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Financial Development:Structure and Dynamics
Augusto de la Torre, Erik Feyen, and Alain Ize
WB ConferenceWashington DC, 16 June 2011
11
Chief Economist OfficeLatin America and the CaribbeanThe World Bank
We know surprisingly little about the process of financial development (FD)
Frictions determine structure Merton and Bodie
Function matters more than form Demirguc-Kunt and Levine Allen and Gale
But in the end: How predictable is FD? Single or multiple paths? What is the sequence? What are the shapes of the development paths?
2
This paper
Links FD to four basic frictions/paradigms de la Torre and Ize (2010, 2011)
Uses the frictions to connect the dark and bright sides of FD Corroborates empirically some predictable patterns
sequencing, shape, returns to scale
Explores the unicity/multiplicity of paths Links differences in FD across countries to differences in frictions and/or
dark episodes Uses the framework to assess LAC’s FD Obvious caveats
The paper only suggests More rigorous and systematic analysis is needed
3
The process of financial developmentThe Bright Side
4
A simple typology of paradigms
Full information / Full rationality
Incomplete information / Bounded rationality
Bilateral focus Costly Enforcement (CE)
Asymmetric Information (AI)
Multilateral focus Collective Action (CA)
Collective Cognition (CC)
5
Frictions, paradigms and failures
Contract stage Finance friction Underlying problem Paradigm Failures
Getting the facts
Agreeing on a
contract
Enforcing the
contract
Uncertainty,
information and
learning costs
Bargaining costs
Enforcement
costs
Asymmetric confusion
Symmetric confusion
Coordination failures
Limited pledgeabilit
y, commitmen
t and liability
Asymmetric Information
AI
Collective Cognition
CC
Collective Action
CA
CostlyEnforcement
CE
Collective
failures
Agency
failures
6
Process of financial developmentFinding the path of least resistance
FailuresFrictions
Public response
Private response
StructureNeeds
7
The private responses
Lessening the frictions Acquiring information, learning Using collateral Delegating
Lessening the exposure Diversifying and pooling Buying insurance and hedges Staying liquid
8
The public responses
Providing public goods (lessening frictions; resolving coordination failures) Macro-monetary environment Legal and institutional framework Information and analysis Infrastructure Oversight
Regulating and taxing consumer protection: resolving agency failures (big brother) internalizing externalities: resolving collective failures
Coordinating (resolving collective failures) catalytic involvement LOLR, RALR mandated participation
Spreading risk through public guarantees (resolving collective failures that derive from agency frictions)
Providing financial services (resolving collective failures through acquiring an agency role)
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The process of financial developmentThe supply side response
Frictions
Public response
Private response
Innovation
Structure
Technological progress
Regulatory
arbitrage
Participation
Network effects
Scale effects
Enabling environme
nt
Needs
Competition
Failures
10
The limits of the bright side
Failures to fully resolve agency frictions At the investor level
• bounded rationality At the borrower level
• governance At the intermediary level
• skin in the game
Failures to fully resolve participation frictions Early and intermediate finance:
developmental policies Mature finance: tail and
systemic risk insurance?• Anginer, de la Torre, Ize (2011)
11
The process of financial developmentThe Dark Side
12
The process of financial developmentThe dark side
Frictions
Public response
Private response
Innovation
Structure
Technological progress
Regulatory
arbitrage
Participation
Network effects
Scale effects
Enabling environme
nt
Needs
Competition
Failures
13
The modes of the dark side
Easing of agency frictions triggers Collective action failures (free riding) Agency failures (multiplication of agency problems)
Easing of collective (participation) frictions builds up systemic vulnerabilities that end up with collective failures: withdrawals give rise to fire sales and liquidity spirals
Þ The positive participation externalities of the bright side mutate on the dark side into devastating negative externalities
Easing of frictions, fueled by innovations, triggers problems of collective cognition (mood swings)
14
The empirics of financial developmentPatterns and paths
15
The econometric study
The financial indicators: 13 depth, 2 efficiency-liquidity, 4 financial globalization, 4 soundness
The controls: GDP x capita (level and square), population and other country-specific structural features
The methodology: Median regressions Cross-section path (collapses time in just one average point per country) Dynamic paths around the cross-section for group medians (grouped by initial income or
by region)
16
Two predictable patterns
Financial activities that are the least affected by frictions should appear first
Thus, we should expect credit to the sovereign to develop before credit to private agents, banking before capital markets, deposits before credit, etc.
