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The Role of Finance in Fostering Sustainable Growth Presentation for the T


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Title: The Role of Finance in Fostering Sustainable Growth Presentation for the T

The Role of Finance in Fostering Sustainable
Growth Presentation for the TÜSIAD-KOÇ
  • By Stijn Claessens
  • Professor of International Finance, University of
    Amsterdam, Senior Adviser, Operations and Policy
    Department, Financial Sector Vice-Presidency, The
    World Bank

Structure of Presentation
  • Finance and growth the evidence
  • What makes for financial sector development?
  • Special issues for middle-income countries?
  • What does changing world of finance imply?
  • Why do countries not reform?

Finance and growth
  • Financial system is important for growth. Much
    evidence finance matters for real sector growth,
    productivity, investment, cost of capital, etc.
  • At the firm, sector and economy level
  • Especially for SMEs and the emergence of new
  • Specific channels shown, also using experiments
  • Some questions remain, however
  • On causality, missing/omitted variables
  • Only recently evidence on the links between
    finance and poverty

Finance and growth
Finance and firms/SMEs
  • While large SME sector characteristic of
    successful economies, SMEs do not cause growth,
    nor do SMEs alleviate poverty or decrease income
  • Rather overall business environmentease of firm
    entry and exit, sound property rights, and proper
    contract enforcement influences economic growth
  • Finance, however, accelerates growth by removing
    constraints on small firms, more so than for
    large firms
  • Finance allows firms to operate on a larger scale
    and encourages more efficient asset allocation.
    Financial and institutional development helps
    leveling the playing field

Finance and the poor
  • Finance helps growth and growth helps poverty
    reduction. Finance helps poverty through growth
  • Finance can help distribute opportunities fairer
    (the more concentrated income, the higher
  • Cross-country studies
  • Beck, Demirgüç-Kunt and Levine 2004 controlling
    for reverse causality financial development gt
    less income inequality
  • Clarke, Xu, Zou, 2002 inequality decreases as
    finance develops
  • Honohan 2004 financial depth explains poverty
    (less than 1 or 2). But, microfinance
    penetration no special effects on poverty

Inequality declines as finance develops
Finance and volatility
  • Evidence that better developed financial systems
    share risks better, are more stable, less prone
    to crisis
  • Evidence at household, firm, sector and economy
  • Specific channels been shown, also using
    experiments, e.g., allowing for (interstate,
    international) diversification, introduction of
    new hedging tools
  • Finance importantly relaxes credit constraints
    with shocks
  • Some questions remain, however
  • On causality, missing/omitted variables, what is
  • Some evidence quantity of finance alone can add

Finance and volatility
What drives financial sector development?
  • Financial development has been shown to depend
  • Good property rights and laws combined with a
    judicial system that enforce those
  • Access to credible information on borrowers and
    consumers and on financial intermediaries
  • Proper regulation and supervision of financial
    intermediaries and markets
  • A competitive/contestable market structure

Finance and fundamentals
  • Importance of effective legal system for
    financial market development, external financing,
    dividend patterns, growth, firm valuation, etc.
  • Well documented for equity and creditor rights
    (La Porta et al., Levine et al., Rajan and
    Zingales, etc.)
  • Includes a well functioning judicial system
  • Structure (bank versus markets) matters less than
    having the right fundamentals (Demirguc-Kunt
    Levine). Banks complement securities markets, in
    corporate governance role

Creditor rights, rule of law and depth of the
financial system
Shareholder protection, rule of law and capital
market development
Stock markets and banks complement in growth
Finance and fundamentals
  • Information is essential
  • Quality of accounting/auditing and credit bureaus
    key components of informational infrastructures
  • Regulation and supervision requires balance
    between market discipline and government role.
  • Without checks and balances, too much power in
    the hand of supervisors retards financial
    development and creates risks
  • Contestability in financial system key
  • Entry (of foreign banks) have helped stability,
    efficiency and access while state-owned banks
    have hindered

Foreign banks can help in financial sector
  • Borrowers perceptions across 36 countries
  • Financing obstacles lower in countries with high
    levels of foreign bank penetration
  • Strong evidence that even small enterprises
    benefit and no evidence they are harmed by
    foreign banks
  • Channel is both competition and direct provision
    of financial services by foreign banks
  • Latin America study
  • Foreign banks with small local presence do not
    appear to lend much to small businesses
  • But large foreign banks in many cases surpass
    large domestic banks

Financial sector development and macro/fiscal and
real sectors
  • Financial sector development depends on stable
    macro-economic environment and little crowding
  • Moderate, positive real interest rates
  • Low fiscal deficits to avoid banks holding only
    government paper
  • Financial services input for real sector and
    vice-versa. Scope for vicious and virtuous
    relationships. Development and effectiveness of
    financial and real sector depends on many similar
    factors, yet still separate finance reform
  • Additional positive effect of finance on growth
  • Financial sector represent allocation of control
    rights, link to political economy of reform in

Current finance research questions
  • How do financial systems evolve?
  • How to tailor financial sector development
    approaches to country circumstances?
  • What are special issues for emerging markets?
  • What does changing world (of finance) imply?
  • Implications for public policy
  • What drives (financial sector) reform?

How do financial systems evolve?
  • Are certain financial market structures more
    attractive at some levels of development?
  • More concentrated banking systems more attractive
    at lower levels of development?
  • How does the balance between banks and markets
    preferably change as countries develop?
  • When to develop non-bank financial markets, e.g.,
    bond markets, securitized markets?
  • How to classify countries financial systems,
    market versus bank or horizontal versus vertical?
    What does it imply for financial development?

