Rethinking government

1
Rethinking governments role in finance

• Governments need to do
• More and better in some area
• Less in others
• And to recognize how finance without frontiers is
  changing what they can do, and can achieve
• Because finance matters for growth and poverty
  reduction, and we have the evidence

2
Main messages

• Well functioning markets need
• legal and regulatory underpinning
• strategy based on harnessing incentives
• Diversity is good for stability and development
• Good safety nets require good institutions
• Governments are not good at providing financial
  services, even when a crisis hits
• Open markets, technology can spur development

3
Whats new?

• Strength of relationship between finance and
  growth
• Importance of legal and information base
• Importance of private sector monitoring for
  development and stability
• The cost of state ownership
• The benefits of foreign banking
• How technology is leading to finance without
  frontiers

4
Overview of presentation

• Making finance effective
• Preventing and minimizing crises
• Government failure in finance
• Finance without frontiers

5
Making finance effective

• Economies are becoming more finance-intensive
• There is a clear causal link between finance and
  development
• A well-functioning financial system requires a
  supporting infrastructure

6
Naïve and modeled impact of financial development
on growth
Average GDP growth 1960-95, percent per annum
8
Model
Naïve
4
0
-4
10
100
Private credit as percentage of GDP (log)
7
Contribution of finance to growth

• Widens access to external finance (more firms,
  more sectors)
• Affects growth through productivity
• not scale
• of investment

8
But beware!

• Bigger is not necessarily better
• Focus on effectiveness not size
• Beware of
• too rapid credit growth
• forcing the pace with state-owned banks

9
Financial structure

• Debt vs. equity?
• Banks vs. market?
• Both support economic growth

10
Financial structure

• Information asymmetry
• and legal weaknesses
• limit access to both
• equity
• and long-term debt

11
Intermediation spreads
Medians
8
Bank credit is costly!
6
4
2
1975
1980
1985
1990
1995
12
Financial structure

• Equity markets can provide some competition .
• but inadequate protection of minority
  shareholders inhibits this
• as reflected in family and pyramid ownership
  structures

13
Market value of family-owned firms as a
percentage of the total equity market value of
the top 20 firms
0
25
50
75
100
14
And the owner is... the Suharto
family group
Tirtamas
Usaha MuliaGroup(cousin Hasim)
Salim Group(friend Soedono)
262 firms with control over 20
21 firms with control over 20
Cemen Cibinong
Sempati Air
18 firms with control over 20
Humpuss Group(son Tommy)
Hanurata Group(son Sigit)
Bank Utama
Suharto Family
Trias Sentosa
17 firms with control over 20
Bank Central Asia
Citra Lamtoro Group(daughter Mbak Tutut)
Indomobile
Bimantara Group(son Bambang)
11 firms with control over 20
Mercu Buana Group(step brother Probo)
Bob Hasan Group(Mohamad Hasan)
Kedaung Group(Agus Nursalim)
Citra Marga
Persda Tollroad
TPI
Bank Yarna
Andomeda
Tripolyta
14 firms with control over 20
22 firms with control over 20
Kiani Sakti
Gatari
Kabelindo Murmi
8 firms with control over 20
15
Financial infra-structure

• So
• better to build a solid infrastructure
• ...than to aim for a particular structure

16
Financial infra-structure

• Different legal systems...
• ...provide differential protection to
  stakeholders
• Protecting outside financiers favors financial
  development investment

17
Access

• Improving the information infrastructure and
  technology can lower intermediation costs
• outweighing potential drawbacks
• (lost privacy and credit discrimination)

18
Effects on credit availability of adopting a
negative-only credit scoring model for various
default rates
Percent of consumers who obtain a loan
Percent decrease in consumers who obtain a loan
with negative-only model
Target default rate (percent)
Negative-only model
Full model
3
74.8
39.8
46.8
4
83.2
73.7
11.4
5
88.9
84.6
4.8
6
93.1
90.8
2.5
7
95.5
95.0
0.5
19
Preventing and minimizing crises

• Financial crises
• hurt the poor... and most everyone else
• have become more numerous and expensive
• can set back reform efforts for years

20
East Asia poverty before and after the financial
crises
Poverty rate (percent)
40
30
20
10
0
Indonesia
Rep. of Korea
Thailand
21
Why finance is so fragile

• Individuals not fully rational in assessing risk
• Excessively weight recent experience
• Trade on noise rather than on fundamentals
• Exhibit positive feedback

22
Emerging market bankingmore fragile still

• Greater information problems
• Generally smaller size of market
• Greater real, nominal, financial volatility
• Regime shifts
• Domination of banking and debt finance, usually
  short term

23
Regulating banks

• Many emerging markets moving to supervised
  capital adequacy
• The transition is difficult!
• Convergence of headline regulations but
• Wide disparities in effective enforcement

24
Classification of sub-standard loans, 1997
25
Strengthening supervision

• Good supervision can help
• But incentives often discourage it
• prevalence of family relationships
• political interference
• good supervision faces legal penalties now, no
  deferred gain later.