Financial activities that are subject to collective frictions should have convex-shaped development paths and, possibly, returns to scale
Thus, activities that are hindered by the highest collective frictions will appear later but, once they appear, should be the most convex
We should also find some correlation between convexity and returns to scale
17
Order of appearance, convexity and returns to scale
Fore
ign P
ublic
Debt
Dom
estic P
ublic
Debt
Pensio
n F
und
Asse
ts
Bank D
eposits
Non-L
ife In
sura
nce
P
rem
ia
Bank W
hole
sale
F
undin
g
Bank P
rivate
Cre
dit
Bank C
laim
s on
Fin
. Institu
tions
Sto
ck M
aket
Capita
lizatio
n
Life
Insu
rance
Pre
mia
Mutu
al F
unds
Asse
ts
Dom
estic P
rivate
D
ebt
Fore
ing P
rivate
D
ebt
-2,000
-1,500
-1,000
-500
0
500
1,000
1,500
2,000
2,500
Order of Appearance, Convexity and Returns to Scale
Appearance Convexity Returns to Scale
18
Public debt
19
Banking
20
02
04
06
08
0
4 6 8 10GROUP MEDIAN LGDPPC
PRIVATE CREDIT / GDP (IFS)
DMB DOMESTIC DEPOSITS / GDP (IFS)
NON-DEPOSIT FUNDING / GDP (IFS)
Many reasons for the dynamic paths to deviate from the cross-section
Country-specific policies: enabling environment, growth, cycles Crashes: dark side Path dependence: initial conditions matter (today’s FD depends on
output, which depends on past FD) Leap frogging: importable innovations Threshold effects: endogenous quantum jumps
21
Multiple dynamics paths around very smooth cross-sections
22
The empirics of financial developmentLinking back to the frictions and the dark side
23
The grinding down of frictions
24Note: LPOP, LPOP_DENSITY, LAGEDEP_YOUNG, LAGEDEP_OLD, OFFSHORE, TRANSITION DUMMY, FUEL EXPORTER DUMMY, and constant were estimated but are omitted.
Credit Information Creditor Rights Property Rights
LGDPPC 0.344*** -1.998 -20.370***(3.438) (-1.416) (-2.859)
LGDPPC2 -0.164** 0.169* 1.837***(-2.465) (1.798) (3.869)
LPOP 0.500*** -0.028 -0.355
Observations 158 158 162Pseudo R2 0.392 0.233 0.501t-statistics in parentheses
*** p<0.01, ** p<0.05, * p<0.1
Explaining the developmental differences: frictions, dark episodes, demand effects
25
BANK PRIVATE CREDIT
BANK PRIVATE CREDIT
STOCK MARKET TURNOVER
STOCK MARKET TURNOVER
ENFORCEMENT -4.047* -5.318** -4.701*** 1.016(-1.864) (-2.358) (-4.508) (0.234)
LEGAL RIGHTS 1.662 1.671 -1.067* 0.570(1.547) (1.385) (-1.981) (0.274)
CREDIT INFO -0.526 3.318***(-0.379) (4.625)
PROPERTY RIGHTS 0.235 0.0690 0.545*** 0.380(1.301) (0.335) (6.499) (1.188)
GDP GROWTH 5.590** 3.029(2.433) (1.102)
CREDIT CRASH DUMMY -77.69** -157.1*(-2.042) (-1.950)
Observations 156 118 103 84Pseudo R2 0.497 0.571 0.456 0.525t-statistics in parentheses*** p<0.01, ** p<0.05, * p<0.1
Can there be too much finance?
The convexity of development paths necessarily implies decreasing returns from FD on growth Arcand et al (2011)
The forces of the dark side probably gather strength with FD interconnectedness-linked collective failures
Þ Can there can be too much finance? (can the costs of instability—or the costs maintaining stability—overcome the benefits of finance?)
26
27
Thank you