has been extensively researched. Public capital has been modeled as an additional input in Ramsey-type exogenous growth models and in endogenous models as well. On the empirical front, the literature has witnessed a proliferation of research over the last 20 years following Aschauer’s (1989) seminal paper on the effects of public infrastructure capital on US total factor productivity. His finding of excessively high returns to infrastructure, however, has not held up. Subsequent research using a large variety of data and more robust econometric techniques has yielded widely contrasting empirical results. For instance, Bom and Ligthart (2008) find that estimates of the output elasticity of public capital range from -0.175 to +0.917 in a wide set of empirical research for industrial countries.

Financing Africa: Through the Crisis and Beyond

Thorsten Beck's picture

In mid-September, the African Development Bank, the German Federal Ministry for Economic Cooperation and Development and the World Bank will launch Financing Africa: Through the Crisis and Beyond , a comprehensive review documenting current and new trends in Africa’s financial sector and taking into account Africa’s many different experiences. During the coming weeks and leading up to the formal launch of the book in Ethiopia on September 15, we will give a sneak peek of the book’s main findings and recommendations. In this first post, we’ll summarize our main messages.

Bank Competition and Stability: Cross-Country Heterogeneity

Thorsten Beck's picture

In a recent Economist debate, Franklin Allen and I discussed the relationship between competition and stability. In the debate I argued that it is not so much the degree of competition in the banking market but rather bank regulation and supervision that drives bank fragility. In a recent paper with Olivier de Jonghe and Glenn Schepens, we now combine these two areas and test whether the regulatory and supervisory framework influences the competition-stability relationship. And we indeed find several dimensions of the market, regulatory and institutional framework that influences the degree to which competition harms or helps bank fragility.

But let us first review what theory tells us about the competition-stability link, and then examine how this relationship might vary with certain country features.