Financial Development:Structure and Dynamics

Augusto de la Torre, Erik Feyen, and Alain Ize

WB ConferenceWashington DC, 16 June 2011

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Chief Economist OfficeLatin America and the CaribbeanThe 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?

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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

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The process of financial developmentThe Bright Side

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A simple typology of paradigms

Full information / Full rationality

Incomplete information / Bounded rationality

Bilateral focus Costly Enforcement (CE)

Asymmetric Information (AI)

Multilateral focus Collective Action (CA)

Collective Cognition (CC)

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Frictions, paradigms and failures

Contract stage Finance friction Underlying problem Paradigm Failures

Getting the facts

Agreeing on a

contract

Enforcing the

contract

Uncertainty,

information and

learning costs

Bargaining costs

Enforcement

costs

Asymmetric confusion

Symmetric confusion

Coordination failures

Limited pledgeabilit

y, commitmen

t and liability

Asymmetric Information

AI

Collective Cognition

CC

Collective Action

CA

CostlyEnforcement

CE

Collective

failures

Agency

failures

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Process of financial developmentFinding the path of least resistance

FailuresFrictions

Public response

Private response

StructureNeeds

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The private responses

Lessening the frictions Acquiring information, learning Using collateral Delegating

Lessening the exposure Diversifying and pooling Buying insurance and hedges Staying liquid

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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)

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The process of financial developmentThe supply side response

Frictions

Public response

Private response

Innovation

Structure

Technological progress

Regulatory

arbitrage

Participation

Network effects

Scale effects

Enabling environme

nt

Needs

Competition

Failures

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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)

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The process of financial developmentThe Dark Side

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The process of financial developmentThe dark side

Frictions

Public response

Private response

Innovation

Structure

Technological progress

Regulatory

arbitrage

Participation

Network effects

Scale effects

Enabling environme

nt

Needs

Competition

Failures

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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

Þ 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)

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The empirics of financial developmentPatterns and paths

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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)

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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

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Order of appearance, convexity and returns to scale

Fore

ign P

ublic

Debt

Dom

estic P

ublic

Debt

Pensio

n F

und

Asse

ts

Bank D

eposits

Non-L

ife In

sura

nce

P

rem

ia

Bank W

hole

sale

F

undin

g

Bank P

rivate

Cre

dit

Bank C

laim

s on

Fin

. Institu

tions

Sto

ck M

aket

Capita

lizatio

n

Life

Insu

rance

Pre

mia

Mutu

al F

unds

Asse

ts

Dom

estic P

rivate

D

ebt

Fore

ing P

rivate

D

ebt

-2,000

-1,500

-1,000

-500

0

500

1,000

1,500

2,000

2,500

Order of Appearance, Convexity and Returns to Scale

Appearance Convexity Returns to Scale

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Public debt

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Banking

20

02

04

06

08

0

4 6 8 10GROUP MEDIAN LGDPPC

PRIVATE CREDIT / GDP (IFS)

DMB DOMESTIC DEPOSITS / GDP (IFS)

NON-DEPOSIT FUNDING / GDP (IFS)

Many reasons for the dynamic paths to deviate from the cross-section

Country-specific policies: enabling environment, growth, cycles Crashes: dark side Path dependence: initial conditions matter (today’s FD depends on

output, which depends on past FD) Leap frogging: importable innovations Threshold effects: endogenous quantum jumps

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Multiple dynamics paths around very smooth cross-sections

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The empirics of financial developmentLinking back to the frictions and the dark side

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The grinding down of frictions

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

Credit Information Creditor Rights Property Rights

LGDPPC 0.344*** -1.998 -20.370***(3.438) (-1.416) (-2.859)

LGDPPC2 -0.164** 0.169* 1.837***(-2.465) (1.798) (3.869)

LPOP 0.500*** -0.028 -0.355

Observations 158 158 162Pseudo R2 0.392 0.233 0.501t-statistics in parentheses

*** p<0.01, ** p<0.05, * p<0.1

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

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BANK PRIVATE CREDIT

BANK PRIVATE CREDIT

STOCK MARKET TURNOVER

STOCK MARKET TURNOVER

ENFORCEMENT -4.047* -5.318** -4.701*** 1.016(-1.864) (-2.358) (-4.508) (0.234)

LEGAL RIGHTS 1.662 1.671 -1.067* 0.570(1.547) (1.385) (-1.981) (0.274)

CREDIT INFO -0.526 3.318***(-0.379) (4.625)

PROPERTY RIGHTS 0.235 0.0690 0.545*** 0.380(1.301) (0.335) (6.499) (1.188)

GDP GROWTH 5.590** 3.029(2.433) (1.102)

CREDIT CRASH DUMMY -77.69** -157.1*(-2.042) (-1.950)

Observations 156 118 103 84Pseudo R2 0.497 0.571 0.456 0.525t-statistics in parentheses*** p<0.01, ** p<0.05, * p<0.1

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

Þ Can there can be too much finance? (can the costs of instability—or the costs maintaining stability—overcome the benefits of finance?)

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Thank you