The Myth of a 'Modern' Financial System for Developing Countries

Tehmina Tanveer February 22, 2010

Tags: economics , IMF , developing countries
The myopic vision of IMF policies
A financial system is a structure that channels funds from agents with surplus to those
with a deficit. Financial systems are crucial for the allocation of resources in a modern
economy. A powerful question to ask then in the context of developing countries is what
the relationship between growth and
the financial system is. Does growth lead to the development of the financial sector or
do financial systems create growth? What can be concluded is that there is a positive
correlation between growth and financial structures. The more important debate lies in
the relative contribution of banks and financial markets in stimulating growth.

The financial system can affect growth through a number of ways. These include, first
by determining how much saving is lost (1- φ) and secondly through affecting the
marginal efficiency of capital (A). By allocating funds towards a project (through
collecting information on high yield project, etc), finance can raise A. It can also affect
the saving rate. The less risk is handled by the financial system the less will the
economy save, the less will be investment and hence the less will be growth and
subsequently development. Development also has social and non economic ideas
linked to it. The neoclassical school believes that development is a technical aspect and
makes no link to social and normative aspects. This view creates substantial flaws in
the models of financial systems that emerge, especially for developing countries where
culture and social norms play an important role.

The modern financial system debate can be broken down into two opposing views. The
first is that of Gerschenkron, who holds the view that bank based finance plays the key
role in development. It is open to state intervention. This view was largely held
throughout the 1960-1970’s. Stiglitz was another supporter of this bank based system.
However during the 1990’s a new point of view emerged that wanted to remove the
distinction between bank based and market based systems and proposed the need for
a “modern financial system” for development. This argument was in favor of a market
based system which took precedence in the 1990’s. It became associated with modern
finance. Thus modern finance closely resembled market finance. This as we will see
later can have quite a detrimental affect on the process of development for developing
countries as is supported in the Singh 1997 paper which states that, “general financial
liberalization and the associated expansion of stock markets in DCs is likely to hinder
rather than assist their development.

The emergence of the stock markets has been a major new development in the
financial systems of developing countries but its impact has been less than ideal. In an
attempt to assist with the liberalization process developing countries have seen a
remarkable growth in their stock markets. Stock markets allow financial services in
addition to banks. Not only is risk reduced in areas of long term risk but they are also
supported by the transparency argument. This has very important implications on
developing countries, where corruption, crony capitalism and lack of accountability
institutions lead to inefficient financial systems. Stock markets provide information on
what a company is and how it is performing. This creates transparency of information
for investment decisions.

These markets further assist in the external financial liberalization of the developing
countries. “In the 1990’s, these markets have emerged as a major channel for foreign
capital flows to DCs.” (Singh 1997). However stock markets raise the productivity of
investments rather than increase them as a whole. Do stock markets lead to faster
economic growth? According to Singh the argument is complicated. While they assist
with the screening and monitoring of projects the actual benefit is debatable. As Singh
argues “Due to various capital market imperfections, a large unprofitable firm has a
greater survival probability than a small efficient firm. Indeed, the former may increase
its chances of survival by further increasing its size through the takeover process itself.”
In this way market based systems may promote inefficiency.

Stock markets are likely to create instant liquidity for the firms. While this is beneficial to
the economy it can also be a source of increased riskiness. “investors need have no
long-term commitment to the firm” (Bhide, I994). One of the drawbacks of the market
based system is that investors are exposed to market risk that is fluctuations in asset
values caused by changes in market information and investors beliefs. This is an
example of how the incompleteness of markets gives rise to the role for institutions.
Market based systems are characterized by dispersed information and dispersed
shareholdings give a large number of people an incentive to gather information on firms
and monitor their performance.(Allen F and Gale D.2000 Chap1).Whether these
supporting institutions exist or not can have significant impact on the degree to which
these markets aid or hinder the process of development. There is also the free rider
problem in market based systems. If information is going to be revealed by the market,
no one has incentive to collect it. There is thus underinvestment in information. While
bank based systems have less success in dealing with uncertainty, innovation and new
ideas. They may however benefit from increasing returns to scale in processing
standardized information (Allen F and Gale D 2000 chap1)

