Transcript World Economic Situation and Prospects 2004

After the crisis: demystifying
financial regulation and debtinflation-growth
Anis Chowdhury
Department of Economic and Social Affairs (UN-DESA)
Professor of Economics, University of Western Sydney,
Australia
IDEAs Conference on Reforming Financial System
Growth Commission (Dec. 2009)
“The crisis delegitimized an
influential school of thought,
which held that many financial
markets could be left to their
own devices, because the self
interest of participants would
limit the risks they took.” (p. 3)
“The financial models of the advanced
countries are now in some disrepute.
What will replace them is still up for
grabs. For poorer countries, seeking to
develop their financial systems, that
means the destination is no longer
clear and will not be for some time.
That anchor has been removed and will
not be replaced until a new system is in
place and has functioned for long
enough to earn confidence.” (p.25)
Deep, wide, and liquid financial markets
are desirable to promote savings and
investment. But it is not clear that the
growing trading superstructure adds
enough social value (other than to its
participants) to justify its costs and
dangers. The balance probably needs
to shift back toward the essential
functions of the financial system: safe
savings channels, credit provision to
various sectors of the economy, and a
means to spread risk to those best
placed to bear it. (p. 25)
Financial sector regulation
TWO distinct categories according to
motives:
• Economic regulation (e.g. controls over
interest rates and credit allocation)
– aims to mitigate market failures in the allocation of
resources.
• Prudential regulation
– aims to protect the stability of the financial system
(i.e. prevent systemic failures or financial crises) and
to protect depositors, especially small depositors.
Haste to deregulate finance
• The distinction between economic &
prudential regulation was often missed
or ignored.
• The fact that market failures are
pervasive in the financial sector has
often been overlooked or ignored in the
pursuit of financial sector liberalisation.
6
Rationale for deregulation
1. Increase savings
2. improve efficiency of investment
3. Deepen financial sector
Outcomes: contrary to the prediction
or rationale – Indebtedness increased
– Overinvestment in speculative & real
estate sectors; no impact on ICOR
– Increased fragility of the financial
sector
7
Deregulation and crisis
Dismantling or lack of strong prudential regulation
is identified as the root cause.
Therefore, discussion of regulatory reforms
focuses mostly on prudential or macroprudential ones.
However, a laissez-faire approach to “economic
regulation” and the deregulation of interest
rates can also be contributory factor.
That is, excessive bidding for deposits leads to
higher interest rates. Thus, banks must charge
higher rates for loans which attract risky
borrowers.
Glass-Steagall Act: what were the
concerns?
Excessive interest on deposits as a
threat to both the liquidity and
solvency of banks.
Especially when there were too
many banks competing for
deposits, squeezing profit margin.
Additional concern – “stock gambling”
• Senator Glass asked George Harrison, Governor
of the Federal Reserve Bank of New York, “do
you think the banks in money centers ought to
be permitted to pay interest on bank deposits?
...does that not have a tendency to draw a vast
amount of funds and credits from interior banks
to money centers?”
• The Governor responded, “I think it does, but
unfortunately such a big percentage of the
banks are not members of the Federal Reserve
System ....”
All these were present in the
Asian crisis
Evidence of the deterioration of FIs’ asset portfolios was
already emerging in 1996
• Korea: banks suffered losses on their equity portfolios in
1996
• Thailand: one bank was taken over by the authorities in
May 1996 after incurring heavy losses through a
speculative and fraudulent lending policy; some finance
companies also suffered heavy losses in 1995 after lending
for stock market speculation.
• Indonesia: signs of distress in the banking system had
begun to emerge in 1995, when one bank suffered a run on
its deposits, and when the Central Bank intervened to
support two distressed banks in the following year.
Asian experience (contd.)
Opening up banking systems to new entrants
lowered the franchise value (expectation of
future profits) of existing banks.
• For example, in Thailand, the entry of foreign
banks increased competition for prime
customers. The increased competition squeezed
the lending margins of the domestic banks,
inducing them to move into more lucrative, but
more risky, activities.
• This shift in activities by the domestic banks
was facilitated by a relaxation of the regulations
governing permissible activities of banks.
Lending growth – far above
nominal GDP growth
Country
Nom. GDP Ann. loan Loan
Net domestic
growth
growth
growth
credit/GDP
/GDP
1990
1996
growth
Indonesia
17
20
Korea
14
17
Malaysia
13
18
Philippines 13
33
118
121
138
45
55
68
79
80
136
26
72
84
130
254
Thailand
14
24
171
Stock gambling in Asia
• Heavy to the property sector with loans to this sector expanding at an
even faster rate than total lending, and to excessively geared large
commercial and industrial conglomerates (Chaebols) in Korea.
