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Domestic financial architecture

Time (GMT +01) 00:00 23:59


Benu Schneider, ODI

Winston Cox, Commonwealth Secretariat

Subrendhu Chatterji, BaseConsulting Ltd

Getting the domestic financial architecture right
Winston Cox

1. Due to the liberalisation and modernisation of financial sectors of developing countries, the need for stronger regulatory and supervisory functions has emerged as a key issue.

2. Before liberalisation, many developing countries possessed cyclical and predictable patterns of liquidity. Following the crop season, sales would take place and overdrafts were liquidated soon after. Liquidity constraints derived from heavily regulated financial sectors and strong governmental intervention in terms of credit allocation, interest charges and reserve requirement. Supervision was limited to ensure that the directives of government were observed.

3. Following liberalisation, many developing countries found themselves involved in a condition of high instability and increasing fragility of their financial systems. Therefore, the question arises as to why countries should enact policies that move their financial systems from a situation of relative stability to one of potential instability.

4. From a theoretical point of view, the early writings of Goldsmith and McKinnon/Shaw have shown the benefits in terms of economic growth. These authors' findings have been largely confirmed by empirical evidence. Nonetheless, evidence has also made clear that liberalisation does not come without costs, particularly in terms of increased turbulence in the financial sector combined with uncertainty.

5. Incorrect sequencing of financial liberalisation is one of the sources of uncertainty. Some countries, in response to either domestic pressures or those originating from international financial institutions, have opened up their financial systems before putting in place an adequate supervisory and regulatory framework.

6. Lack of independence on the part of regulators is a second source of uncertainty. Regulators often fail to perform because of the failure of institutions or because of political interference. Moreover, regulators often find themselves involved in a conflict situation between the preservation of the system and the interests of atomistic depositors. Very often the latter prevail at the expense of the former.

7. Contagion spreads within the domestic financial system, often originating from the less regulated and supervised sectors and affecting the core sectors of the system.

8. The concept of financial architecture is a very static hard-shell notion, which does not incorporate the flexibility of a concept that is more about an organic type of structure. If we changed the approach to the financial system in terms of organic biology rather than in terms of engineering science of architecture, we probably would stand a higher chance of getting our heads around the kinds of concepts and interplay that are essential for making the system work in developing countries.

The domestic architecture of financial sectors in developing countries
Subrendhu Chatterji

9. As Winston Cox rightly emphasises, the financial system has to be viewed as organic agglomerate and in analysing it one has to put emphasis on the linkages and knock-on effects of its different sectors and components. Moreover, corporate governance by banks and stock exchanges plays a key role within financial sectors, performing a monitoring role that is crucial to the financial system.

10.10. Developing countries' financial sectors suffer from a number of weaknesses, which impair their ability to carry out these roles. These are grouped into five broad areas:

(i) Incompleteness of markets and institutions, undermining the efficiency of investment allocation.

(ii) Fragmentation, undermining the flow of capital towards higher return investment.

(iii) Distortion, due to government intervention and the nature of regulation.

(iv) Lack of competition, ensuing in little incentive for augmenting efficiency of intermediation and thereby lowering its costs.

(v) Fragility and vulnerability to external shocks after liberalisation.

11. In order to address these weaknesses, developing countries need to reform their financial systems on the one hand and define their development needs on the other. A strategy of financial development needs to be set up, based on the analysis of the building components of the financial system.

12.In Mr Chatterji's financial sector diagnostic framework, the building components of a financial system are represented as follows:

(i) Infrastructure and environment
All factors supporting the financial sector and having an indirect impact on the functioning of the markets and institutions, such as the wider economic, legal and social environment, accountancy, etc. Weak legal and information infrastructure impairs the ability of financial institutions to operate effectively and generally restrict the level of transparency.. Recommendations:

(ii) Governance and regulations
For the institutions making up the financial structure to function effectively, they need to have strong governance (refers to ownership, government influence, stakeholder discipline, recent experience) and operations (assessed by factors such as management incentives, credit culture, internal controls, risk management, re-capitalisation, financial indicators). Governance-related issues are particularly important in developing a view of financial sector robustness.

