Challenges posed by underdeveloped financial markets and instruments Kevin Davis Professor of Finance, University of Melbourne Research Director, Australian Centre for Financial Studies (and Professor, Monash University)

Outline Finance and Growth – the relationship Finance – channels of influence Impediments to financial development Policy Options

Financial Development and Economic Growth Research indicates financial development causes faster economic growth Although economic development also stimulates financial sector growth

Financial Sector Functions Market frictions Information costs Transactions costs Financial markets and Intermediaries Financial Functions Mobilise savings Allocate resources Exert corporate control Facilitate risk management Ease trading of goods, services, contracts Channels to growth Capital accumulation Technological innovation Growth Source: Adapted from Levine (1997)

Functions of the Financial Sector Mobilize and pool savings for investment Ease the exchange of goods and services Create liquidity – reconciling long term needs of users with short term preferences of savers Facilitate risk management – across participants and across time Create price signals and information to guide decisions on capital allocation Monitoring / disciplining recipients of funds to ensure efficient and proper use of funds

Long run consequences: Finance and Growth Improved finance sector can increase growth through productivity growth by better allocation of funds encourage savings and investment (example shows effect of higher investment rate and productivity)

Impediments to Financial Development Market frictions Information costs Transactions costs Financial markets and Intermediaries Financial Functions Mobilise savings Allocate resources Exert corporate control Facilitate risk management Ease trading of goods, services, contracts Channels to growth Capital accumulation Technological innovation Growth Look at impediments to overcoming information and transactions (including contracting) costs.

Impediments to Financial Development Legal Systems Property rights and certainty of contract Access to courts and redress Information, Education, Financial Inclusion Accounting / Auditing and information reliability Economic Stability Redistributive effect of unexpected inflation & contracting problems when high inflation Macroeconomic fluctuations and default risks Financial Institution Safety / Prudential Regulation Regulation and Vested Interests

Regulatory Impediments Example: interest rate ceilings Imposed to “protect” borrowers Consequences: less funds available for borrowers Poorer borrowers rationed out Social loss Interest rate Supply Ceiling Demand Loans Lost opportunities

Regulatory Impediments Example: Capital account restrictions Consequences: less funds available for borrowers At higher interest rate Social loss from foregone profitable investments Interest rate Domestic Supply rd “world” Interest rate rw Domestic Demand Loans Lost opportunities

Vested Interests Marginal Cost = Monopoly Supply Financial system evolution shaped by influence of existing vested interests Example: existing monopolies lose profits if competition allowed Lobby to influence legislators and protect position Social loss – in addition to redistributive effects Interest rate Average Cost = Competitive Supply rm rc Demand Lost opportunities Loans

Retirement Financing Challenges or As economies become wealthier, family sizes shrink And mortality improvements mean larger share of aged

Retirement Financing Challenges or Less reliance on family support for aged Need for retirement savings – but individuals generally don’t! Increased call on government safety nets / pensions when aged dependents / working age population falling Rationale for tax incentives/compulsion/defaults for long term retirement income saving Higher saving generates a pool of investable funds Potentially available for longer term investments

The Importance of Financial Consumer Protection Economic development generates increasing household involvement with the financial sector Financial development leads to increasing complexity of financial products and services Financial literacy is generally low Opportunities for miss-selling, overcharging are significant, particularly given individuals’ gullibility and greed

Gullibility and Greed Fools and their money are easily parted A fundamental challenge of Financial Consumer Protection Protecting individuals from themselves As well as from others! Fools and their money are easily parted If it’s too good to be true it probably is!

The Importance of Financial Consumer Protection Economic development generates increasing household involvement with the financial sector Financial development leads to increasing complexity of financial products and services Financial literacy is generally low Opportunities for miss-selling, overcharging are significant, particularly given individuals’ gullibility and greed Some providers of financial products, services, and advice may have questionable ethics, governance, incentives Financial failures, scams, consumer losses reduce confidence and cause sub-optimal use of the financial sector

G20 Financial Consumer Protection Principles 1 Legal, Regulatory & Supervisory Framework 2 Role of Oversight Bodies 3 Equitable, Fair Treatment of Consumers 4 Disclosure and Transparency 5 Financial Education and Awareness 6 Responsible Business Conduct of Providers and Agents 7 Protection of Consumer assets against Fraud and Misuse 8 Protection of Consumer Data and Privacy 9 Complaints Handling and Redress 10 Competition The World Bank Good Practices for Financial Consumer Protection (2012) provides guidance on practices at a sectoral level Source: OECD

FCP Policy Underpinnings The legal/regulatory framework is crucial When can redress be sought? Strict “terms and conditions” v “reasonable expectations” Abusive practices definitions Duty of care How can redress be sought? Individual legal action Class actions (and litigation funders) Legislated dispute resolution schemes Government agency (enforcement) role

Financial Development Opportunities Technological advance is changing (reducing) information and transaction costs Past financial development patterns may be less relevant Threats to existing business models Electronic finance not without its problems Cyber-crime; potential instabilities

Financial Development Opportunities Some potential areas of focus Micro-finance: social networks and incentives Electronic payments: SMEs and financial inclusion Information sharing: credit bureaus Retirement savings programs

Conclusions and Cautions Government policies for financial development Need for good “financial infrastructure” Law, politics, stability, financial system One size does not fit all Need to take account of existing social and economic structure / constraints Need to recognise individuals have behavioural biases Promoting competition is important But market imperfections are substantial Financial stability is not guaranteed Sound regulation / supervision essential

Thank You Questions?