Financing Prosperity

Ross Levine

University of California, Berkeley

3 Questions

① Does the functioning of the banking system influence long-run economic prosperity?

▫ Economic growth.

▫ Poverty & income inequality

Note: I will focus on the long-run, not on crises and business cycle fluctuations.

3 Questions

① Does the functioning of the banking system influence long-run economic prosperity?

②What regulations foster well-functioning banking systems?

▫ I will focus on regulatory strategies.

▫ I will not focus on details in the presentation.

▫ I will not focus on legal, political, & other determinants.

3 Questions

① Does the functioning of the banking system influence long-run economic prosperity?

②What regulations foster well-functioning banking systems?

③ Is Chile different?

▫ Besides torta mil hojas, cuchufli, etc.

▫ Are Chile’s banks important for prosperity?

▫ What bank regulatory challenges face Chile?

Does the functioning of the banking system influence long-run economic growth, poverty, and the distribution of income?

The debate: Casino view

Financial markets are unproductive casinos, where the rich come to place their bets.

▫ If they win, people lose.

▫ If they lose, people still lose.

➢Regulations should protect people from them.

This view is popular in

Hollywood

It is also popular at regulatory agencies,

international institutions, & within academia

The casino view:

▫ The fundamental determinants of prosperity are savings, education, and innovation.

▫ Finance plays little role in shaping these determinants.

▫ Finance’s bigger role is in shaping fragility.

➢Protect the economy from financial crises

The debate: Banks are essential view

• Banks shape economic horizons.

• “The banker authorizes the entrepreneur in the name of society to innovate.” Schumpeter (1912)

Essential view:Banks shape how well an economy …

• Mobilizes savings for “immense” works.

• Allocates capital to those with the best entrepreneurial ideas, rather than to those with most wealth & connections.

• Exerts sound governance over the use of that capital.

• Provides mechanisms to manage risk.

Thus, the essential view argues that

banks, and bank regulations can …

• Accelerate growth.

▫ Ease credit constraints and facilitate entrepreneurship.

▫ Enhance resource allocation and innovation.

• Disproportionately help the poor.

▫ Loosen links between access to credit and wealth.

▫ Increase the dynamism of labor markets.

Does the functioning of the banking system influence long-run economic growth, poverty, and the distribution of income?

Evidence?

Cross-country regressions

• Y = either economic growth, growth of income inequality, the income of the poor, extreme poverty.

• F = Measure of financial development.

• X1 … Xn = control variables, such as the level of GDP per capita, education, inflation, deficits, black market exchange rate premia, openness to trade, revolutions and coups, political assassinations, etc.

• Then, I graph the resultant relationship between Y and F: β

• Over the same period, 1960-2005 data permitting.

Finance and growth

Finance and inequality growth

ARG

AUS

AUT

BEL

BGD

BOL

BRA

CAN

CHE

CHL

CMR

COLCRI

DNK

DOM

ECU

EGYESP

FIN FRA

GBR

GHA

GRC

GTM

HKG

HND

HUN IDNIND

IRL

IRN

ITA

JAM JORJPN

KOR

LKA

LSO

MEX

MUS

MYS NER

NLD

NORNPL

NZL

PAK

PAN

PER

PHL

PRT

SEN

SLE

SLV

SWE

THATTO

TUN

TURTZA

URYUSA

VEN

ZMB

-.0

2-.

01

0

.01

.02

Gro

wth

in

the

log

of th

e G

ini C

oeffic

ient

-2.5 -2 -1.5 -1 -.5 0The Partial Component of The log Private Credit

Note: This suggests that finance is disproportionately good for lower income households. Not a trickle down story.

