Chapter 2 The Financial System, Money Demand, and Monetary Policy

1. The World Bank Chapter 2The Financial System, Money Demand, and Monetary Policy © Pierre-Richard Agénor

2. The Financial System • Indirect Instruments of Monetary Policy • Credit Rationing • Monetary Policy in a Dollarized Economy • The Demand for Money

3. Key features of financial system in developing countries : • low degree of institutional diversification; • limited availability of financial assets; • importance of government intervention.

4. The Financial System • Figure 2.1. • Financial Repression • Banks and Financial Intermediation

7. Financial Repression State of financial repression is defined as: • ceilings on nominal interest rates; • quantitative controls and selective credit allocation across government considered priority sectors, regions or activities; • high minimum reserve requirement; • loan decisions of state owned banks are guided by political factors; • forced allocation of assets or loans to the public sector by private commercial banks, for example, statutory liquidity ratios (required to hold a proportion of assets in the form of government debt).

8. Interest rate ceiling may distort the economy by: • increasing the preference of individuals for current consumption as opposed to future consumption, as a result, by reducing savings; • reducing the supply of funds through the banking system (disintermediation); • leading bank borrowers to choose more capital-intensive project due to low interest rate on loans; • financing low-yielding project more heavily. • Motivation for financial repression: inability to raise taxes either due to administrative inefficiencies or political constraints.

9. Government manipulates the financial system to promote its development goals through financial repression. • Financial repression yield substantial revenue to the government. • First source: implicit tax on financial intermediationby high reserve requirement rates. • Second source: implicit subsidy; government benefits by obtaining access to central bank financing at below-market interest rates. • Giovannini and De Melo (1993): on average, governments in their sample of developing countries extracted about 2% of GDP in revenue from financial repression.

10. Implications of financial repression: • severe inefficiencies; • restrict the development of financial intermediation; • increase the spread between deposit and lending rates; • and reduce saving and investment in the economy; • arise informal modes of financial intermediation; • alter substantially the transmission process of monetary policy.

11. Banks and Financial Intermediation • Banks dominate the financial system in most developing countries. • Bank deposits: most important form of household savings. • Bank loans: most important source of finance for firms. • Figure 2.2: share of domestic credit provided by banks in proportion to GDP is high. • Equity markets: increase in size in several developing countries (Figure 2.3).

15. Results of development in equity markets: • allow greater dispersion of risk; • more efficient allocation of resources; • greater mobilization of savings; • active secondary markets in government debt help to conduct monetary policy through indirect instruments. • In most developing countries, corporate bond markets remain quite narrow, concentrated, and relatively illiquid.

16. Main functions of banks: • transformation: transform the short-term, liquid deposits held by households into illiquid liabilities issued by firms; • delegated screening and monitoring: screen potential borrowers and monitor actual borrowers on behalf of depositors; • facilitate transactions : between agents (firms and workers, buyers and sellers) by providing payment services.

17. Problems in banking system: • Inadequate prudential supervision: create systemic fragility and may precipitate bank runs and currency crises. • This complicates the conduct of monetary policy since banks that are less able to control their balance sheets will be less responsive to changes in the base money stock or interest rates. • Problems may lead to pressure on the central bank to extend credit to bail out troubled banks.

18. Indirect Instruments of Monetary Policy

19. Under financial repression central banks use direct instruments of monetary policy. Problems: • create severe inefficiencies in credit allocation and the financial intermediation process; • lose effectiveness of direct instruments since agents start to rely on informal credit channels. • As a result, many countries have liberalized their financial systems and adopted indirect instruments of monetary management. • Indirect instruments of monetary policy are market based and operate essentially through interest rates.

20. Main purpose: affect overall monetary and credit conditions through changes in the supply and demand for liquidity. • Indirect instruments: • open-market operations; • refinance and discount facilities; • reserve requirement. Open-market operations: • The direct sale or purchase of financial instruments (treasury bills or central bank paper) in the secondary market for securities or through central bank intervention in primary markets for securities to influence the level of liquid reserves held by commercial banks.

