Informal Networks and Shadow Banking: Policy Implications

1. Informal Networks and Shadow Banking: Policy Implications Robert M. Townsend Elizabeth & James Killian Professor of Economics, MIT FPD Chief Economist Talk World Bank Washington, DC December 8, 2011

2. Local Networks: Kinnan (2010) In turn, 3019 borrows from Commercial Bank. As such, 2012 has indirect access.

3. Kinship and Financial Networks, Formal Financial Access and Risk Reduction (Kinnan& Townsend 2011) • Gifts from other households in the same village equal 9 percent of average expenditure • The average amount borrowed per transaction is 12,200 baht, which is equal to 60% of average monthly household expenditure • The average household who ever borrows, borrowing from other villagers 4.75 times over 84 months • For borrowing/lending and transfers with other households in the village, the surveyed household is asked to identify the structure (essentially, the address) • Matched to a village census • Identify the counterparty household for each within-village transaction, even if they are not themselves in the survey • Some households are directly connected to banks, while others are indirectly connected

4. Data From Urban/Rural and from Every Region Villages are clustered by design Urban is towns and cities (capital of province)

5. Overview of Surveys: Annual & Monthly • Annual Data • Started in Rural Areas in 1997 with 192 villages • Resurvey in 64 villages every year since 1998 • Longest running survey of its kind in the developing world • Expanded to North and South in 2003 and 2004 • Extended to Urban Areas in 2005 • Monthly Data • Survey Design: • 16 villages, 45 households per village • Data include: • Village-level family networks, markets and formal credit and insurance institutions • Measures of savings and loans, income, wealth, consumption

7. Monthly Income Statement Archawap (2011) [Source: Samphantharak & Townsend, 2006]

8. Policy Implication • Panel Data Extremely Valuable • Measuring Financial Access and Quality of Use • Less Data Is OK Too

9. Bank of Thailand (BOT) & CFSP Collaboration • Background • BOT implemented first Survey on Savings and Financial Access (SFA), 2006 • RMT asked to advise on 2nd SFA survey design and questionnaire, 2010 • After 2006 survey, BOT needed better information on two main issues: • What was households’ satisfaction with the financial services received? • What types of financial services with what kinds of characteristics do households need? • Pursuing More Accurate Answers to BOT Policy Questions • Challenge: If BOT asked questions to households directly, could yield inaccurate responses, wide subjectivity due to levels of product awareness • Solution: Modify some questions in SFA to yield answers that are compatible with economic models.

10. Impact and Quality of Access: Understanding Shocks and Risk in Data • Is risk allocated optimally? • A benchmark standard based on the theory would say: • Idiosyncratic risks are pooled • Aggregate shocks are shared • Investment depends on expected productivity but not current cash flow

11. Evaluating Formal/Informal FI as Member SyndicateConsumption Smoothing: A Rating/ Score Card Instrumenting for Access • Alem and Townsend • First column: estimates of the time-varying constant for members of the institution • Second column: sensitivity of consumption to income changes for non-participants of the financial institution • Third column: the effect of financial participation on the income coefficient sensitivity • Fourth column: tests the complete-markets-full-insurance hypothesis for financial participants • A new way to rate financial institutions using GE benchmarks • Policy suggestions • Need to come back to intermediaries in GE Table 4: Impact of Financial Institutions on Consumption Smoothing

12. Evaluating Formal/Informal FI as Member SyndicateInvestment Smoothing: A Rating/ Score Card Instrumenting for Access Table 5 Impact of Financial Institutions on Investment Sensitivity to Shocks (Eq. 25)

13. Impact of Networks • Being directly connected to a bank reduces the consumption-income comovement by 0.1658 baht (significant at 1 percent) • An indirect connection has a virtually identical impact, reducing the consumption-income comovement, relative to no connection, by 0.1643 baht (significant at 1 percent), yielding a net sensitivity of 0.0002, insignificantly different from zero (p=0.958) • Investment is highly sensitive to cash flow for households without kin in the village, with a one baht income change associated with a 0.6526 baht investment change, significantly different from zero at the 1% level • The presence of kin in the village substantially mitigates this sensitivity, however, reducing the response to a one baht change by 0.4136 baht. • Bank connections do not appear to be significantly helpful in smoothing investment, in contrast to their central role in consumption smoothing

14. Policy Implications • Savings and financial access can understate reach of formal financial system • Hide true underlying vulnerability • Blind us to underlying informal mechanisms

