From hedge funds to mortgage-backed securities, unregulated and risky activities have fallen out of favor since the Lehman Brothers debacle. Aggressive, casino-type behaviors and obscure transactions definitely played an important role in the run up to the financial crisis of 2008. But are all financial activities that operate outside the regular banking system bad?
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Book Title: In From the Shadow : Integrating Europe’s Informal Labor
by Truman Packard, Johannes Koettl, Claudio Montenegro
Few phenomena that occupy the time of governments and economists are as ambiguously defined and difficult to measure as the “shadow" or "informal" economy. Those terms immediately make some people think of the guys who built an extension for their house and insisted on being paid in cash. Others remember the taxi driver who took them home after a late night out, and either didn’t have a meter or didn’t turn it on. Those who have been in very poor countries might recall bustling markets where you can haggle for anything from a handful of fresh chilies to a pair of sandals or even livestock. All of these are likely to be part of the unregulated and untaxed transactions that make up a country's informal economy.
Supporters of social entrepreneurship often cite examples of “heroes” who have successfully built organizations to solve social problems on a global scale. But social entrepreneurship also includes many efforts to fix targeted, local problems rather than working toward large-scale global change. An increasing number of social entrepreneurs are experimenting with ways to use commercially generated revenue to grow and maintain their social impact.
These findings are part of one of the most robust quantitative studies of social enterprise to date. Undertaken by Harvard Business School Associate Professor Julie Battilana and her colleague Matthew Lee, a doctoral student at Harvard Business School, they analyzed 6 years worth of applicant data from Echoing Green. The purpose of the study is to expand the field of vision beyond “heroic stories” that dominate the discussion on social entrepreneurship. In this interview, they share some initial findings from their research.
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.
One of the interesting debates in the finance and development literature is on financial structures: does the mix of institutions and markets that make up the financial system have any impact on the development process? Last week we hosted an interesting conference on the topic at the World Bank (click here for the agenda and papers). Those of you who have been following this literature will know this is not the first time this topic has been discussed – we held a conference on financial structures over ten years ago.
What do financial structures look like? How do they evolve with economic development? What are the determinants and impact of financial structures? Years ago Ross Levine and I, along with many others, tried to answer these questions and saw clear patterns in the data. One stylized fact: Financial systems become more complex as countries become richer with both banks and markets getting larger, more active, and more efficient. But comparatively speaking, the structure becomes more market-based in higher-income countries. We also saw that countries did not get to B from A in a single, identical path. You didn’t have any market-based financial structures in the lowest-income countries, but as soon as you got to lower-middle income, financial structures became very diverse: Costa Rica was bank-based, whereas Jamaica was much more market-based; Jordan was bank-based, Turkey was market-based etc. etc. So countries were all over the place and the correlation between GDP per capita and financial structure was less than 30 percent.
Bankers often extend credit to firms owned by their close business associates, members of their own families or clans, or businesses that they themselves own. On the one hand, this allows banks to overcome information asymmetries and creates mechanisms for bankers to monitor borrowers. But on the other hand, related lending makes it possible for insiders—bank directors—to expropriate value from outsiders, be they minority shareholders, depositors, or taxpayers (when there is under-funded deposit insurance). The evidence suggests that during an economic crisis insiders have strong incentives to loot the resources of the bank to rescue their other enterprises, thereby expropriating value from outsiders. In a crisis, loan repayment by unrelated parties worsens, and banks thus find it more difficult to reimburse depositors and continue operations. Consequently, insiders perform a bit of self-interested triage: they make loans to themselves, and then default on those loans in order to save their non-bank enterprises. Outsiders, of course, know that they may be expropriated, and therefore behave accordingly: they refrain from investing their wealth in banks, either as shareholders or depositors. The combination of tunneling by directors, the resulting instability of the banking system, and the reluctance of outsiders to entrust their wealth in banks results in a small banking system.
And yet, the economic histories of many developed countries (the United States, Germany, and Japan) indicate strongly that related lending had a positive effect on the development of banking systems. If related lending is pernicious, why then did it characterize the banking systems of advanced industrial countries during their periods of rapid growth? In fact, related lending is still widespread in those same countries.
The Proposition: "Can state-owned banks play an important role in promoting financial stability and access?"
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.
Editor's Note: Murat Seker 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 series.
Many studies point to the importance of firms that export to economic growth and development. These firms tend to be larger, more productive, and grow faster than non-exporting firms. These findings have focused policymakers’ attention on the importance of international trade for economic growth. From the 1980s to the 2000s traditional trade policies have improved significantly—applied tariff rates across a wide range of countries with varying levels of income have decreased from around 25 percent to 10 percent. However, improvements in trade policies are often not enough to reap the full benefits of international trade. To be fully effective, they require complementary reforms that improve the business environment for firms. In a recent paper on Rigidities in Employment Protection and Exporting, I focus on a particular aspect of the business environment, namely employment protection legislation (EPL), and show how these regulations relate to the decisions of firms to enter export markets.1
Evidence shows that export market entry is associated with significant changes and adjustments in firm performance around the time at which exporting begins. In data collected via the Enterprise Surveys project, the employment levels of firms that subsequently enter export markets ("future-exporters") grow by 13%, four times higher than the growth rate of firms that don’t enter export markets.2 Bernard and Jensen (1999) find that the growth premium for these future-exporters as compared to non-exporters in the U.S. is 1.4% per year for employment and 2.4% for shipments.