21. Repurchase agreements: acquisition of financial instruments by the central bank under a contract stipulating an agreed date and a specified price for the resale of these instruments; and reverse repurchase agreements. • In contrast with direct operations, these agreements provide temporary financing of cash shortages and surpluses, but do not directly influence supply and demand in the instrument used as collateral. Refinance and discount facilities: • Short-term lending operations that involve rediscounting high-quality financial assets (such as treasury bills) by the central bank.

22. Reserve requirements: • Remunerated reserve requirements: commercial banks must hold a specified part of their assets in the form of reserves at the central bank. • All these instruments allow policymakers to exercise greater flexibility in implementing monetary policy. • Process of financial liberalization accompanied by increased reliance on the use of indirect instruments in developing countries.

23. Problems in conduction of open-market operations: • If volume of central bank transactions is larger than total volume of transactions in the secondary market, sales of government securities by the central bank may lead to a rise in interest rates on these securities • This raises the domestic debt burden of the government. • In this case, repurchase operations may be preferable. • Other problem: conflict arises between monetary management objectives and debt management objectives when monetary policy relies on primary market sales of government securities.

24. Credit Rationing

25. Because of imperfect or asymmetric informationbetween banks and borrowers, probability that the borrower will actually repay the loan is less than unity. • Stiglitz and Weiss (1981) showed credit rationing may emerge endogenously. Credit Rationing: • As the interest rate on the loan increases, the probability of repayment may decline. • Banks has less incentive to lend in such conditions and they may even stop lending completely.

26. Stiglitz-Weiss model: Assume: • Economy populated by a bank and a group of borrowers, each of whom has a single, one-period project in which he (or she) can invest. • Each project requires a fixed amount of funds, L, and this is the amount that each borrower must obtain to implement the project. • Each borrower must pledge collateral in value C < L. • Each project requiring funding has a distribution of gross payoffs, F(R,); • R: project's return and borrower cannot affect it; • : measures the riskiness of the project.

27. Projects yield either R (if they succeed) or 0 (if they fail). • The higher value  represents an increase in risk. An increase in  captures an increase in the variance of the project's return, while leaving its mean constant. Shifts in  are thus assumed to be mean preserving. • Borrower receives the fixed amount of loans, L, at the contractual interest rate r and defaults on the loan if the project's return R plus the value of the collateral C are insufficient to repay the loan. • Bank receives either the full contractual amount (1+r)L or the maximum possible, R + C.

28. If lenders face no collection or enforcement costs, the return to the bank is: min {R + C ; (1+r) L} • Return to the borrower: max {R - (1+r) L; - C} • For a given contractual interest rate, r, there is a critical value of , say , such that an agent will borrow to invest if, and only if,  > . • Interest rate serves as a screening device. ~ ~

29. Increase in r triggers two types of effects: • adverse selection effect (rise in the threshold value ): • by increasing the riskiness of the pool of applicants, less risky borrowers drop out of the market; ~ • adverse incentive effect, or moral hazard effect: • Borrowers are induced to choose projects for which the probability of default is higher (because riskier projects are associated with higher expected returns). • This has a negative effect on the lender's expected profit, which may dominate the positive effect of an increase in the contractual interest rate.

30. ~ First result (/r > 0): • positive effect of an increase in the contractual interest rate on the bank's expected rate of return on its loans, , may be partly offset by the negative effect due to the increase in the riskiness of the pool of borrowers. • If the latter effect dominates,  will not be monotonically related to r and rationing may incur in equilibrium.

31. Figure 2.4: • Ld: demand for loanable funds; Ls: supply of loanable funds; both as functions of the contractual loan rate, r. • Ld: negative function of r. ~ • Ls: positively related to r only up to r. ~ • increases in r beyond r trigger adverse selection and incentive effects, which lead to decreasing amounts of credit offered to borrowers. • Thus, Ls curve has a concave shape.

