1. EC3040 Economics of LDCs Module B Topic 3 Financial sector issues

2. Finance and development 1.Financial systems growth and poverty reduction 2.Financial crises 3.Microfinance 4.Macroeconomic stability and international finance 5.The debt problem

3. 1. Financial system development and growth: Outline How it was discovered that finance causes growth Some evidence on finance and poverty Measuring finance: –Weakness of banking depth –An alternative based on second generation evidence

4. Elements of the financial system Banks (and bank-like institutions such as building societies, credit unions, microfinance institutions). Intermediaries Markets (stock market, bond market, foreign exchange market) Financial instruments (bank deposits, bank loans, bonds, equities…) Other financial firms providing ancillary services (payments technologies, credit rating agencies…)

5. Intermediaries Pool resources from depositors and lend the proceeds to borrowers (including government and its agencies) Provide risk-sharing services for depositors, creditworthiness appraisal and monitoring for borrowers Also provide other services including payments (cheques, domestic and international transfers…) Intermediaries, especially banks, form a much larger share of the financial system in developing countries than in advanced economies.

6. Simplified balance sheet of a bank

7. Beck, Demirguc-Kunt, Levine, 2001

10. But: Post hoc ergo propter hoc? Updated from Levine, 2005 The discovery that finance affects growth (and not just the other way around)

11. How can we get around chicken-and-egg problem of causality Is the correlation between financial depth and economic growth causal? If so, which is the direction of causation? Richer countries produce deeper financial systems But do deeper financial systems also generate growth? Method of instrumental variables (remember dead bishops) –Suppose we have data on something that helps explain financial depth, but has no causal impact on growth (for example, the nature of the legal system -- stronger protection for creditors vis- à-vis debtors helps financial system) –Replace actual financial depth by its predicted value

12. Valid instruments (A simplified note on econometric methodology) Correlated with explanatory variables Not independently relevant to explaining dependent variable Predicted value from regression of explanatory variables on instruments used to explain dependent variable (growth) –Example: legal origin

14. Pitfalls of relying on banking depth as the main measure of financial development 1

15. Pitfalls of relying on banking depth as the main measure of financial development 2

16. Where do banks invest their resources?

17. Banking is expensive: Net Interest Margins