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.
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.
Editor's Note: Professor Franklin Allen came to the World Bank on October 27 to give an FPD Chief Economist Talk on the topic of Reforming Global Finance: What is the G20 Missing? Please see the FPD Chief Economist Talk page to download a copy of his presentation and watch a video of his Talk.
The recent financial crisis clearly had more than one cause. My view is that the most important one was a bubble in real estate prices, not only in the US but also in a number of other countries such as Spain and Ireland. It was the bursting of this bubble that has led to so many problems in the world economy. A significant part of this is a direct effect on the real economy rather than an effect transmitted through the financial system. For example, Spain had one of the best regulated banking systems and its banks did much better than in other countries. Yet with a doubling of its unemployment rate to 20 percent, its real economy has been devastated. In contrast countries like Germany that did not have a real estate bubble but had much larger drops in GDP have not suffered nearly as much. Germany's unemployment rate is now lower than at the start of the crisis.
Too big to fail has become a key issue in financial regulation. Indeed, in the recent crisis many institutions enjoyed subsidies precisely because they were deemed “too big to fail” by policymakers. The expectation that large institutions will be bailed out by taxpayers any time they get into trouble makes the job of regulators all the more difficult. After all, if someone else will pay for the downside risks, institutions are likely to take on more risk and get into trouble more often—what economists call moral hazard. This makes reaching too-big-to-fail status a goal in itself for financial institutions, given the many implicit and explicit benefits governments are willing to extend to their large institutions. Hence, all the proposed legislation to tax away some of these benefits.
But could it be that some banks have actually become too big to save? Particularly for small countries or those suffering from deteriorating public finances, this is a valid question. The prime example is Iceland, where the liabilities of the overall banking system reached around 9 times GDP at the end of 2007, before a spectacular collapse of the banking system in 2008. By the end of 2008, the liabilities of publicly listed banks in Switzerland and the United Kingdom had reached 6.3 and 5.5 times their GDP, respectively.
In a recent paper with Harry Huizinga, we try to see whether market valuation of banks is sensitive to government indebtedness and deficits. If countries are financially strapped, markets may doubt countries’ ability to save their largest banks. At the very least, governments in this position may be forced to resolve bank failures in a relatively cheap way, implying large losses to bank creditors.
It is no surprise that the recent financial crisis has sparked a new round of regulatory reform all around the world. The crisis has certainly exposed significant weaknesses in the regulatory and supervisory framework and led to a debate about the role these weaknesses may have played in causing and propagating the crisis. As a result, reform of regulation and supervision is a top priority for policymakers, and many countries are working to upgrade their frameworks. But there are more questions than answers: What constitutes good regulation and supervision? Which elements are most important for ensuring bank soundness? What should the reforms focus on?
The Basel Committee – a forum for bank supervisors from around the world – has been trying to answer these questions since 1997. The Committee first got together that year to issue the Core Principles for Effective Bank Supervision (BCPs), a document summarizing best practices in the field. Since then many countries have endorsed the BCPs and have undertaken to comply with them, making them an almost universal standard for bank regulation. Since 1999, the IMF and the World Bank have conducted evaluations of countries’ compliance with these principles, mainly within their joint Financial Sector Assessment Program (FSAP). Hence the international community has made significant investments in developing these principles, encouraging their wide-spread adoption, and assessing progress with their compliance.
In light of the recent crisis and the resulting skepticism about the effectiveness of existing approaches to regulation and supervision, it is natural to ask if compliance with this global standard of good regulation is associated with bank soundness. This is what I have tried to do with Enrica Detragiache and Thierry Tressel, two of my colleagues from the Fund. Specifically, we test whether better compliance with BCPs is associated with safer banks. We also look at whether compliance with different elements of the BCP framework is more closely associated with bank soundness to identify if there are specific areas that would help prioritize reform efforts to improve supervision.
The costs of excessive regulatory burdens can stifle incentives for firms to innovate, invest and grow. In recent years, aid agencies and developing countries have been stepping up efforts to reduce numerous and lengthy regulatory procedures. However, the focus on aggregate measures of regulatory burden for a country and relying on measures of formal requirements misses a lot of the action.
The World Bank has interviewed over 100,000 entrepreneurs and senior managers in over 100 countries as part of its Enterprise Surveys project. Among the measures collected is the de facto time it takes businesses to complete various interactions with the government (e.g., the time to get goods through customs, get a construction permit, or get an operating license). In the chart below, each vertical line represents a country, and the length of the line represents the distribution of time for firms to clear goods through customs. The first thing to notice is just how much variation there is – within individual countries. There are favored firms for whom it takes a couple of days to obtain permits or clear customs – and disfavored firms, for whom the wait can be weeks or even months. The variation within most countries is considerably larger than the differences in averages across countries.