Peterson Institute publications
The Peterson Institute for International Economics is a private, nonprofit, nonpartisan
research institution devoted to the study of international economic policy. More › ›
RSS News Feed Search

Speeches and Papers

The Rationale For Financial Sector Reform

by John Williamson, Peterson Institute for International Economics

Outline of a speech given at the "Workshop on Financial Sector Reform"
Sponsored by the US-Nepal Chamber of Commerce
September 6, 1999

© Peterson Institute for International Economics


This paper was written while Mr. Williamson was the Chief Economist for the South Asia Region at the World Bank.

 

When we speak of financial sector reform, we have in mind two distinct but complementary types of change that are needed in order to establish a modern financial system capable of acting as the "brain of the economy" and allocating the economy's savings in the most productive way among different potential investments. First, we mean liberalization of the sector: putting the private sector rather than the government in charge of determining who gets credit and at what price. Second, we mean establishing a system of prudential supervision designed to restrain the private actors so that we can be reasonably sure that their decisions will also be broadly in the general social interest. Liberalization without supportive arrangements for proper supervision can easily lead to anti-social behavior by bankers, of the forms referred to as "looting and gambling". This provides a paradigmatic example of the more general proposition that establishment of a market economy requires a change in the role of government rather than the elimination of all government action, with the new role being one that focuses on providing an environment within which the private sector can act effectively.

My paper is organized to consider first the case for liberalization and then that for supervision. I assume that before reform the economy had a financial system of the sort that Ronald McKinnon (1973) and Edward Shaw (1973), the joint initiators of the analysis of financial repression and liberalization, would have characterized as "repressed". That is, it was the government rather than private banks that made most of the key financial decisions, although much of their lending was to private firms or state enterprises that were expected to pay their way1, and since the government exercised such control it did not feel it necessary to devote many resources to supervising itself. In a number of respects Nepal has already advanced beyond the model of a repressed financial system over the past decade, but it will be much clearer if I seek to make the case for financial reform by contrasting a reformed with an unreformed system rather than a reformed with a partially-reformed one.

One other preliminary remark. My paper is confined to considering the banking system (the commercial banks and to some extent the central bank), and ignores the many other actors that one finds in a sophisticated, fully-developed financial system (e.g. a range of specialized banks to lend to particular sectors like housing, investment banks, finance companies, insurance companies, mutual funds, pension funds, bond and money markets, leasing companies, derivatives markets, and so on). This is partly because the financial systems of small countries at an early stage of development, like Nepal, are typically dominated by the banking sector, but it also reflects a belief that the most urgent task in such countries is to get a well-functioning banking sector, and that it would be a mistake for policy to concentrate on the early development of the other actors.

 

Liberalization

In a recent study, Molly Mahar and I distinguished six different dimensions of financial liberalization (Williamson and Mahar 1998):

  • The elimination of credit controls.
  • The deregulation of interest rates.
  • Free entry into the banking sector (or, more generally, the financial services industry).
  • Bank autonomy (allowing bankers rather than bureaucrats to decide whom to employ, at what wage rate, where to open branches, etc.).
  • Privatization of bank ownership.
  • Liberalization of international capital flows.

Let us start by considering the logic of the first two reforms, eliminating credit controls and deregulating interest rates, i.e. allowing the market rather than the government to handle the process of intermediating between savers and investors. What is the impact on the first leg of that process, that of mobilizing savings? One can distinguish two possible effects. First, the liberalization of interest rates has typically resulted in their increasing above the low levels that are usually found in repressed financial systems. Advocates of financial liberalization argued that this would increase the level of saving, and therefore investment, and so promote growth. There has been much empirical work examining this thesis in recent years. The evidence suggests that the level of saving has little elasticity with respect to the rate of interest. However, while the overall level of saving does not systematically increase when the interest rate rises, more of the saving that does occur is placed in the financial system, so that financial depth (as measured, for example, by the ratio of M2 to GDP) does rise, and hence more of a given level of saving is intermediated through the formal financial system.2 That will bring a benefit if the formal financial system is better at allocating savings than alternative mechanisms (such as the informal financial system or buying gold). The higher interest rates will also benefit savers, which should be counted a social benefit to the extent that savers tend to be less wealthy than investors. (Some evidence suggests that the ability to draw on financial savings is about as important as the ability to borrow on reasonable terms as a mechanism for the poor to protect themselves against adverse temporary shocks, which suggests that it would be quite wrong to dismiss savers as the rich [see Bennett and Cuevas 1996, Binswanger and Khandker 1995]).

The other half of the intermediation function is to select those potential borrowers who will receive credit. In a repressed financial system this decision is largely made by the government, while in the market system it is made by bankers. There are three reasons for expecting that private bankers, provided they have received appropriate professional training in the art of loan appraisal, will do a better job of allocating credit than government bureaucrats. First, they can be expected to have better knowledge of the prospects of the borrowers, since bankers are widely distributed across the country and aware of the cash flows of their potential borrowers, who normally hold their bank accounts with the banks from which they seek to borrow. Second, they will be free of the pressure to lend to politically favored borrowers, pressure that is almost inevitable when banks are publicly owned and therefore charged with promoting objectives set by the Ministry of Finance. Third, banks will maximize their expected profits when loans are extended to those borrowers who offer the best combination of risk and return.