(iii) Regulation and Supervision
Regulation relates to rules on entry, capitalisation, connected lending, etc, whereas supervision essentially relates to its enforcement. The factors making up the regulation and supervision parameter seek to assess both the existence as well as the enforcement of regulation.

(iv) Financial Structure and Government Involvement
The range of institutions and markets that make up a financial sector and the degree of government involvement in those sectors. Financial institutions and markets undergo a typical evolution over time, from short-term finance channelled through the banking sector towards a longer term and higher risk investment in a more progressed stadium of financial sector development. A crucial feature is the degree of inter-linkage between different segments. For example, institutions and markets should work in a way that bank deposits can partly flow towards venture capital. Often, though, we observe developing countries having a financial system composed by a banking system that is to 80% made up of two or three government owned banks, and a stock exchange with virtually no trading going on. Another area is the informal sector, which also needs to have strong linkages with the formal sector.

The financial sector acts therefore as a system of inter-linked institutions, markets and supporting infrastructure, drawing on its enabling environment for strength, financial institutions must operate efficiently themselves. They must additionally fulfil effectively their functions as components of the country's financial system. Measures to develop new institutions and markets must take into account these systemic interdependencies.

Moreover, given these inter-linkages, weaknesses in one component of the financial system, for instance in the infrastructure and environment, lead to fragility in the other parameters of the financial sector.

(v) Sequencing
Sequencing is important. The order in which to expect the components and its factors to develop is of crucial importance. Regulation and supervision should be strengthened before privatisation of financial institutions takes place.

(vi) Donors
vi. Donors can support local patterns in developing new financial products, including new debt and equity instruments as well as specialist credit products in longer-term finance, SME finance, trade and agricultural finance. Products such as leasing are particularly suited to the underdeveloped legal infrastructure in developing countries. In addition to technical expertise, financial assistance through participation in equity funds, credit guarantee funds and credit lines can stimulate these activities and can be beneficial provided they are designed to achieve long-term self-sustainability and minimise market distortions.


The 'bad-loan problem' and financial liberalisation

Financial problems and bad debt are not confined to countries that have liberalised but are endemic in many developing countries. Political authorities for policy lending have often misused banks. However, whilst the bad loan problem can arise without liberalisation, it certainly becomes more dramatic once liberalisation has taken place. Therefore, more emphasis should be placed on basic credit management skills and discipline in countries' banking systems. Moreover, bad loan problems can also occur in advanced countries, as it is the case with Japan, and often endure for decades.

Another aspect of credit management is collateral and enforcement. Providing the legal system is in place to enforce contracts, lending takes place either on the base of collateral or reputation. If the legal framework is absent, collateral is not enforceable and credits are not recouped.

This leads to a question mark - should we pursue expansionary ideas as far as the financial sector is concerned? Certainly, a failure of intermediation frequently needs to be bridged. However, from a historical perspective, many financial reforms promoted by the IFI's have provoked a much more restrictive approach to banking systems. The primary objective would be to have healthy and viable financial intermediaries, which do not need to be constantly bailed out. This is tied in with a situation of indirect monetary control and tighter fiscal discipline. Indeed, fiscal deficits have often been financed by T-Bills, intermediated by commercial banks. This creates a safer system with more secure balance sheets and is good for development. It is thus questionable whether we should promote more outward looking financial systems, which come with strong pit-falls in financing, as opposed to more closed systems that play safe and offer the necessary financial stability for domestic development.

Mr Cox felt that the owners of financial institutions generally come away from financial collapses totally unscathed. Therefore, he believed that the safety of the domestic financial system should take priority over its expansion.

Mr Cox argued that liberalisation often poses a strong constraint on fiscal balances because governments have to finance an increasing interest bill, leaving less proportion of the budget for health, education, military etc. He posed the question of whether this is trade-off is a desirable outcome? Further, Mr Cox argued that McKinnon and Shaw had demonstrated long ago that liberalisation does not necessarily move the investment function in the real sector but rather induces financial investment with people getting money from treasury bills. Moreover, financial liberalisation has detrimental effects in terms of income distribution and equity. Mr Cox concluded that he would advocate for strong financial sector regulation and supervision rather than financial liberalisation.