15. Mechanisms: Bridge Loans Correlation Between Amount Repaid and Amount Borrowed

16. Mechanism: Informal Money Market, Trips to the “Bank” • Two examples profiles

17. Sophisticated Risk Sharing Labor Syndicates (for some): Response to Idiosyncratic Risk is Small • participation, 1 standard dev increase • -.05473126 • hours_w, 1 standard dev increase • .00034717

18. Sophisticated Financial Markets • Using a capital asset pricing model (CAPM) Samphantharak & Townsend (2010) find that income/asset ratios have rate of return data using Euler equations, • Idiosyncratic risk also remains

19. CAPM in Village Networks: Beta and Expected Return

20. Risk Adjustments in Measuring Individual Productivity

21. Poor Are More Vulnerable to Shocks - Annual • Annual Townsend Thai data show that consumption is close to that predicted by optimal allocation of risk bearing and it is optimal overall, but not for the poor who are quite vulnerable Risk Sharing Regressions by Wealth • participation, 1 standard dev increase, poor • -.14140841 • hours_w, 1 standard dev increase, poor • -.02040001 • Some remain vulnerable

22. Policy Caveat: The obvious remedy is not so obvious • Welfare costs of aggregate risk • Positive numbers mean the household has a welfare loss from aggregate risk and is willing to pay to eliminate risk; negative numbers mean the household has a welfare gain from aggregate risk. • Even poor households can have high risk tolerance, so get hurt with external insurance

23. Variation in Networks: Micro-Finance Implications

24. Microfinance in Rural and Urban Thailand: Policies, Social Ties and Successful Performance (de la Huerta, 2011) • Households in rural areas have some knowledge about the customs and characteristics of people and institutions in the region which varies across communities and predicts success and failure of the microfinance program • Being rated by the households themselves as the best village in cooperation, lowers the default rate on loans from 5 to 8 percent, and rated as best in institutions (again in a survey before the million bhat program was even imagined) from 18 to 24%. • Practices such as requiring compulsory savings and providing training or information to borrowers are positive predictors of repayment in both rural and urban environments • Training and compulsory savings, though effective in both, are even more effective in urban communities

25. Network Morphs into Other Forms: Village Balance of Payments

26. Capital Market Integration • If the international capital market is perfect, capital should flow to the countries with the highest returns on investment, and there should be no correlation between a country’s saving rate and its investment rate • On the other hand, Feldstein and Horioka (1980) find that the national saving rate and the national investment rate are highly correlated within the OECD countries • To test whether the similar pattern exists in our village economies, we estimate the following equation • We get the estimated value for β at 0.05 and insignificant • On the other hand, if we change from the saving level to the saving plus gifts, the estimated values of β for the level specification is 0.277, which is significant at 5% level

27. Remittances are Getting Bigger over Time

28. Policy: Don’t Break up Risk Syndicates Samphantharak

29. Shadow Banking: Regulation? • What about credit chains, cascades of default, systemic risk? • Informal networks as (unregulated) shadow banking • Lessons • Unlimited ex post side trade can cause damage, undercut high powered incentives • Or cause pecuniary externalities • Remedies • Indexation to aggregate shocks • Appropriate liquidity provisions • Create market in ex ante exchange islands to commit to unwind commitments

30. Vision for Regulation and Policy: Optimal Ex Ante Design • Infinite Horizon economies • Debreu (1954), "Valuation Equilibrium and Pareto Optimum” • Jones (1983), "Existence of Equilibria with Infinitely Many Consumers and Infinitely Many Commodities: A Theorem Based on Models of Commodity Differentiation" • Private Information • Prescott and Townsend (1984), "General Competitive Analysis in an Economy with Private Information“ • Indivisibilities • Rogerson (1988), "Indivisible labor, lotteries and equilibrium” • Externalities and Lindahl Equilibria • Private Information: • Prescott and Townsend (1984), "Pareto Optima and Competitive Equilibria with Adverse Selection and Moral Hazard“ • Bisin and Gottardi (2006), “Efficient Competitive Equilibria with Adverse Selection” • Collateral Constraints • Kilenthong and Townsend “Moral Hazard, Retrading, Externality, and Its Solution” • -,“Market Based, Segregated Exchanges in Securities with Default Risk” • OLG, at least in general • Incomplete markets • Monetary economies • Manuelli and Sargent (2009), Alternative Monetary Policies in a turnpike economy • Jack, Suri and Townsend (2010), "Monetary Theory and Electronic Money: Reflections on the Kenyan Experience," Works May Work Does not work