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Finance, Growth, and Fragility: What Role for Government?

Thorsten Beck's picture

When I was invited to give the Maxwell Fry Global Finance Lecture in Birmingham last year, I decided to stay in the tradition of Maxwell Fry (1988) and focus on the role of government in the financial sector, a continuously controversial issue. Maxwell Fry was one of the first economists drawing the attention to the importance of the financial sector for economic development, well before the empirical finance and growth literature took off in the 1990s, while at the same time documenting the negative effect of excessive government intervention into financial markets, also referred to as financial repression.

Financial development has been identified as a key policy area for economic development, while at the same time rapid credit expansion often results in systemic fragility and economic crisis. The critical issue has been the question of what explains the variation in financial sector development (both shallow markets in some, but also over-expanding markets in other countries and periods). Economists have provided three different kinds of answer. In the following I will refer to them as the (i) policy approach, (ii) political approach and (iii) historical approach. While these three views are not incompatible with each other, they imply very different views on the nature and role of government within the financial system.

The Policy View

The first approach focuses on policies to foster financial deepening while at the same time prevent overshooting. Among these policies are macroeconomic stability, strong informational and contractual frameworks and a regulatory framework that aligns risk-taking incentives with (both negative and positive) returns on these decisions. Cross-country comparisons have shown a strong link between macroeconomic stability and financial development (Boyd, Levine and Smith, 2001). A large literature both across countries but also exploiting within-country variation and policy changes has shown the importance of the institutional infrastructure for financial deepening (e.g., Djankov, McLiesh, Shleifer, 2007). And the literature has also pointed to macroeconomic predictors of systemic banking distress and the optimal structure of the financial safety net, including deposit insurance and the regulatory framework (Barth, Caprio and Levine, 2007). In summary, the policy view sees the problem of financial deepening as one of choosing the right policies. It also emphasizes, however, that this mix might very much differ across countries at different levels of economic and financial development and with different needs. The policy view has been behind the extensive financial sector work by both IMF and World Bank across the developing and the developed world.

The political view

A second approach starts with the question that if economists (and therefore policy makers) know which policies are needed to foster sustainable financial development, why are they not being implemented? While there might be limited knowledge, capacity constraints and fixed cost barriers to policy reform, the political approach to financial sector policies focuses more on the private interests of those tasked with implementing financial sector policies. Let me mention just a few examples to illustrate this view. When designing the financial safety net, policy makers face the trade-off between limiting the contagion and spill over effects of bank failure on the remainder of the financial system and the fall-out for the real economy, on the one hand, and limiting moral hazard risks, on the other hand, i.e. incentives for banks to take aggressive risks, which might be reinforced by banks’ expectations of a bail-out if policy makers care heavily about contagion effects. The design of the financial safety net, however, reflects the strength of different interests, including bankers, politicians, and taxpayers who tend to emphasize contagion risks and moral hazard risks to a different degree. That the design of financial safety nets is subject to political decision processes is empirically confirmed by Demirguc-Kunt, Kane and Laeven (2008) who show that countries with more undercapitalized banks and thus higher incentives to take aggressive risks adopt more generous deposit insurance schemes, as do countries with more political space for special interest groups.

Another example is the establishment of credit registries. While cross-country comparisons have shown the importance of credit information sharing for financial deepening, there are both winners and losers of effective systems of credit information sharing. Specifically, a wider sharing of information about borrowers, which allows these borrowers in turn to build up reputation capital, undermines information rents of incumbent banks. As recently shown by Bruhn, Farazi and Kanz (2013), countries with lower entry barriers into the banking market and thus a greater degree of contestability in the banking system are less likely to adopt a privately-run credit bureau as are countries characterized by a high degree of bank concentration. In these countries, incumbent banks stand to lose more monopoly rents from sharing their extensive information with smaller and new players. Interestingly, these relationships do not hold for public credit registries (mostly at Central Banks), which underlines the limitations of purely private institutions and the positive role of governments.