Mr Cox stated that there is a line of thought proposing some constraint and competition among banks, particularly with respect to deposit rates. Mr Cox argued that sometimes we observe interest rates on deposits of exorbitant magnitude but that this signals inefficiency and should be ascribed to poor macroeconomic policies rather than financial liberalisation.

Mr Chatterji argued that bad debts in developing economies are usually a function of two elements. One is risky lending, which may be enforced by lack of assessment skills or weaknesses on the operational side. The other is governance in a broad sense. If the owner is a private sector organisation, typically problems may arise because of insider lending. If the owner is a government, there may be political lending or illegitimate budgetary strategies. In the latter case, spending is channelled through banks and is re-capitalised every two-three years.

Mr Chatterji stated that liberalising countries basically have two options to get rid of the bad debt: either balance sheets are cleaned up altogether, as it was the case in Poland, or it can be done progressively, as in China. Whilst the slower strategy is probably more expensive in the longer term, it is also more feasible in political terms.

In conclusion, Mr Chatterji suggested that the banking sector needs to be in good shape before a country embarks on liberalisation. However, he did not feel that there could be a black and white answer, particularly if one takes into consideration that the main impetus to reform domestic banking sectors derives from international competition rather than through the central bank or government. The bad loan problem is thus also related to how competition and reform of banks is engendered. Further, there is consensus in the recent literature and among observers that the fiscal balance needs to be in order before embarking on liberalisation of the domestic financial system and that liberalisation should be enacted gradually.

Government intervention in the financial sector

There are instances of countries, for example Korea and Taiwan, where governments have played a growth enhancing role by forcing domestic banks to channel low interest funds into strategic sectors or towards firms that otherwise would not have access to bank lending. Should governments perform such a potentially positive role?

Mr Cox stated that he had not come across any body of evidence that government lending had had a positive impactive on development.

Often we observe strong political involvement in developing countries' import and export licenses and also in foreign exchange, which makes it very difficult to know whether the political class of a country itself is interested in reforming and liberalising its financial sector. Mr Cox said that he strongly believed that import and export licenses and foreign exchange allocations induce rent-seeking behaviour.

'Specialised financial institutions and an incentive structure for loan recovery

Benu Schneider argued that financial institutions may not be optimal in developing countries, particularly in rural sectors. She provided that example of the Grameen Bank in Bangladesh, which has demonstrated that alternative structures are far more appropriate in the presence of large informal and rural sectors. Moreover, Dr Schneider felt that loan-recovery should also be considered. In the state of Bihar in India, labourers sold their labour if they could not repay the loan. In Madheya Pradesh, the borrower gave up the sue of his land for a period of time as payment. In modern banking, the borrower loses the asset altogether.

Dr Schneider believed that there might be instances that require the existence of specialised financial institutions, such as corporate banks. Indeed, formal financial systems often do not reach certain groups in the economy. Therefore, there is a case for formal and informal institutions co-existing in financing development.

Why do financial systems not collapse more often?

The question was posited that if it is true that it is impossible not to liberalise, and liberalisation exposes countries to enormous risks and financial turmoil that which can only be avoided by having a complex set of laws, institutions and regulations in place that are largely unavailable to many developing countries, why do we not witness crises more often in developing countries? What are developing countries doing right in order to avoid the occurrence of frequent crisis?

Mr Cox responded by pointing out that there are instances of financial systems that have collapsed (e.g. Guyana) and there are individuals that have lost all their capital. Nonetheless, it would be also wrong to believe that all agents operating in the financial systems are there in order to destabilise the system and operate illegally. In contrast, most of the individuals operating in the financial sectors are persons of integrity.


Speakers at this event presented on two topics around domestics financial architecture: getting the domestic financial architecture right; and the domestic architecture of financial sectors in developing countries.