My previous blog post  introduced the Global Financial Development Report (GFDR), a new series of publications by the World Bank Group. Each of these GFDRs will feature a financial sector topic that is prominent on the international agenda. In the first edition, slated for release in September 2012, we’ll be focusing on one of the most pressing issues faced by policymakers in the wake of the global financial crisis: Rethinking the Role of Government in Finance.
In the decades preceding the global financial crisis, we have seen a steady push towards lowering the role of government in finance. On balance, empirical studies on the topic  have been pointing out the harmful effects of government interventions. Policymakers had absorbed these ideas, and we saw that the market shares of state-owned financial institutions have been on the decline in the runup to the crisis . We also saw a broader trend towards reducing the role of government regulation and leaving more scope for market discipline.
The crisis has disrupted this trend, and revived the notion that government, through more stringent regulations and other interventions (including possibly direct ownership of financial institutions) can help maintain stability, drive growth, and create jobs. Is this rethinking warranted? Are market failures more severe than government failures? This topic is highly relevant for the post-crisis policy debates, and it is likely to remain so in the coming years.
Table 1. The Four Roles of Government in Finance
Governments take on many roles in the financial sector. GFDR 2013 will re-examine the arguments and evidence for and against the four key roles of government: (i) ownership, guarantees, and other direct interventions; (ii) regulation and supervision; (iii) promotion of competition; and (iv) provision of infrastructure and technology (Table 1).
Ownership and other direct interventions. You may recall the recent lively debate  we had on this very blog, discussing whether state-owned banks can play an important role in promoting financial stability and access. Kicking off the debate, Franklin Allen (Wharton School) provided an affirmative answer  to this question, while Charles Calomiris (Columbia University) argued against the proposition . Interestingly, a poll of blog readers showed that a 3:1 majority favored the positive answer  that state-owned banks can indeed play an important role. That was perhaps a bit surprising given that many of the comments on the blog were skeptical, pointing out the many shortcomings of state-owned financial institutions in terms of financial performance and contribution to financial and economic development.
I see this as a reflection of a broader disconnect. Although state-owned institutions may seem to hold much promise, this has clashed with the less-than-rosy reality on the ground. Indeed, existing studies suggest  that the performance of many state-owned financial institutions has tended to been less than stellar (relatedly, recent research presented on this blog  indicates that there is scope to reduce the market share of state banks in some Middle Eastern and North African countries where such banks still dominate financial intermediation). But some of the debate on this blog indicates that perhaps there are conditions under which such financial institutions can actually be useful, and perhaps the real question is what conditions or frameworks need to be in place to reap those benefits while limiting the risks.
In any case, the blog debate confirms that this is a discussion that holds many people’s attention. It is also one with much practical importance: while some countries have relatively little state ownership of financial institutions, in others state-owned banks are dominant (Figure 1). The GFDR will pick up on these debates, re-examining the impact of state interventions using fresh post-crisis data, and trying to address issues such as the extent to which state-owned banks can play a positive role in promoting financial development. It will also examine the scope for other forms of direct—but perhaps better calibrated and better targeted—intervention, such as subsidies and guarantees.
Figure 1. Shares of Majority State-, Private-, and Foreign-Owned Banks in Selected Countries (percent of total banking assets)
Regulation and supervision. Another part of the report will focus on the role of state as a regulator and supervisor. It will address questions such as: Has the crisis changed the approach towards regulation and supervision? What can be left for market discipline, and what needs to be regulated? What are some of the likely regulatory changes, and what can be expected in terms of their impact on the World Bank’s client countries? To provide answers to these questions, GFDR 2013 will build on an update of the World Bank database of banking regulation and supervision around the globe . An update of the database was launched in early 2011, with results expected in late 2011. This fresh data will be used to provide new information on regulatory practices around the world and in particular the key changes in response to the crisis. An analysis of the data promises to provide some answers as to which regulatory strategies tend to work better than others. Given that some of the pre-crisis work based on the earlier iterations of the survey has argued for relatively light regulation and a greater role for market discipline, the updated version of the survey will provide an interesting opportunity to re-visit the issue of the interplay between regulation and market discipline.
Promotion of competition in finance. The report will also examine the role of state in determining financial structure and level of competition. Again, this topic has been highlighted by the recent financial crisis, with some observers raising questions about the extent to which competition may have contributed to the crisis  through the creation of a bubble in housing prices and the massive extension of loans to subprime borrowers, and more generally through the fierce search by banks for more profitable opportunities such as structured products and securitization. GFDR 2013 will take a closer role at the government’s competition policy in finance, asking questions about the respective roles of competition agencies and prudential supervisors, the role of entry, including foreign entry, the role of exit and too-big-to-fail policies, and the right balance between promoting competition and preventing possible excesses that could lead to instability. On the related concept of “optimal financial structure” and its link to economic development, the report may build on papers that will be presented in an upcoming conference, organized by World Bank’s Development Research Group in Washington, DC on June 16, 2011 .
Promotion of financial infrastructure and technology. Finally, the financial crisis has also put back into the spotlight the importance of financial sector infrastructure (such as credit information systems, payment and securities settlement system, and collateral registries) for well-functioning and sustainable financial sectors. The absence of reliable infrastructure makes it difficult for lenders to evaluate risks, reduces the ability of borrowers to obtain financial products on competitive terms, and decreases the efficiency of intermediation. Against this background, the report will examine the critical issues in setting up financial infrastructures, such as what types of infrastructure the government needs to establish, and which ones can be left to the private sector to develop. Also, it will examine the roles that governments can play in promoting technology and other innovations in the financial sector.
In sum, this promises to be an exciting inaugural issue of the GFDR. Please let us know your comments, suggestions, and inputs.