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Financial Development: Structure and Dynamics

Financial Development: Structure and Dynamics. Augusto de la Torre, Erik Feyen , and Alain Ize WB Conference Washington DC, 16 June 2011. Chief Economist Office Latin America and the Caribbean The World Bank. 1.

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Financial Development: Structure and Dynamics

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  1. Financial Development:Structure and Dynamics Augusto de la Torre, Erik Feyen, and Alain Ize WB Conference Washington DC, 16 June 2011 Chief Economist Office Latin America and the Caribbean The World Bank 1

  2. 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?

  3. 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

  4. The process of financial development The Bright Side

  5. A simple typology of paradigms

  6. Frictions, paradigms and failures ContractstageFinance frictionUnderlyingproblemParadigmFailures Asymmetric confusion AsymmetricInformation AI Uncertainty, information and learningcosts Getting the facts Symmetric confusion CollectiveCognition CC Collective failures Agency failures Agreeing on a contract Coordination failures Bargainingcosts Collective Action CA Enforcing the contract Enforcement costs Limited pledgeability, commitment and liability Costly Enforcement CE

  7. Process of financial developmentFinding the path of least resistance Public response Needs Frictions Failures Structure Private response

  8. The private responses • Lessening the frictions • Acquiring information, learning • Using collateral • Delegating • Lessening the exposure • Diversifying and pooling • Buying insurance and hedges • Staying liquid

  9. 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)

  10. The process of financial developmentThe supply side response Scale effects Network effects Participation Public response Needs Frictions Failures Structure Private response Innovation Technological progress Enabling environment Regulatory arbitrage Competition

  11. 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)

  12. The process of financial development The Dark Side

  13. The process of financialdevelopmentThe dark side Scale effects Network effects Participation Public response Needs Frictions Failures Structure Private response Innovation Technological progress Enabling environment Regulatory arbitrage Competition

  14. 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 • 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)

  15. The empirics of financial development Patterns and paths

  16. 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)

  17. 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

  18. Order of appearance, convexity and returns to scale

  19. Public debt

  20. Banking

  21. Many reasons for the dynamic paths to deviate from the cross-section • Country-specific policies: enabling environment, growth, cycles • Crashes: dark side • Pathdependence: initial conditions matter (today’s FD depends on output, which depends on past FD) • Leapfrogging: importable innovations • Thresholdeffects: endogenous quantum jumps

  22. Multiple dynamics paths around very smooth cross-sections

  23. The empirics of financial development Linking back to the frictions and the dark side

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

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

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

  27. Thank you

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