How to tailor approaches to countries?
  • Consistency of reform rather than speed is key
  • Many country-specific requirements and tradeoffs
  • E.g., degree of competition and access to
    financing relate differently when information
    more obscure
  • Limits to what government/regulation can achieve
  • Much evidence that government is poor regulator,
    e.g., more power does harm if checks and balances
    missing minimally paid supervisors unlikely to
    resist corruption securities markets private
    better than public oversight
  • Regulations to vary. Are all standards good?
    Core 25, Basle II, IOSCO, etc., will not always

What are special issues for emerging markets?
  • Finance based on the same principles and finance
    industries undergoing similar changes as ROW
  • Countries generally benefit from reform and lib.
  • Institutional weaknesses more severe, limits
  • Can lead to crises, especially when integrating.
    Causes of crises shift, however, tools to predict
    may fail
  • No fixed, a-priori pre-conditions for successful
  • Often deeper causes political economy, moral
    hazard, low pay, corruption, etc. Rebalance
    government role
  • Issues of size and special nature of banks and
    safety net need to consider government capacity

Many financial systems are small
Deposit insurance rapidly expanded
What does changing world imply?
  • Financial services are changing rapidly
  • Globalization capital flows, cross-border
    financial services, listing in financial centers,
    foreign bank entry
  • Deregulation within markets, geographic,
    including cross-border, across markets and
  • Technology advances in information, particularly
    internet and increased remote delivery
  • Factors are changing financial services
    industries structures and altering forms of
  • Banks and finance becoming less special
    increasingly more substitutes available more
    remote delivery possible local markets less
    relevant lines between products and financial
    institutions blurring

What does changing world imply?
  • Nature of the firm altering
  • Intangibles, new economy, network-type assets
    more important for production and productivity
  • Investments to be financed changing
  • Investors invest in ideas, rather than fixed
  • Ideas need more protection for investors
  • Implications for financial sector
  • Fewer fixed assets makes debt more difficult
  • Higher risk requires other financing structures
  • More VC-type and more equity markets as VC to
  • Greater importance of corporate governance

Implications for public policies
  • Revisit enabling environment for finance
  • Greater emphasis on property rights (laws and
    enforcement), information infrastructure, etc.
  • Do not expect market, but neither government to
    solve all problems focus on core role of
  • Revisit current prudential and institutional-orien
    ted approaches implied by standards and reduce
    safety net
  • More need for consumer/investor protection as
    financial services become more like other
  • Revisit tools/approaches used for managing risks

Revisit especially competition policy
  • More active competition policy possible/needed
  • Finance and banks particularly less special
  • New paradigm to be developed and applied
  • To go beyond institutional and functional
    approaches to be both global and horizontal and
  • Approach to resemble other network industries
  • Countries can benefit from committing to
    pro-competitive framework
  • Credibility more at a premium, competition policy
    authorities weaker, political economy more
  • WTO, FTA-type of arrangements help (more)

Why do countries not reform?
  • Countries do not adopt most efficient
  • Institutional change in general slow, although
    some transition economies, crisis countries are
  • In many dimensions unclear whether globalization
    will allow for convergence in effective
  • Financial markets are subject to global
    competition, yet very imperfect convergence and
    at high costs
  • Firms and markets can adapt to weaker
    environments, but alternative mechanisms have
    limits and costs

In general institutions are rigid
  • Institutions and rules are rigid and path
  • Best example is legal origin which has
    long-lasting effects, from colonization centuries
    ago to today
  • Property rights not only institutional
    difference, though
  • Regulation of labor markets, ease of entry for
    new firms restraints on executive, degree of
    democratic institutions, degree of corruption
    quality of regulation
  • Institutions are highly correlated. Suggests
    deeper factors
  • Settlers mortality social capital natural
    factor endowments physical environment ethic
    heterogeneity culture religion others?

What drives institutional (financial sector)
  • Institutions are quite stable and by some measure
    can explain level of development.
  • What still triggers changes? How do institutions
    evolve and in turn affect (financial sector)
  • When do countries reform? What is the role of
    real sector changes? How does competitionreal,
    financialaffect legal and financial systems?
  • Is there a channel from ownership to reform? Any
    benefits of certain privatization models?
  • Why does it often take a crisis? Are crises
    blessings in disguise? What is role of political

Can financial crises spur reform?
  • Are financial and real sector crises blessing in
    disguise? Do political changes cause crises and
    thus reform, in financial sector especially? What
    type of crises work best growth or financial
    crises? What measures enacted in crises
    actually stuck and made a difference?
  • Are financial crises (only) cause for
    international financial institutions to get busy
    with financial sector? Is finance a too long term
  • Has the link between finance and poverty not made
    clearly? Has the link to inequality and lack of
    access not been shown sufficiently?

How can other reforms support financial reform?
  • If financial sector reform is difficult, are
    there other, indirect ways to get desired
  • Competitionopenness to trade, capital flows,
    entry in financial and corporate sectors, ability
    of corporations to list in other marketsaffects
    systems in two ways
  • Competition can deliver functional convergence,
    but in what areas? Can corporations hire
    corporate governance by cross listing in foreign
    markets? Are foreign-owned banks a substitute or
  • Competition can overcome/weaken political economy
    constraints. More generally, real sector reform
    interacts with financial sector reform

Can ownership changes provide political support?
  • Need for middle-class to push for and support
    reform, including financial sector reform
  • Can degree of general public ownership (directly)
    affect incentives to push for some reforms?
  • Channel from ownership to reform. When ownership,
    control and political economy structures not
    change, reforms not deep enough and insiders
    hijack reforms. With extensive ownership changes,
    reform more likely deeper
  • Benefits of certain privatization strategies.
    With large state-ownership, after
    crisis/transition, certain ownership distribution
    encourage reforms

Ownership concentration and institutional