• Over-investment in both the corporate and real estate sectors pushed
down returns - Average profit margins of the Chaebols fell to
negligible levels in the mid 1990s and several went bankrupt.
• Much of the lending was collateralised by real estate, the value of
which was dependent upon increasingly inflated, and unsustainable,
property prices.
• Banks and finance companies also lent money for speculation in
stock markets, or invested directly in stock markets, on which equity
prices had also been inflated to unsustainable levels.
• Once property and equity prices fell, banks and NBFIs incurred heavy
losses.
Financial deregulation &
Development crisis
• Deposits/savings flowed from the rural economy to the
commercial sector or non-traded activities such as real
estates.
• Examples: Ecuador- financial liberalization in 1984
• the supply of credit declined drastically with the
contraction of government provided loanable funds from
23% of GDP in 1983 to 9% in 1990.
• The share of long term loan fell from 12% in the early
1980s to 8% in 1992. The growth rate of real long term
credit was negative for most years.
• The percentage of directed credit for longer term
maturities declined from 59.3% in 1985 to 35.9% in 1990.
• The percentage of directed short-term credit declined
from 31.1% in 1985 to 3.3% in 1992.
Urban bias - Bangladesh
Share of Rural Sector in Total Bank
Deposits & Advances (%)
Year
Deposits
Advances
1984
0.17
0.258
1990
0.214
0.219
1995
0.227
0.197
1998
0.227
0.165
Bangladesh (contd.)
Share of Credit to Agriculture (%)
Year
Agriculture 1
Agriculture 2
1983
0.254
0.309
1986
0.374
0.308
1990
0.211
0.218
1995
0.173
0.159
1998
0.161
0.146
Agriculture 1: Based on bank advances by main economic purposes
Agriculture 2: Based on bank credit by sectors (private and public).
Global financial crisis & developing
countries
• The less sophisticated financial systems in developing
countries weathered the crisis better than their more
elaborate counterparts in the West.
• Developing countries do not have shadow banking
systems of any size. Their banks did not hold complex,
toxic assets. This could be partly due to self-restraint. But
it was mostly due to regulatory constraints.
• Developing countries do not have resources for large bail
outs. Therefore, the best defence for developing countries
is prevention or guarding against system-wide failure.
• Bank-based finance plays a major role in developing
countries. Therefore the financial sector policy must fulfil
the developmental needs and support structural change
and industrialisation.
Preventing system-wide failure
Segregation
• A portion of the banking system should
be segregated and heavily regulated.
Banks in this segment should offer a
limited range of services, such as deposit
and savings accounts, and hold a
restricted range of safe assets.
• This ensures that at least some channels
of credit remain open, even if the rest of
the system goes under.
Preventing system-wide failure
Restraint
• Should have restraint on excessive bank
competition & entry; tighten prudential
regulation, and curb financial products they
may be ill equipped to handle.
• Should have control over both deposit and
lending rates to prevent excessive risk-taking
and encourage long-term investment.
Hellmann, Murdock and Stiglitz (1997) call this
“financial restraint”.
Ownership matters
• Banks in the regulated and segregated
sector do not have to be natural
monopolies, nor do they have to be
government-owned.
• But large state-owned banks provide a
layer of reassurance. Even though
they may lag behind their private
competitors in boom times, they
remain the main vehicle for
maintaining the credit line during bad
times.
Ownership matters
• A country needs major domestic
players, which can participate in
implementing a crisis response.
• Therefore, domestically owned banks
must dominate the financial sector.
• Foreign banks will have divided
loyalties at best, and may be wholly
preoccupied with events in their home
countries.
Meeting development needs
• The regulated and segmented sector
must also include specialised banks for
such sectors as agriculture and SMEs,
which may not appear very attractive to
private banks from profit maximisation
point of view.
• Financial sector deregulation has not
served these sectors well.
Financial restraint
• Serves both stability and development needs
• Through careful control of the financial sector (keeping
the real interest rate low and encouraging/directing
credit to priority sectors) Japan and other East Asian
countries experienced enviable economic growth and
structural transformation.
• Emran and Stiglitz (2009) show that well-designed
deposit rate policies and temporary restriction on
competition in banking are appropriate when the focus
of development strategy is the discovery of
entrepreneurial talents and stimulating dynamic
learning.