Further the volatility of the stock market can create problems for developing countries
that already suffer from an unstable financial system. “Thus, even when financial
markets have been expansionary, their bandwagon and herd characteristics generate
considerable instability for the real economy.” (Singh 1997).There is also evidence to
suggest that such volatility is higher for developing countries compared to the
developed. “Evidence supports the prediction of much higher share price volatility in
DCs compared with industrial countries” (Singh 1997).Banks have there own set of
instability problems. “the bankruptcy of a single bank--and even more so the bankruptcy
of multiple banks--may disrupt the flow of credit to particular borrowers” (Stiglitz,
1993).In this way neither system on its own can guarantee stability.

A major weakness of market based financial systems is that markets are incomplete.
Many small markets are not viable because of fixed cost reasons. Other markets are not
viable because of asymmetric information, moral hazard. Financial systems based on
bank systems can overcome these problems by made to measure risk sharing
contracts. Also the interdependence of the markets can allow banks to exert control
over equity markets. “Banks, through their threat not to renew credit, often exercise far
more influence” (Stiglitz 1993). These markets are thus not the perfect solution to the
question of the ideal type of financial system for the developing country.

Those that favor the bank based system are seen to be favoring some form of financial
repression. This meant that the state could ration credit as oppose to the financial
system rationing it. But even under a free market there is bound to be some level of
credit rationing as markets can fail (Stiglitz 1993).Adverse selection is at the heart of
market failure that does not allow the markets to clear. There are many projects in the
market and the lender has very little information (asymmetric information) to filter good
from bad projects. Thus even under the free market with information asymmetry one
gets credit rationing because banks will not lend beyond a limit as they start
experiencing decreasing returns(primarily because of attracting bad debt with a higher
level of interest rate).

Returns to a bank do not rise monotonically to interest. The social returns of a loan are
also ignored by the bank and in such a case “Directed credit--this time, restrictions on
certain categories of loans--may be
Desirable” (Stiglitz 1993) Thus even with free markets we still get credit rationing. The
only difference is that the rationing comes from banks instead of the state.

This led Stiglitz to suggest that for developing countries a bank based system is more
likely to create a disciplined and productive industrial sector. Bank based provides
stability and risk sharing. He expanded the argument of credit rationing to explain that
systems based on banks create a relationship between banks and the industrial sector
(borrowers). This allows the banks to monitor the industry and hence disciplines
industrial activity. The disciplining acts primarily through the threat of take over. This is
supplemented by the argument of voice. But he cautions that managers may manipulate
the share price and make takeover expensive or use AGM’s to disarm the shareholders.
There is thus this looming danger of “crony capitalism”. What is needed for the bank
based system to work is for there to be a closer relationship between banks and firms
with mild repression by the state in the form of information flows.
Banks suffer from volatility problems, “geographic restrictions on banking have, as we
have noted, ambiguous effects on competition, but they do limit the extent of portfolio
diversification of banks, thus amplifying the effects of local shocks on lending activity
and increasing the solvency risk of banks.” (Stiglitz 1993).The size of the banks is
another policy concern, “many small banks can be highly profitable, exploiting their
greater knowledge of local markets and avoiding the diseconomies of scale arising from
managerial problems. (Large banks, may, however, realize economies of scale arising
from advertising and name recognition, quite distinct from the economies arising from
the more central functions of financial institutions.)” (Stiglitz 1993)
So far the poor have been excluded from lending within this modern financial system.
This is a very important area of discussion when designing the financial system for
developing countries. The majority of the population in these countries is poor. They
remain excluded despite the deregulation of finance because transaction costs are very
high in lending to the poor. These transaction costs include on part of the lender
screening costs, disbursement costs, monitoring and ensuring payment. For the
borrower these costs involve the cost of lodging applications, obtaining and securing
loans. These transaction costs are pronounced with the absence of institutions such as
tax collection systems, legal systems, rating agencies, insurance systems and
education. The poor form the majority of the population in most developing countries.
Thus this may be an oversight on part of the financial system proposed for these
countries. One solution put forth is that of micro finance. The precursor to this system
was the ADB. These suffer from the problem of sustainability and the result of such
efforts has been disappointing based on the results in the last few decades. The answer
then is still greater formal involvement and not MFI’s. (Lecture notes)

