Financial Development: Structure and Dynamics Augusto de la Torre, Erik Feyen, and Alain Ize WB Conference Washington DC, 16 June Chief Economist Office Latin America and the Caribbean The 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 development The Bright Side 4

A simple typology of paradigms 5

Frictions, paradigms and failures Contract stage Finance friction Underlying problem Paradigm Failures Getting the facts Agreeing on a contract Enforcing the contract Uncertaint y, informatio n and learning costs Bargaining costs Enforcemen t costs Enforcemen t costs Asymmetric confusion Symmetric confusion Coordination failures Limited pledgeabilit y, commitment and liability Asymmetric Information AI Asymmetric Information AI Collective Cognition CC Collective Cognition CC Collective Action CA Collective Action CA Costly Enforcement CE Costly Enforcement CE Collecti ve failures Collecti ve failures Agency failur es Agency failur es 6

Process of financial development Finding the path of least resistance Failures Friction s Public response Public response Private response Private response Structure Needs 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) 9

The process of financial development The supply side response Friction s Public response Public response Private response Private response Innovation Structure Technologica l progress Regulato ry arbitrag e Participatio n Network effects Scale effects Enabling environmen t Needs Competitio n 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 development The Dark Side 12

The process of financial development The dark side Friction s Public response Public response Private response Private response Innovation Structure Technologica l progress Regulator y arbitrage Participatio n Network effects Scale effects Enabling environmen t Needs Competitio n 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  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 development Patterns 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 18

Public debt 19

Banking 20

Many reasons for the dynamic paths to deviate from the cross-section  Country-specific policies  Country-specific policies: enabling environment, growth, cycles  Crashes  Crashes: dark side  Path dependence  Path dependence: initial conditions matter (today’s FD depends on output, which depends on past FD)  Leap frogging  Leap frogging: importable innovations  Threshold effects  Threshold effects: endogenous quantum jumps 21

Multiple dynamics paths around very smooth cross-sections 22

The empirics of financial development Linking back to the frictions and the dark side 23

The grinding down of frictions 24 Note: LPOP, LPOP_DENSITY, LAGEDEP_YOUNG, LAGEDEP_OLD, OFFSHORE, TRANSITION DUMMY, FUEL EXPORTER DUMMY, and constant were estimated but are omitted.

Explaining the developmental differences: frictions, dark episodes, demand effects 25

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  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