1. 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)

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

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

4. 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)

5. 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

6. 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)

7. 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.

8. 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

9. 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

10. 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

11. 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

12. Retirement Financing Challengesor
As economies become wealthier, family sizes shrink
And mortality improvements mean larger share of aged

13. Retirement Financing Challengesor
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

14. 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

15. 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!

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. Thank You Questions?