26
Towards better banking

• Focus more on owners and markets to monitor banks
• subordinated debt as a potentially useful tool
• Correct the balance of terror for supervisors
• Limit safety nets and other subsidies to risk
  taking.

27
Subordinated debt in Argentina,1996-99
Percent
30
20
10
0
Deposit rate
Deposit growth
Capital ratio
Nonperforming loans
28
The rise of deposit insurance around the world,
1934-99
Cumulative frequency of explicit deposit
insurance systems established
70
60
50
40
30
20
10
0
29
Cautions on deposit insurance

• Insurance, coupled with limited liability,
  facilitates risk-taking
• But absence of explicit coverage may mean
  unlimited, implicit coverage
• Does imposition of explicit, limited insurance
  raise or lower risk of crisis, and help or hurt
  financial sector development?

30
Evidence on deposit insurance

• With explicit insurance and weak institutions
• odds of a crisis are higher
• monitoring by markets less
• financial sector development less
• So risk-taking grows, and taxpayers likely know
  it!

31
On preventing and minimizing crises

• Use market incentives
• Improve transparency of banking and of the
  supervisory process
• Correct the balance of terror
• Limit safety nets

32
Government failures in finance

• State ownership declining but remains widespread
• Poor record of state as permanent or temporary
  owner
• Privatization can lead to a more efficient
  banking sector, though the process needs care

33
Government ownership of bank assets
Share of the assets of the top 10 banks owned or
controlled by the government
60
40
20
0
1970
1985
1995
34
State ownership in banking, 1998-99
35
Bureaucrats as bankers the pros

• State can better allocate capital commanding
  heights
• Private ownership will concentrate credit in the
  hands of a few
• Private banking said to be more prone to crises

36
Bureaucrats as bankers the cons

• Incentives bureaucratic rewards usually linked
  to politics, not efficiency
• Incentive conflict government as owner vs.
  government as regulator and supervisor
• Biggest failures have been state banks!

37
Bureaucrats as bankers the evidence

• Greater state ownership leads to

• less financial sector development, lower growth,
  lower productivity
• higher interest rate spreads, less private
  credit, less nonbank financial development
• greater concentration of credit
• some tendency towards more crises, weaker
  monitoring

38
Privatizing banks

• While state ownership is bad, privatization is
  dangerous, and requires care
• Large fiscal savings from bank privatization
• Improvement in performance under private ownership

39
Nonperforming loans, Argentina, 1991
Percent of total loans
60
40
20
0
40
Lending to state-owned enterprise in Argentina
Percent
20
15
10
5
0
1996
1997
1998
1999
41
Privatizing banks

• Enforce regulations for all banks to reveal state
  banks weaknesses publish audits.
• Prepare regulatory/information environment, and
  banks themselves
• Avoid rapid privatization (Mexico) and excessive
  delays (Czech Republic).

42
Governments as caretakers

• State ownership rises in crises
• Let markets work as much as possible
• Easy policies of injecting resources
• led to more costly crises
• subverts market signals

43
Use markets to deliver the news

• Selection of winners and losers is what markets
  do best
• Rather than have governments pick banks, inject
  funds to banks that
• secure matching private funds
• restrict dividends/payouts for private parties
• adhere to stiff transparency requirements

44
Rescuing banks who is fit to survive?
Percent
8
0
Time
45
Lessons

• Let governments stick to what only they can do
  infrastructure and incentive environment
• Less state ownership will lead to faster growth
  and more poverty alleviation
• When crises hit, look for quick exit of state
• Dont look for simple lessons from rich countries
  no Saab in every garage

46
Finance without frontiers

• Consequences of being small
• Foreign bank entry can strengthen system
• Despite some setbacks equity market
  liberalization has lowered cost of capital

47
Finance without frontiers

• Countries must choose which financial services to
  buy
• and which to build
• Access to financial services is more important
  than who provides them

48
National financial systems ranked by size
M2, billion of dollars (log scale)
10,000
1,000
100
10
1
0.1
0.01
49
Financial services foreign provision

• Emerging markets can benefit from importing
  financial services
• Despite worries that foreign firms could
  destabilize domestic finance
• there is little evidence to support such fears

50
Financial services foreign provision

• Foreign banks will become more than niche players
• Increased competition reduces domestic profit
  margins
• But no evidence that systems relying on foreign
  banks disadvantage smaller customers

51
Comparing the share of foreign and state
ownership in crisis and noncrisis countries
52
Into the future technology and communications

• Accelerating trends in technology ande-finance
• will primarily benefit the users of financial
  services
• Globalization and technology will increase the
  costs of having a small system, as well as the
  penalty for not improving the infrastructure and
  incentive environment.