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Finance and Development: What we Know and What we Need to Know

Svetlana Andrianova and Panicos Demetriades

This article, written before the current international financial crisis and with developing countries in mind, is particularly topical because its policy implications are now, if anything, even more relevant for developed countries. Our research for UNU-WIDER emphasizes the positive role that can be played by strong institutions and direct government interventions in finance. It also highlights the importance of political economy factors in shaping financial development. The international financial crisis of 2008 clearly shows that the same ingredients are at play in developed economies. Like in developing countries, financial liberalization combined with weaknesses in regulation, proved to be lethal for financial systems, given the enormity of information problems and associated market failures. Government ownership of banks, up to recently a feature of developing countries finance and an anathema for many neoclassical economists, is now a prominent feature of developed banking systems. The UK government is now the proud owner of three of the largest high street banks, while even in the US, the government is taking a large stake in some of the giants of finance in order to prevent them from collapsing. Government takeovers of banks in both the US and Europe was the only medicine that worked in the face of massive market failures that were about to cause financial and economic meltdown of perhaps greater proportions than the Great Depression. Finally, understanding the weaknesses in regulation would be futile without acknowledging the role of political economy factors: capture of regulators by interest groups seems to have been a key ingredient in the current crisis.

Sources and Effectiveness of Financial Development, our UN study, examines three broad reasons or determinants of financial system development: policy measures, institutions, and political economy. It explains the limitations of financial liberalization and bank privatization and argues that widespread government ownership of banks often reflects mistrust of privately owned banks and weaknesses in depositor protection. It stresses the importance of strong institutions for financial development and discusses the role of political economy factors in helping us to understand financial development.

Policy Measures

The early literature highlighted ill-conceived government interventions, such as interest rate controls, high reserve requirements, and capital controls, as the main source of financial under-development. Freeing the financial system from government interventions was seen as critical in delivering financial development. For a time these policies became the mantra of the IMF and the World Bank, where officials prescribed ‘financial liberalization’ to many developing countries.

The consequences of financial liberalization in the 1970s and early 1980s were, however, different from what was expected. Real interest rates soared to unprecedented levels as a result of fierce competition for funds and excessive risk-taking by both firms and banks. When borrowers became unable to repay their loans, many banks failed. Governments were therefore forced to (re-)nationalize them, resulting in very large fiscal costs. Instead of greater financial development, there was financial fragility; instead of more prosperity there was more poverty.

Subsequent analyses of what went wrong highlighted adverse preconditions, such as macroeconomic instability and inadequacies in banking supervision, and an incorrect sequencing of reforms. Also, following the problems with financial liberalization in the 1980s, the adequate regulation, and supervision of banks was stressed to be necessary in order to contain moral hazard problems in the banking system. These may be especially relevant when banks are not sufficiently well capitalized. Under-capitalized banks have incentives to take excessive risks, especially if they are protected by government safety nets. It is often believed that such safety nets encourage banks to behave imprudently, since they allow them to benefit from a one-way (unfair) bet against the government. By making speculative loans at very high interest rates they stand to make very large profits, assuming of course that the borrowers do not default. If the borrowers do default, the bank will not suffer the full cost of these defaults if it is bailed out by the government. Even if the bank is allowed to fail, the depositors may not suffer if they are protected by deposit insurance. Thus, depositors have no incentives to monitor bank managers when they are protected by deposit insurance. Bank shareholders have no incentive to monitor bank managers either when they do not have much capital at stake. These lessons from the 1970s and 1980s seem particularly relevant in the face of today’s financial upheaval.

The argument that less government intervention in the financial system will inevitably result in greater financial development is thus far from proven. It presupposes the presence of an institutional framework that aims at containing market imperfections, such as moral hazard and adverse selection. Thus, institutions and political economy factors, not less government intervention, may well be the true fundamental determinants of financial development.

Institutions

An effective system of financial regulation and supervision would ensure that banks have adequate risk management systems and that bank shareholders are penalized if banks take excessive risks. Capital requirements are one mechanism for achieving this. Increased transparency regarding banks’ risk management systems, as well as increased disclosure concerning exposure to large risks, can help to increase market discipline on bank managers, and may well contain such risk taking. Institutions such as contract enforcement and the rule-of-law also matter, since they have implications for the protection of investors’ property rights. Much of the literature on institutions, however, examines their effects on growth, not on financial development, and for instance, on the legal institutions for finance. This literature seem to suggest that civil-law countries, which seem to offer less legal protection to minority shareholders and creditors, have less developed capital markets and greater concentration of ownership at both industry and firm level. However, the implications of legal origins for the development of the banking system – perhaps the most important part of the financial system for many developing countries – are less clear cut. Moreover, legal traditions may themselves be determined by historical, cultural, socioeconomic, and political factors, so it is not easy to draw out any policy implications from these results. Legal origins are, in fact, highly correlated with a number of other institutional quality indicators, including the efficiency of the judiciary, bureaucratic quality, generalized level of trust, etc., so it is difficult to disentangle the effects of legal origins on financial development from those of other institutions. Finally, there remains the question of how to transform an inadequate legal system. These issues offer fertile ground for more research.

Political Economy Factors

The key to solving the puzzle of financial underdeveloped, according to authors such as Rajan and Zingales, is the lack of political will, or the capture of politicians by interest groups opposed to financial openness. Openness to either international trade or international capital, while beneficial for the country’s welfare in stimulating the development of its financial and product markets, breeds competition and thus threatens the rents of incumbents. When financial markets are underdeveloped, two types of incumbents enjoy rents and therefore may oppose openness and financial development. Established industrial firms, or ‘industrial incumbents’, are in a privileged position when obtaining external finance due to their reputational capital and their ability to provide collateral. Their rents are generated because new firms with profitable business projects have to team up with an industrial incumbent in order to obtain financing. ‘Financial incumbents’, in turn, capitalise on their informational advantage which stems from relation-based financing and become monopolists in providing loans to firms when problems of poor disclosure and weak contract enforcement raise fixed costs of new financial entrants. Financial development improves transparency and enforcement, thus, reducing the barriers to entry and undermining not just the profits of incumbents who have to operate in a more competitive environment, but the source of their rents since entrants are able to effectively operate without any help from incumbents. Despite the benefits it brings (after all, better disclosure rules improve operating conditions for all firms – existing and new), financial development threatens both the profits and the positional rents of the incumbents.

While the ideas in Rajan and Zingales advance our understanding of political economy factors, further questions that need to be addressed, both theoretically and empirically, include the following. How do special interest groups come into existence? What institutions and policies – ‘political pre-conditions’ for financial development – moderate the influence of interest groups? If the most effective way to curb incumbents’ opposition to financial development is by means of increased openness and competitiveness, then what is the best combination of policies that could pave the way for rapid institutional development? What is the role of the state for shaping the institutional infrastructure in a way that limits the power of the interest groups and the scope for capture of the government policies by special interests? These are all exciting questions that await researchers’ attention.

 

WIDER Angle newsletter, November 2008

ISSN 1238-9544

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