Download Pitfalls of relying on banking depth as the main measure of financial

EC3040 Economics of LDCs
Module B Topic 3
Financial sector issues
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
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
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…)
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.
Simplified balance sheet of a bank
Assets
Liquid asset reserves
Loans and Advances
Liabilities
Deposits
Capital (residual)
Beck, Demirguc-Kunt, Levine, 2001
Beck, Demirguc-Kunt, Levine, 2001
Beck, Demirguc-Kunt, Levine, 2001
The discovery that finance affects growth
(and not just the other way around)
Deep (>0.5)
0.25 to 0.5
Ratio of liquid
liabilities to GDP in
1960
0.15 to 0.25
Shallow (<0.15)
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
Average per capita GDP growth 1960-2000
Updated from Levine, 2005
But: Post hoc ergo propter hoc?
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 visà-vis debtors helps financial system)
– Replace actual financial depth by its predicted value
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
Growth and financial development
Naïve and model-based relationship
Acerage GDP growth 1960-95
8
6
4
Actual
2
Model
Naive
0
-2
-4
0
2
4
Private credit as % GDP (log)
6
Pitfalls of relying on banking depth as the main
measure of financial development 1
China: Provincial Banking Depth and Growth
15%
14%
Provincial growth rate
13%
12%
11%
10%
9%
8%
7%
6%
5%
40%
60%
80%
100%
State-bank deposits as % provincial output
120%
Pitfalls of relying on banking depth as the main
measure of financial development 2
Korea: Money and Growth
11
160
10
banking depth
140
9
120
100
8
80
7
60
6
40
5
20
0
4
1961 1966 1971 1976 1981 1986 1991 1996 2001
M2 % GDP
Pvt Credit % GDP
GDP Growth
centred 5-year average GDP growth
180
Where do banks invest their resources?
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
East Asia & Europe &
Pacific
Central Asia
Claims on Private Sector
High
Income
Claims on Govt.
Latin
Middle East South Asia
America &
& North
Caribbean
Africa
Claims on SOEs
Foreign Assets
SubSaharan
Africa
Liquid Assets
Banking is expensive: Net Interest Margins
Regional Distributions
1. High Income
2. East Asia & Pacific
3. Europe & Central Asia
4. Latin America & Caribbean
5. Middle East & North Africa
6. South Asia
7. Sub-Saharan Africa
0
.05
.1
Net Interest Margin
Sample size: 142 countries
Time period: 2004
Source: Financial Structure Database, 2006 (The World Bank)
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