Prudential & Economic Regulations
Type of
Regulation
Objectives
Examples of Key Policy
Instruments
Macroeconomic
Maintain control over
aggregate economic
activity - maintain
external and internal
balance
• Reserve requirements
• Direct credit and deposit
ceilings
• Interest rate controls
• Restrictions on foreign
capital
Allocative
Influence the
allocation of financial
resources in favour of
priority activities
• Selective credit allocation
• Compulsory investment
requirements
•Preferential interest rates
Structural
Control the possible abuse •
of monopoly power by •
dominant firms
Prudential
Preserve the safety and
soundness of
individual financial
institutions and
sustain public
confidence in systemic
stability
•
•
•
•
Organisational
Ensure smooth
•
functioning and
integrity of financial
•
markets and
information exchanges •
Protective
Provide protection to
users of financial
services, esp.
consumers and nonprofessional investors
•
•
•
Entry and merger controls
Geographic and functional
restrictions
Authorisation criteria
Minimum capital
requirements
Limits on the concentration
of risks
Reporting requirements
Disclosure of market
information
Minimum technical
standards
Rule of market-making and
participation
Information disclosure to
consumers
Compensation funds
Ombudsmen to investigate
and resolve disputes
Guidelines for regulation
• Although the Table has set up the
different types of financial regulation as
seemingly mutually exclusive categories,
in reality different regulations have
effects that cut across their designated
domain.
e.g. global credit controls that stem from
macroeconomic objectives also fulfil a
prudential function to the extent that they
restrain banks from imprudent expansion
of credit.
steps to reduce the likelihood of
banking crises:
• Develop and improve legal systems and
information disclosure.
• Impose rate ceilings on bank deposits.
• Establish limits either on the rate at
which banks can expand credit or on the
rate of increase in their exposure to
certain sectors, such as real estate.
• Require greater diversification of bank
portfolios.
• Reduce the restrictions on the range of
activities in which banks can engage.
Debt, inflation & growth
“Good”, “Responsible” and “Sound” finance
are buzz words
Fear of debt & inflation leading to calls for
mopping up the stimulus packages
This is not new:
President Roosevelt quickly backed down and
promised “a balanced budget [was] on the
way”. In 1938, slashed spending for fear of
inflation, although unemployment shot up to
19%.
For developing country context – Rao (1952);
Dasgupta (1954)
Debt financed growth
Most developing countries have to depend on
debt financing: i.e. printing money for
addressing both recovery and development
needs
But the effectiveness is doubted even as early
as in the 1950s
V.K.R.V. Rao (1952); A.Dasgupta (1954) used
different logics, but arrived at the same
conclusion – inflationary with no impact on
growth and employment.
Debt sustainability?
• The argument ignores the productivity
enhancing role of fiscal policy.
• Evsey Domar (1944) “that deficit financing
may have some effect on income … has
received a different treatment. Opponents of
deficit financing often disregard it
completely, or imply, without any proof, that
income will not rise as fast as the debt….
There is something inherently odd about
any economy with a continuous stream of
investment expenditures and a stationary
national income.”
Ditching “sound” finance
• Need to abandon the narrow concept
of “sound” finance measured by the
debt/GDP ratio.
• Should adopt the concept of
“functional” finance, which evaluates
government finance based on its
impact.
See, Lerner (1943)
Crowding out, Ricardian equivalence
etc.?
• No convincing evidence
• ignores the consequences (e.g. low
profitability, bankruptcies etc.) of a
depressed economy in the absence of
increased government spending.
• Inaction by the government for the
fear of crowding out will not help
private investors.
Deficit & interest rate?
• The immediate financial implications of expansionary
fiscal policy when the central bank uses interest rate – in
a world of ‘endogenous money’ – is to add to the cash
reserves of the private sector banks in which the
government checks are deposited.
• This increases (net) liquidity in the cash market, assuming
that the central bank did not implement offsetting market
operations.
• The actual central bank discount rate should tend to
decrease, causing downward pressure on retail interest
rates.
• This conclusion is contrary to the conventional belief, and
therefore should encourage instead of crowd out private
investment.
Debt & inflation?
• Should not cause inflation in a
depressed economy.
• The first principle of functional finance
is to keep the total rate of spending
“neither greater nor less than that rate
which at the current prices would buy
all the goods that is possible to
produce.” (Lerner, 1943)
Money & inflation?
• If expansionary fiscal policy achieves its
intended purpose of boosting output and
employment, the increased money supply
will match increased demand for money
needed for a higher level of transactions.
• Not “too much money chasing too few
goods”
Inflation & growth?
• “Is inflation harmful to growth? The ratio
of fervent beliefs to tangible evidence
seems unusually high on this topic.” Bruno
& Easterly (1998, p. 3)
• Milton Friedman (1973, p. 41), “Historically,
all possible combinations have occurred:
inflation with and without [economic]
development, no inflation with and without
[economic] development.”
Thank you