Finance and the incomes of the poor

ARGAUS

AUT

BEL

BGD

BOL

BRACAN

CHE

CHL

CMR

COL

CRI

DNKDOM

ECU

EGY

ESP

FIN FRA

GBR

GHA

GRC

GTM

HKG

HND

HUN

IDN

IND

IRL

IRN

ITA

JAMJOR

JPN

KOR

LKA

LSO

MEXMUS

MYSNER

NLD

NOR

NPL

NZL

PAK

PAN

PER

PHL

PRT

SEN

SLE

SLV

SWE

THA

TTO

TUNTURTZA

URY

USA

VEN

ZMB

-.0

4-.

02

0

.02

.04

Th

e P

art

ial C

om

po

ne

nt of G

row

th in T

he L

ow

est In

co

me S

ha

re

-2.5 -2 -1.5 -1 -.5 0The Partial Component of The log Private Credit

Finance and extreme poverty

DZA

BGD

BOL

BWA

BRA

CMR

CHL

COL

CRI

DOM

ECU

EGY

SLV

GMB

GHA

GTM

GUY

HND

HUNIDN

IRNJAM

KEN

LSO

MWI

MYS

MLI

MRT

MEX

NPL

NICNER

PAK

PAN

PRY

PER

PHL

POL

RWA

SEN

LKA

THA

TTO

TUN

TUR

UGA

URY

VEN

ZMB

ZWE

-.2

-.1

0.1

Th

e P

art

ial C

om

po

ne

nt of G

row

th in H

ead

co

un

t

-3 -2.5 -2 -1.5 -1 -.5The Partial Component of The log Private Credit

Remember why?

➢ Let’s conduct a “quasi-natural” experiment

➢ We will examine a policy change than improved banks in the different states of the United States in different years.

➢ Then, we can assess the effect of this “treatment” on outcomes.

A little history

• From the 1800s – 1995, U.S. states controlled:

▫ New banking licenses.

▫ Branching.

▫ Entry of banks from other states.

• They sold local banking monopolies.

▫ States sold banking licenses to banks.

▫ States protected those banks from competition.

A little more history

• This produced LOTS of banks: ≈30,000 banks! But, little competition.

• Produced a rich constituency for keeping those regulatory protections.

The end of history

• What changed? Was it a recognition of the inefficiency of those regulatory protections?

➢No.

➢Technology changed.

Competition and state growth

log(GSP)st = α + β1D-10

st + β2D-9st + … + β25D+15

st + As +Bt + εst

Competition & state inequality

-.06

-.04

-.02

0

.02

.04

Perc

en

tag

e c

ha

ng

e

-10 -5 0 5 10 15Years relative to branch deregulation

log(Gini)st = α + β1D-10

st + β2D-9st + … + β25D+15

st + As +Bt + εst.

Competition and wage growth

• Yes.

• Well-functioning financial systems foster prosperity.

• Poorly-functioning banks stymie prosperity.

• Are synthetic credit default swaps really disproportionately good for the poor?

Are financial and technological

innovation linked?

• Initially, only local investors could monitor trains

• This restricted growth.

Financial and railroad innovations

• Then: Specialized banks emerge to screen /monitor

• New financial / accounting reports help.

This is a dynamic process …• Besides new financial institutions and accounting …

• New financial instrument were designed too, e.g., preferred stock, income bonds (contingent on railroad profitability),

• By providing a menu of securities, financiers expand interest.

Last word on trains …

• Without financial innovation, the technological development of trains would have been slower.

Financial and oceanic explorations …

▫ from from partnerships to the commenda, and

▫ from limited partnerships, to the joint stock company

Financial & technological innovation continues

From IT and venture capitalism …

… to bio-technologies

Financial & technological innovation

A graphical illustration …

Technological innovation

level j

level j+1

Sector 1

• Entrepreneurs seek profits by innovating

• Success rate of innovation:• Property rights (profits)• Competition• Quality of innovator

Technological innovation + finance

level j

level j+1

Sector i

Finance

Better finance = better screening to find best innovator

But, is this complete?

• This ignores the VC and bio-tech story.