The political view does not contest the validity of the policies identified for sustainable financial sector deepening. Rather, it tries to understand under what circumstances such policies can be implemented and have their maximum impact. And there are examples where partial reforms have had rather negative effects as they strengthened rent seeking. One interesting example to illustrate this point is Nigeria, which undertook a broad program of financial liberalization in the mid-1980s, but maintained a multiple exchange rate regime, thus opening a new area of arbitrage and rent seeking for financial institutions that had privileged access to foreign exchange auctions (Lewis and Stein, 2002).  In the following years, the number of banks tripled from 40 to nearly 120, employment in the financial sector doubled and the contribution of the financial system to GDP almost tripled; financial intermediation, however, shrank, with deposits in financial institutions and credit to the private sector, both relative to GDP, decreasing dramatically. The increasing number of banks and human capital in the financial sector was thus channeled into arbitrage and rent-seeking activity rather than financial intermediation. By 1990, the bubble started to burst.

The historical view

A third view, directly related to the finance and politics view, sees today’s level and structure of financial systems as result of historical processes and thus reflections of historic political conflicts. One set of theories sees historic events in Europe more than 200 years ago as shaping the legal and regulatory frameworks across the globe today through their influence on political structures in these countries. Specifically, the legal origin theory sees political conflicts in England and France in the medieval age and during the Glorious and French Revolutions shaping the role and independence of judiciaries in these countries. According to this view, the differences between Common and Civil Law countries persist until today shaping the development and structure of financial sectors through their impact on the overall political and institutional framework of countries (La Porta et al., 1998). An alternative explanation refers not to the identity of the colonizing power but the mode of colonization, as posited by Acemoglu, Johnson, and Robinson (2001, 2002). The political structures developed during the colonization period endured after independence, therefore also making the weak property rights and contract enforcement institutions persistently weak beyond independence.

Beyond documenting the importance of initial political structures and resource distribution, the historical view also shows the importance of persistence in financial system development and suggests that major policy changes are only possible under outside pressure or exogenous shocks. Examples abound for such exogenous shocks to change financial sector policies with positive effects on financial deepening. In Brazil the introduction of the Real Plan in 1994 that terminated the long-running inflationary tradition prevented the government from bailing out banks owned by individual states, as it had done several times before, and thus forced a complete restructuring of these institutions (Beck, Crivelli, and Summerhill, 2005). In Argentina, the establishment of a currency board in 1991 started the restructuring process of provincial banks (Clarke and Cull, 2002). Technological innovation was critical in driving branch deregulation in the United States in the 1970s and 1980s reducing the monopoly power of local banks, weakening their ability and desire to fight against deregulation (Kroszner and Strahan, 1999).

The role of government — a conundrum

Where does this discussion leave us in terms of the role of government? On the one hand, effective authorities are needed to create the policy space and institutional framework for financial institutions and markets to flourish, but internalize all consequences of their risk decisions. On the other hand, we have learned that governments cannot necessarily be trusted, which leaves us with a conundrum of the financial sector reform, as it is often the countries with the most captured regulatory and government authorities that need a strong role for government to overcome market failures. In line with Acemoglu’s (2003) argument that a Coase Theorem is impossible on the country level, the efficiency and distributional repercussions of financial sector reform cannot be separated.

Experience across countries has given some insights into possible solutions, although there is no silver bullet. Independent but accountable regulators can certainly help, thought additional safeguards against the "not-on-my-watch" phenomenon of forbearance are needed. Moving regulatory and supervisory processes to the supra-national level, thus more removed from local political influences might be helpful, although it does raise concerns of accountability. Most important, however, is that political economy constraints have to be taken into account when designing financial sector reform programs. The optimal role of government intervention in the financial sector is a function of the overall political structure, including checks and balances and accountability in a country. There is thus a need to move from best-practice to best-fit approaches. Ultimately, all financial sector policy is local!

On a broader level, the experiences I have discussed so far show the importance of competitive and contestable financial markets to reap the benefits of financial innovation and reduce long-term monopolistic rents. Yes, informational rents are at the core of many relationships and innovation often needs to be incentivized with rents, but there is a strong case for "sunset clauses" for such rents, to the benefit of long-term financial deepening. In the same vein, a focus on financial services rather than on specific institutions or markets is called for.


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