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.
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.