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The Pitfalls of Financial Regulatory Reform

Ryan Hahn's picture

On May 25 we invited Professor Charles Calomiris of Columbia University to come speak at the World Bank as part of our FPD Chief Economist Talk series. Professor Calomiris discussed the on-going process of regulatory reform, particularly in the U.S., and was, to put it mildly, less than sanguine about the legislation that is currently making its way through the U.S. Congress. Watch a video of his talk (below the jump). The talk itself runs about 46 minutes, and a Q&A session follows.

Impact Assessment Meets the Market

David McKenzie's picture

Rigorous impact evaluations are one of the most important tools we have for understanding “what works” in development. Impact evaluations compare the outcomes of a program or policy against an explicit counterfactual of what would have happened without the program or policy. This kind of evaluation has been gaining more recognition recently, particularly since Esther Duflo, a professor at MIT and a pioneer in this field, received the prestigious John Bates Clark Award. But her work and that of others in the field has focused primarily on health and education. That is starting to change, with finance and private sector development finally getting their due.

In a recent overview paper, I examine why impact evaluations have been slow to occur in the areas of finance and private sector development, and provide examples of successful cases where it has occurred. I suggest key barriers to their use, including (1) a lack of experience with these methods by operational staff working in these fields; and (2) a perception that many of the policies being implemented are not amenable to evaluation.

Bank Competition and Access to Finance

Asli Demirgüç-Kunt's picture

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?

Asli Demirgüç-Kunt's picture

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. 

Bailing Out the Banks: Reconciling Stability and Competition in Europe

Thorsten Beck's picture

The relationship between market structure, competition and stability in banking has been a policy-relevant but controversial one (see Beck, 2008 for a pre-crisis survey).  The current crisis has put the topic back on the front-burner, and particularly so in Europe, where competition concerns about the effect of national bail-out packages on competition across Europe rank high.  Together with four other European economists, I have tackled this question in a recent CEPR report: Bailing out the Banks: Reconciling Stability and Competition.

The crisis has provoked two common but quite different reactions concerning the role of competition policy in the banking sector.  One reaction has been to jump to the conclusion that financial stability should take priority over all other concerns and that therefore the "business as usual" preoccupations of competition regulators should be put on hold.  Another reaction has been to fear that intervention to restore financial stability will lead to massive distortions of competition in the banking sector, and therefore to conclude that competition rules should be applied even more vigorously than usual, with the receipt of State aid being considered presumptive grounds for suspecting the bank in question of anti-competitive behavior.  We endorse neither of these points of view. 

Thoughts on the Financial Crisis and Improving Financial Regulation

Editor’s Note: The following post was contributed by Ross Levine, the James and Merryl Tisch Professor of Economics at Brown University.  This post summarizes a presentation Professor Levine gave at the World Bank on April 28 entitled An Autopsy of the Financial System: Suicide, Accident, or Negligent Homicide?  The presentation from the event is available here and video of the event will be made available soon on the All About Finance blog.  

In this blog entry, I address three issues: (1) The causes of the cause of the financial crisis, (2) Core approaches to financial regulation, and (3) Systemic improvements.  I also direct readers to longer treatments of each of these issues.


In a recent paper, An Autopsy of the U.S. Financial System: Accident, Suicide, or Negligent Homicide, I show that the design, implementation, and maintenance of financial policies by U.S. policymakers and regulators during the period from 1996 through 2006 were the primary causes of the financial system’s collapse.  I study five important policies (1) Securities and Exchange Commission (SEC) policies toward credit rating agencies, (2) Federal Reserve policies that allowed banks to reduce their capital cushions through the use of credit default swaps, (3) SEC and Federal Reserve policies concerning over-the-counter derivatives, (4) SEC policies toward the consolidated supervision of major investment banks, and (5) government policies toward the housing-finance giants, Fannie Mae and Freddie Mac.

Let me be blunt—time and again, U.S. regulatory authorities and policymakers (1) were acutely aware of the growing fragility of the financial system caused by their policies during the decade before the crisis, (2) had ample power to fix the problems, and (3) chose not to.  This crisis did not just fall from the sky on the heads of policymakers; policymakers helped cause this crisis.  While Alan Greenspan (former Chairman of the U.S. Federal Reserve) depicts the financial crisis as a once in a “hundred years flood” and a “classic euphoric bubble,” the evidence is inconsistent with these overly simple characterizations.  More importantly, this focus on “irrational exuberance” self-servingly deflects attention from the policy determinants of the crisis.

Regulators were not simply victims of limited information or a lack of regulatory power. Rather, the role of regulators in the five policies I mention above demonstrates that the crisis represents the selection—and most importantly the maintenance—of policies that increased financial fragility.  The financial regulatory system failed systemically.  To fix it, we need more than tinkering, we need systemic change. 

What Do We Know about the Consequences of Foreign Bank Participation in Developing Countries?

Maria Soledad Martinez Peria's picture

The process of financial globalization that accelerated in the 1990s has brought many changes to the financial sectors of developing countries.*  Countries have opened up their stock markets to foreign investors, allowed domestic firms to cross-list and issue debt overseas, and welcomed foreign direct investment into their local financial sectors.  When it comes to the banking sector, arguably no change has been as transformative as the increase in foreign bank participation in developing countries.  On average, across developing countries, the share of bank assets held by foreign banks has risen from 22 percent in 1996 to 39 in 2005.  At the same time, foreign bank claims on developing countries, which together with the loans extended by foreign bank branches and subsidiaries include cross-border loans, increased from 10 percent of GDP in 1996 to 26 percent in 2008 (see Figure 1).

Total foreign claims

What Explains Firm Innovation in Developing Countries?

Asli Demirgüç-Kunt's picture

Many economists agree that innovation is essential for economic growth.  But the little we know about firm innovation is based on the study of large, publicly-traded firms in developed countries.  As Moisés Naím, editor-in-chief of Foreign Policy magazine, pointed out at the recent Financial and Private Sector Development Forum, large, publicly-traded firms have served as the basis for a lot of formal economic analysis, but they are much less typical of developing countries.  This is a problem, since we know from existing studies that small and medium size firms play an important role in developing countries.

What might explain the likelihood of these firms to innovate?   Here are some of the key issues that deserve closer scrutiny:

  • Are certain types of firms more innovative than others?
  • What is the role of finance, governance and competition?
  • Is ownership or corporate form important?
  • Does foreign competition or trade openness matter?
  • And what about the education and experience of managers and workers?

How Do Firms Finance Investment?

Asli Demirgüç-Kunt's picture

A large body of literature has found that in countries with weak institutions firms are able to obtain less external financing, resulting in lower growth.  Indeed, even simple cross-country comparisons of firm financing patterns can be quite revealing.  In a paper co-authored with Thorsten Beck and Vojislav Maksimovic, this is exactly what we do.  Using data from the World Bank’s Enterprise Surveys dataset (WBES) for 48 countries, we investigate what proportion of firm investment is financed externally, and, of this external finance, how much of it comes from different sources, such as bank and equity finance, leasing, supplier credit, development banks, and informal sources such as money lenders.

In our sample of firms, on average just over 40 percent of firm investment is externally financed.  Breaking external financing down into its parts, about 19 percent of all financing comes from commercial banks and 3 percent from development banks.  Another 7 percent is provided by suppliers and 6 percent through equity investment.  Leasing is another 3 percent, and less than 2 percent comes from informal sources.  More recent enterprise survey data for an expanded sample of countries and firms also suggest similar patterns (Figure 1).

Source: Enterprise Surveys, covering 71 countries