Presentation on theme: "Anis Chowdhury Department of Economic and Social Affairs (UN-DESA)"— Presentation transcript:
1After the crisis: demystifying financial regulation and debt-inflation-growth Anis ChowdhuryDepartment of Economic and Social Affairs (UN-DESA)Professor of Economics, University of Western Sydney, AustraliaIDEAs Conference on Reforming Financial System
2Growth 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)
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)
4Deep, 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)
5Financial 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 regulationaims to protect the stability of the financial system (i.e. prevent systemic failures or financial crises) and to protect depositors, especially small depositors.
6Haste 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.
7Rationale for deregulation Increase savingsimprove efficiency of investmentDeepen financial sectorOutcomes: contrary to the prediction or rationale -Indebtedness increasedOverinvestment in speculative & real estate sectors; no impact on ICORIncreased fragility of the financial sector
8Deregulation 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 macro-prudential 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.
9Glass-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.
10Additional 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 ....”
11All these were present in the Asian crisis Evidence of the deterioration of FIs’ asset portfolios was already emerging in 1996Korea: banks suffered losses on their equity portfolios in 1996Thailand: 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.
12Asian 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.
13Lending growth – far above nominal GDP growth CountryNom. GDP growthAnn. loan growthLoan growth/GDP growthNet domestic credit/GDP19901996Indonesia17201184555Korea141216879Malaysia131813880136Philippines332542672Thailand2417184130
14Stock gambling in AsiaHeavy 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.
15Financial 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 1984the 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 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.
16Urban bias - Bangladesh Share of Rural Sector in Total Bank Deposits & Advances (%)YearDepositsAdvances19840.170.25819900.2140.21919950.2270.19719980.165
17Bangladesh (contd.) Share of Credit to Agriculture (%) Year 19830.2540.30919860.3740.30819900.2110.21819950.1730.15919980.1610.146Agriculture 1: Based on bank advances by main economic purposesAgriculture 2: Based on bank credit by sectors (private and public).
18Global 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.
19Preventing system-wide failure SegregationA 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.
20Preventing system-wide failure RestraintShould 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”.
21Ownership mattersBanks 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.
22Ownership mattersA 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.
23Meeting 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.
24Financial 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.
25Prudential & Economic Regulations Type of RegulationObjectivesExamples of Key Policy InstrumentsMacroeconomicMaintain control over aggregate economic activity - maintain external and internal balanceReserve requirementsDirect credit and deposit ceilingsInterest rate controlsRestrictions on foreign capitalAllocativeInfluence the allocation of financial resources in favour of priority activities Selective credit allocation Compulsory investment requirementsPreferential interest rates
26StructuralControl the possible abuse of monopoly power by dominant firms Entry and merger controlsGeographic and functional restrictionsPrudentialPreserve the safety and soundness of individual financial institutions and sustain public confidence in systemic stabilityAuthorisation criteriaMinimum capital requirementsLimits on the concentration of risksReporting requirementsOrganisationalEnsure smooth functioning and integrity of financial markets and information exchanges Disclosure of market informationMinimum technical standardsRule of market-making and participationProtectiveProvide protection to users of financial services, esp. consumers and non-professional investorsInformation disclosure to consumersCompensation fundsOmbudsmen to investigate and resolve disputes
27Guidelines 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.
28steps 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.
29Debt, inflation & growth “Good”, “Responsible” and “Sound” finance are buzz wordsFear of debt & inflation leading to calls for mopping up the stimulus packagesThis 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)
30Debt financed growthMost developing countries have to depend on debt financing: i.e. printing money for addressing both recovery and development needsBut the effectiveness is doubted even as early as in the 1950sV.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.
31Debt 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.”
32Ditching “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)
33Crowding out, Ricardian equivalence etc.? No convincing evidenceignores 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.
34Deficit & 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.
35Debt & 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)
36Money & 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”
37Inflation & 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.”