Technological innovation + static finance

level j

level j+1

Sector i

Thickness = screening quality

Finance

Technological innovation + static finance

level j

level j+1

Sector i Finance

level j+2

Screening quality diminishes as technology advances

level j+3

Technological innovation + static finance

level j

level j+1

Sector i Finance

level j+2

level j+3As technology advances, screening quality diminishes

Innovation rate slows

Technological innovation + static finance

level j

level j+1

Sector i Finance

level j+2

level j+3

Without financial innovation, technological innovation stops.

by financial entrepreneurs

Technological innovation + financial innovation

level j

level j+1

Sector i

level j+2

level j+3

level j

level j+2

level j+3

level j+1

Finance

Technological innovation + financial innovation

level j

level j+1

Sector i Finance

level j+2

level j+3

level j

level j+2

level j+3

level j+1

level j

level j+1

Sector i Finance

level j+2

level j+3

level j

level j+2

level j+3

level j+1

Financial and technological innovation

• Technological innovation makes “old” finance obsolete

➢Economic growth slows.

• Financial innovation makes “new” finance more effective

➢Facilitates technological innovation and boosts economic growth.

Monopolies slow technological & financial innovation.

• Yes.

• Well-functioning banks foster long-run prosperity.

• Poorly-functioning banks stymie long-run prosperity.

• Financial innovation is crucial for sustained technological innovation and hence economic growth.

• Of course, not all financial innovations foster long-run prosperity.

Regulatory strategies

① Competition

▫ Competition among banks spurs efficiency and improvements in financial services.

▫ Competition among banks spurs competition among nonfinancial firms, which enhances efficiency and technological innovation.

➢Opportunities flow increasingly to those with the best ideas and initiative.

Regulatory strategies

②Wariness of “strong” supervision & regulation

▫ Often stymie competition and financial innovations.

▫ Often distort the flow of credit toward political ends

▫ Often impede the funding of the most promising entrepreneurs.

➢ Official interventions in banking often lead to corruption, inefficiency, stagnation, and fragility.

Regulatory strategies

③ Transparency / incentives

▫ Regulations that enhance the private governance of banks work best:

Laws that force transparency

Credit bureaus, accounting systems

Legal rights & means for investors to exert governance

Regulatory strategies

③ Transparency / incentives

▫ Regulations that enhance the private governance of banks work best.

▫ Regulations that hinder the effective governance of banks work worst.

Implicit and explicit guarantees.

Official oversight implies official responsibility

Of course!

Banks and prosperity

• Chile looks very similar.

▫ Chile is not an outlier.

▫ Chile fits the estimates very closely.

➢Suggests that the bank-prosperity link is also very strong in Chile.

Bank, prosperity, and Chile

• Chile has been the most successful economy in Latin America over the last few decades.

▫ But: Growth slowed markedly over the last 5 years

Bank, prosperity, and Chile

• Compared to LA, Chile has well-developed banks

▫ Size: Credit / GDP

▫ Efficiency: net interest margins / overhead

▫ Inclusiveness: people accessing banks

• But:

▫ Looking beyond LA …

▫ Is it positioned to foster future improvements in long-run prosperity?

Regulations

• Competition

▫ Entry restrictions on foreign banks?

▫ Entry restrictions on the emergence of domestic banks?

▫ Other regulatory impediments to competition?

Regulations

• Competition

• Strong regulators

▫ Are they distorting the flow of credit?

▫ Are they limiting innovation?

▫ Are they raising the costs of doing banking?

▫ Are regulators well-governed themselves?

Regulations

• Competition

• Strong regulators

• Incentives / transparency

▫ How effective is the private governance of banks?

▫ Are regulations fostering or impeding governance?

▫ Do the legal and regulatory system facilitate the private governance of banks?

Concluding remarks

① The functioning of the banking system influences long-run economic prosperity

② Competition, a wariness of official regulation, and private governance improve banking

③ Chile faces similar challenges to other countries.