Financial Deepening and Bank Productivity in Latin America Georgios Chortareas University of Athens Claudia Girardone University of Essex Jesus G. Garza Garcia University of the West of England Cass Business School Emerging Scholars in Banking and Finance December 9 th, 2009

Introduction Financial liberalisation has been a recent important trend in the financial sectors in Latin America. Main idea was to generate a more competitive banking sector. Aizenman (2005) suggests that financial liberalisation gained from increased savings in the economy (mainly through foreign capital). This increase in savings in the economy was expected to increment the level of financial deepening in the economy (particularly the credit to the private sector).

Financial Deepening Figure 1 Bank Credit to the Private Sector in terms of GDP, Average Percentage Data obtained from IFS (International Financial Statistics) from the IMF (line 32D.ZF).*The Latin American average is calculated using the following countries: Argentina, Brazil, Chile, Colombia, Costa Rica, Paraguay, Peru, Uruguay and Venezuela. For Venezuela the average is calculated from due to data availability. **The South East Asia average is calculated using the following countries: Brunei, Cambodia, Malaysia, Laos, Myanmar, Singapore, Thailand, Hong Kong, South Korea, Philippines and Vietnam. The average for Brunei and Vietnam was computed for the years and for Myanmar from due to data availability. ***The data for the EURO Area was elaborated including all the countries in the European Union.

Figure 2 Financial Deepening in Latin America Source: IFS (International Financial Statistics from the IMF) *The Latin American average is calculated using the following countries: Argentina, Brazil, Chile, Colombia, Costa Rica, Paraguay, Peru, Uruguay and Venezuela; except for M2/GDP in which Peru and Venezuela were excluded due to data availability.

Literature Review Economists have largely disagreed on the role of financial development and economic growth. Increased numbers of financial institutions and financial instruments help reduce information costs in the economy (Rioja and Valev, 2004). Many other studies find a positive relationship between finance and growth (King and Levine (1993a, b, c), Roubini and Sala-i-Martin (1992), Pagano (1993), Jayaratne and Strahan (1996), Levine (1997a, 1998), Arestis and Demetriades (1997), Rajan and Zingales (1998), Lindh (2000), Levine et al. (2000) among others.

Literature Review “Thus, if finance is to explain economic growth, we need theories that describe how financial development influences resource allocation decisions in ways that foster productivity growth...” Levine, 2004: p. 6

Literature Review Recent studies address how financial development affects economic growth through greater productivity (economic). Particularly, Levine et al. (2000), Arestis et al. (2002) and Arestis et al. (2006) argue that financial development affects economic growth through productivity growth. There are various studies which suggest that financial development may enhance greater economic productivity and contribute to a more efficient allocation of capital.

Motivation Latin American financial systems are highly bank- based. Extensive literature on the relationship between financial deepening and economic growth. No literature focusing on the microeconomic relationship: financial deepening and banking productivity and/or vice-versa. Financial deepening forms the broad environment in which banks operate.

Data Data obtained from Bankscope and the IFS from the IMF. Study includes 9 Latin American countries: Argentina, Brazil, Chile, Colombia, Costa Rica, Paraguay, Peru, Uruguay and Venezuela. Observations: 973 Years:

Methodology TFP = TOTAL FACTOR PRODUCTIVITY PCR= CREDIT TO THE PRIVATE SECTOR /GDP CPI = CONSUMER PRICE INDEX TRADE = SUM OF EXPORTS + IMPORTS / GDP GOV = TOTAL GOVERNMENT EXPENDITURE / GDP XRATE = AVERAGE ANNUAL EXCHANGE RATE GDP per capita = GROSS DOMESTIC PRODUCT per capita GMM Panel Data: endogenous variables (TFP, PCR) exogenous variables: macro variables

TFP or the Malmquist Index The Malmquist Productivity Index is a distance function which measures the degree of productivity using a multi input and multi output approach. Created by the Swedish statistician Malmquist in 1953, it was first proposed by Caves, Christensen, and Diewert (1982). It has since been further developed by Fare (1998), Fare et al. (1994) among others.

TFP or the Malmquist Index Where M is the Malmquist Productivity Index D is the distance function made up of inputs and outputs. A value of M >1 implies an increase of productivity A value of M=1 means no change in productivity and M <1 is a reduction in productivity. The distance function is the DEA input-oriented approach. x = inputs (interest rate expenses, personnel expenses and other operating expenses) y= outputs (loans and other earning assets)

TFP or the Malmquist Index MI(TFP) TEC TC Where MI represents the Malmquist Index (TFP- Total Factor Productivity), TEC is the technical efficiency change and TC is the technological change. The technical efficiency change relates to how close firms are operating in relation to the best practice frontier. On the other hand, technical change refers to the shift in the best practice frontier.

Empirical Results Figure 3 TFP, TC and TEC average annual geometric average in Latin America (%) TFP, TC and TEC are the geometrical averages for the corresponding years in Latin America. The Latin American average includes the countries in study: Argentina, Brazil, Chile, Colombia, Costa Rica, Paraguay, Peru, Uruguay and Venezuela.

Empirical Results Table 1 GMM dynamic panel data, TFP as the dependent variable TFP (a) TFP (b) TFP (c) TFP lagged(t-1) PCR1.133***1.488*** PCR lagged(t-1)1.56***-.845 PCR lagged(t-2).832*.228 CPI.032***.031***.043*** TRADE GOV-2.618***-2.857*-2.647** XRATE-.036***-.095*-.058* GDP per capita Cte.1.481** ** AR(1) p-value AR(2) p-value Hansen J test p-value Observations Year dummies (0.042) 1.22 (0.224) (0.359) 973 Yes (0.113) (0.853) (0.166) 513 Yes (0.062) (0.977) (0.427) 973 Yes

Empirical Results Table 2 GMM dynamic panel data, PCR as the dependent variable PCR (d) PCR (e) PCR (f) PCR lagged(t-1).463**.986***.835*** TFP.016***.008* TFP lagged(t-1) TFP lagged(t-2)-.024**-.005 CPI-.005***-.004***-.006*** TRADE.286***.22***.223*** GOV.683*** XRATE GDP per capita.095***.11***.117*** Cte.-.8*** -.902***-.951*** AR(1) p-value AR(2) p-value Hansen J test p-value Observations Year dummies -2.6 (0.009) (0.043) (0.006) 973 Yes (0.150) (0.251) (0.024) 513 Yes (0.293) (0.310) (0.257) 513 Yes

Results The main findings indicate there is a strong positive relationship between TFP and PCR and vice-versa (model f). CPI is positive and significant when explaining banking sector productivity but negative and significant when explaining financial deepening. TRADE, is positive and significant when explaining financial deepening. Government expenditure is negative and significant with TFP, implying that greater government expenditure decreases banking productivity.

Other results XRATE variable is negatively and significantly related TFP. GDP per capita is positively and significantly related with PCR.

Conclusions 1/2 The above results are in general supportive of a positive relationship between financial deepening and banking productivity. This finding suggests that a channel through which the beneficial effects of financial deepening find their way through the economy is the banking system.

Conclusions 2/2 Evidence of reverse causality between financial deepening and banking productivity. The finding of reverse causality may indicate the existence of a virtuous cycle between financial deepening and banking productivity where one facilitates the other.

Policy Implications Policy oriented measures in the region should take in consideration the positive causality between financial deepening and banking productivity and try to increase the level of credit to the private sector as a stimulant of economic growth.