Despite the importance of pro poor financial systems the major point of contention is the
use of banks or stock markets in the development process and greater emphasis on
financial liberalization. While the harmony between the two is ideal, different authors
recommend varying degree of use of the two. This is observed in the paper by Singh
A.1997 “In the recent endogenous models of finance and development, King and Levine
(I 993) emphasize the merits of financial intermediation with respect to the promotion of
technical progress and entrepreneurship. Others have stressed the risk-sharing,
monitoring and screening functions which the stock market may perform with respect to
new investment projects (Allen, I 993). Levine and Zervos (I995) suggest that the two
main channels of financial intermediation - banks and the stock market - complement
each other. Atje and Jovanovic (I993), however, conclude that whilst stock markets
positively effect growth, raising it by a huge 2-5 % p.a., banks have little influence.”

Both the credit market and the equity market need to be in sync for the developing
countries to benefit from the effects of financial liberalization. “We need simultaneous
emergence of stock markets and banks for development.” (Levine R. 1997)

Conclusion

The analysis of financial systems is complex since a wide range of different systems
has existed in the industrialized countries too. “Even with in the sharp distinction
between the market based and bank based system lies important differences such as
political affects, relationship between banks and industry, role of the government and
the impact of frictions such as transaction costs and asymmetric information are of
primary importance” (Allen F and Gale D 2000, Chap 2). It can be argued that the
“sophistication that the London capital markets developed was a result of the financial
revolution. In the United States the banking history is quite different. The banking
system that emerged was rather fragmented primarily “due to the dislike of powerful
institutions of any kind domestically .It was also significantly affected by the Great crash
of 1929. France’s experience with the Mississippi Bubble profoundly affected the
subsequent development of the stock market and banks. In Germany the close
relationships between banks and firms led to the development of the hausbank system
where firms form a long term relationship with a particular bank and use them for most
of their financing needs. (Allen F and Gale D 2000, chap 2).

Thus the historical context in which these financial systems emerged is an important
aspect to consider and cannot be homogenous to all countries. Other relevant factors
include “Telecommunication, computers, non financial sector policies, institution sand
economic growth influence the quality of the financial services and restructure of the
financial system…Undoubtedly the financial system is shaped by non financial
developments” (Levine R. 1997)

Also institutional set up may vary across the developing countries. “ Institutions and
organizations play an important role in lessening transaction costs and hence improving
market efficiency in short institutions are social arrangements that frame individual
choice and thus reduce transaction cost” (Lapavitsas C.2003, chap 5).There is then a
problem of missing markets in developing countries.
Social norms create a similar divergence across countries. Social norms are “norms that
are enforced through sanctions that draw on the approval or disapproval of other
members of the society. Thus the general equilibrium model may have to adjust to take
account of these. If individual behavior is conditioned by social norms it follows that
there are economic phenomena that result from a combination of economic and non
economic factors.” (Lapavitsas C. 2003, chap 5)

A further point to consider is the element of trust.” Trust is the foundation of credit’
(Lapavitsas C. 2003, chap 5). Trust emerges when agents have regular contacts with
each other in networks of social and cultural relations” “A society with a substantial
stock of capital is presumable permeated by a climate of trust confidence reliability and
moral obligation among its members”. The degree of trust prevailing in an economy can
differ substantially.

Finally the success of a particular financial system for developing countries depends
upon how well it functions in the context of that particular country. Here the role of the
state as an insurer can reduce the instability found within financial markets but it leaves
open the argument of whether the state involvement creates a moral hazard problem.
“Markets are seen as the only realistic and efficient way of delivering growth but state
intervention is also necessary to sustain and supplement markets” (Lapavitsas C. 2003,
chap 5) There is however, no unique model that can be prescribed. Non economic
factors can alter the impact of financial systems and need to be factored in to the model
of the financial system. “The influence of property, power, hierchy and social
connections on economic relations formed through the credit system remain vital”