33.  is the product of r and the probability of repayment. • Owing to the adverse selection and incentive effects, the repayment probability declines by more than the increase in r beyond r. • So the relationship between  and r is nonmonotonic (RR curve) and RR is more concave shape than Ls. • There is a positive relationship between  and Ls (Southwest panel of Figure 2.4). • The northwest panel shows a 45-degree line mapping of the equilibrium loan amount and Ls. ~

34. Point A givesvalue of r that ensures equality between Ls and Ld. • Credit-rationing equilibrium occurs at the interest rate r, where  is at its maximum level. ~ • Market-clearing interest rate is not optimal for the bank, because at that level bank profits are less than at r. ~ • It is also inefficient, because borrowers with high repayment probabilities drop out and are replaced by those with high default risk.

35. ~ • The non-market-clearing rate r is both optimal and efficient, because bank profits are at a maximum level and risky borrowers are rationed out. • Thus, under imperfect information, lending rates that are below market-clearing levels can be observed even in competitive credit markets. • Such non-market-clearing lending rates reflect an efficient response to profit opportunities. Implication: • Increases in interest rates, beyond credit-rationing level, can be counterproductive.

36. Stiglitz-Weiss model is helpful to understand why in some developing countries bank credit is severely rationed with bank lending rates unresponsive to excess demand for credit. • Kaufman (1996) used the Stiglitz-Weiss model to explain some of the aspects of Argentina's economic crisis of 1995-96. • Degree of riskiness of projects can be endogenously related to the level of economic activity---which itself depends on the amount of loans available. • This link creates a channel through which credit rationing can be exacerbated and may display persistence over time.

37. Stiglitz-Weiss model may also be useful to explain the high holdings of excess reserves by commercial banks in developing countries. • In an environment in which the probability of default on loan commitments is high, excess reserves will also tend to be high. • Figure 2.5: evolution of excess liquid assets held by deposit money banks in Thailand, before and after the financial and economic crisis that erupted in mid 1997. • Very sharp increase in excess liquidity in the immediate aftermath of the crisis. • But this increase could also be, at least in part, demand induced.

39. In general, nevertheless, the effectiveness of monetary policy actions depends importantly on • whether banks are holding excess liquid reserves or not; • degree to which interest rates can be deemed sensitive to changes in excess reserves; • degree to which bank lending decisions are influenced by the perceived riskiness of potential borrowers. Limitations of Stiglitz-Weiss model: • Assumption that lenders are completely unable to assess the degree of riskiness of potential borrowers.

40. Banks have incentives to invest in screening technologies in order to acquire information about the risk characteristics of their customers. • This is particularly plausible in a dynamic context. • Role of collateral, C: • Wette (1983): adverse selection effects similar to those emphasized by Stiglitz and Weiss may result if lenders attempt to raise mean returns by increasing the collateral required from borrowers. • Bester (1985): if lenders can vary both collateral requirements and the contractual loan rate to screen loan applicants, the possibility of a rationing equilibrium disappears.

41. Stiglitz and Weiss (1992): even if banks are able to manipulate interest rates and collateral, rationing may still emerge in equilibrium if borrowers are subject to decreasing absolute risk aversion. • Absence of collection and verification costs. • Asymmetry of information is ex ante: although projects differ in their distributions of return before implementation, lenders can observe actual outcomes. • Williamson (1986): assume that projects are ex ante identical but lenders must incur ex postmonitoring and enforcement costs to • verify the outcome of the project and

42. legally enforce the terms of the loan contract if the borrower chooses to default. • Credit market imperfections may be particularly relevant for developing countries, where enforcement of loan contracts may be difficult due to the severe weaknesses in the legal system.

43. Monetary Policy in a Dollarized Economy

44. Dollarization (currency substitution): foreign currency is used as a unit of account, store of value, and a medium of exchange, concurrently with the domestic currency. • Figure 2.6: dollarization (proportion of foreign currency deposits held in the banking system relative to the domestic broad money stock) has been at times pervasive. • Figure 2.7: dollarization ratio grew significantly during the period, in line with the increase in inflation rates in Turkey.