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More and better financial tools, fewer financial crises: The role of the financial system in managing risk

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Only by providing useful risk-managing tools and keeping its house in order, can the financial system fulfill its socially beneficial risk management function. Through the provision of useful financial tools, the financial system can shield people from bad shocks, and better position them to pursue opportunities. However, if the financial system fails to manage the risk it retains, it can also hurt people directly by hindering access to finance or indirectly by hampering refinancing of enterprises and straining public finances, and thus make people lose jobs, income, or wealth.

Public policy can stimulate the financial system to broaden the share of people with access to financial services (financial inclusion), so more people have more and better financial risk management tools. It can also promote measures to better control the risk that affects the whole financial system and foster financial stability. However to succeed on both fronts, the World Development Report 2014, in its chapter on the financial system, argues that public policy must take into account the trade-offs and synergies in the financial sector. The first step to balanced and successful policies is to establish an institutional framework that brings together policymakers and experts from the financial industry and academia.

I elaborate on this idea in subsequent paragraphs and encourage interested readers to pick up WDR 2014, in particular its chapter on the financial system, to learn more about the background and justifications for this proposal.

The financial system can offer a range of financial tools that enhance risk management

Because people face risks of varying frequency and intensity, which are either idiosyncratic or systemic in nature, they need a mix of financial tools to boost their resilience. However, the Global Findex data on financial portfolios of individuals suggest that formal savings and insurance are each used by only about 17 percent of people in developing countries, and credit is used by about 8 percent—although great heterogeneity exists across countries.1 Hence, up to three-quarters of people in developing countries could be using either informal financial tools or no financial tools at all.

Various obstacles impede better financial risk management at the individual level. At lower stages of financial development (below $8,000 gross national income per capita), national financial systems concentrate in banking, which comprises about 55 percent of total financial sector assets; thus curtailing the supply of a wide range of financial tools to households. On the demand side, people exclude themselves from using financial services because of their distrust in financial institutions, preference for informality, and lack of financial literacy.2 In Mexico, for example, low-income consumers trusted department stores to hold their savings more than they trusted banks, noting: “They don’t give us anything, but at least they don’t take anything away.”3

The financial system can hurt people if it fails to manage the risks it retains

While credit provision aids economic growth, banking crises, for example, in Thailand (1997), Colombia (1982), and Ukraine (2008) were preceded by excessive credit growth of 25 percent, 40 percent, and 70 percent per year. Providing the right amount of credit—not too much and not too little—is a major concern for all countries.

Financial firms have been largely unsuccessful in implementing good corporate governance, so that the prevailing perverse incentives, including distorting compensation policies, have made bankers (from managers to loan officers) maximize short-term profits and disregard prudent risk-taking.4 Moreover, the 2008 global crisis reveals the potentially significant influence of industry lobby groups on the supervision of systemic risk, resolution of crisis, and future regulatory reforms.

The experience from 147 banking crises that struck 116 countries from 1970 to 2011 indicates that, in advanced and emerging economies, the cumulative loss of output in the tree years following a banking crisis is substantial: 33 percent and 26 percent of GDP respectively, on average.5 The 2008 wave of banking crises in Eastern Europe and Central Asia hit households mainly through the labor market channel reducing their wage income. As a result, households deployed some costly coping strategies, including cuts in basic consumption, health care, and education.6

Public policy, to succeed, must consider trade-offs and synergies in finance

To succeed on both promoting financial inclusion and fostering financial stability, public policy must take into account trade-offs and synergies in the financial sector. However, evidence suggests that, in 90 percent of cases, national financial sector strategies do not address specific trade-offs between financial development goals and the management of systemic risk, although more than two-thirds of countries commit to achieving both goals within their strategy.7

A financial policy committee with an effective governance structure, featuring major stakeholders in financial sector policy, can produce more balanced policies and improve policy coordination. However, intermediate solutions exist as well. For instance in Malaysia, the central bank takes the lead on engaging all stakeholders in financial sector policy (from the ministry of finance to private sector experts) to prepare its national financial sector strategy that takes into account tradeoffs  between financial (inclusion) development and systemic risk in the financial system.8


Allen, Franklin, Asli Demirguc-Kunt, Leora Klapper, and María Soledad Martínez Pería. 2012. “The Foundations of Financial Inclusion: Understanding Ownership and Use of Formal Accounts.” Policy Research Working Paper 6290, World Bank, Washington, DC.

Brown, Martin. 2013. "The Transmission of Banking Crises to Households: Lessons from the ECA Region 2008–2012." Background paper for the World Development Report 2014.
Central Bank of Malaysia. 2013. "Financial Stability and Payment Systems Report 2012." Central Bank of Malaysia, Kuala Lumpur, Malaysia.

Cole, Shawn, Martin Kanz, and Leora Klapper. 2012. "Incentivizing Calculated Risk-Taking: Evidence from an Experiment with Commercial Bank Loan Officers." Policy Research Working Paper 6146, World Bank, Washington, DC.

Collins, Daryl, Nicola Jentzsch, and Rafael Mazer. 2011. "Incorporating Consumer Research into Consumer Protection Policy Making." Focus Note 74, CGAP, Washington, DC.

Demirguc-Kunt, Asli, and Leora F. Klapper. 2012. “Measuring Financial Inclusion: The Global Findex Database.” Policy Research Working Paper 6025, World Bank, Washington, DC.

Laeven, Luc, and Fabian Valencia. 2012. "Systemic Banking Crises Database: An Update." IMF Working Paper WP/12/163, IMF, Washington, DC.

Maimbo, Samuel, and Martin Melecky. 2013. "Financial Policy Formulation: Addressing the Tradeoff between Development and Stability." Background paper for the World Development Report 2014.

1 Demirguc-Kunt and Klapper 2012.

2 Allen and others 2012.

3 Collins, Jentzsch, and Mazer 2011.

4 Cole, Kanz, and Klapper 2012.

5 Laeven and Valencia 2012.

6 Brown 2013.

7 Maimbo and Melecky 2013.

8 Central Bank of Malaysia 2013.


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