It is important to understand that one does not want banks to lend to those who promise the highest returns, for they will almost always be the most risky borrowers. Nor should they seek to lend to the least risky, for the most rewarding investment prospects almost inevitably involve some element of risk ("nothing ventured, nothing gained", as an old English proverb expresses it). The ideal is to lend to those who offer the prospect of a good return, given the risk involved. One wants a bank to be free to charge an interest rate that reflects the riskiness of each particular loan, and then make a prudent portfolio choice that will bring it a good overall return for a modest level of risk, after limiting its risk by choosing a diversified portfolio. Note that if the government is setting the interest rate it will almost inevitably have to specify the same interest rate to all borrowers in a given class in order to avoid charges of favoritism, which will then make it rational for a conscientious bank manager who succeeds in avoiding politically-directed lending to choose the safest projects that can meet the hurdle rate of return established by the set interest rate. He has no incentive to seek out the best projects, in the sense of those that promise the best risk/return combination. That is presumably why the empirical evidence does indeed confirm that lending is usually directed to more profitable projects in a liberalized than in a repressed financial system, thus leading to a higher growth rate as a consequence of liberalization.

Does this argument imply the desirability of early action to eliminate all forms of directed lending? My own view is that an attempt to steer credit toward sectors like agriculture or manufacturing industry, and away from (say) real estate speculation, may be quite sensible. But two conditions seem to me to be crucial if directed lending is not to be pernicious. One is that there should be no requirement for a concessional interest rate, since any such requirement inevitably gives the banks an incentive to seek out the least needy, because best-colaterallized or least costly to administer, borrowers; thus excluding the poor (who need to be allowed to bid for loans if they are to have a chance of getting credit from a source other than the traditional money-lender). The other crucial condition is that the sectors to which credit is to be provided should be drawn broadly enough so that the banks are not able to evade responsibility for bad lending decisions by claiming that they were forced to lend to particular enterprises or industries.

Consider next the rationale for free entry into the banking sector. This is very similar to the rationale for free entry into any other sector. The threat of actual or potential competition keeps the interest spread down and disciplines banks into operating efficiently, and eliminates any banks that are not capable of keeping up with current standards of efficiency. The entry of foreign banks can bring modern techniques into the industry. Free entry avoids political favoritism being used to award rents to friends. However, there is also a serious intellectual case against free entry, which stems from the notion that a substantial positive franchise value induces self-discipline in lending (Hellmann and Murdock 1997). The argument is that a bank that does not have a stake in being able to continue to lend in the future will have an incentive to make risky loans, taking gambles that will yield it big gains if things turn out right but impose big losses on others (the government or depositors, depending on whether bank deposits are effectively guaranteed or not) if things go wrong. But if it knows that it can expect to earn a stream of quasi-rents from its reputational capital in the future, it will not risk its reputation. Prudence may thus suggest maintaining a balance between the benefits and the costs of early action to permit free entry.

This seems an appropriate place to acknowledge that one other restraint on financial liberalization has sometimes been advocated in the interest of maintaining a positive franchise value of the banks. This is to place a ceiling on the interest rate that banks are allowed to pay on deposits (Stiglitz 1994). An interest rate modestly below the competitive level will increase the profitability of banking, and thus the franchise value of the banks, without having much effect on saving (though it will make savers somewhat worse off). If the ceiling is set equal to the treasury bill rate, such a regulation will also prevent banks bidding for deposits by offering more than the risk-free interest rate, an offer that can only be justified on deposits if they are recognized to be risky or else if effective deposit insurance provides a subsidy to the bank.

The case for bank autonomy is straightforward. One cannot expect bankers who are not allowed to manage their own banks by deciding whom to appoint, and how much it is necessary to pay to motivate and retain good staff, to take responsibility for the outcome of their operations. One wants bankers to make their own decisions, guided perhaps by general rules, but making inherently discretionary decisions like these for themselves so that the responsibility for bad outcomes is unambiguous.

Privately-owned banks will necessarily have autonomy, which is a part of the case for privatizing banks. Another consideration is that a publicly-owned bank may be subject to pressure to allocate loans according to the political interests of governing politicians rather than in accordance with commercial considerations. But perhaps the most important consideration stems from a different role of banks. Allocating lending between alternative prospective borrowers is only part of their job: they also need to monitor the use made of their loans to maximize the probability that they will be repaid on time.

In the Anglo-Saxon countries, this monitoring is done in an arms' length way. A bank is able to observe the cash flow of its borrowers, and can threaten not to renew loans falling due if they see a borrower's financial position weakening. This pressures the borrower into cutting back its activities. In Germany and Japan, in contrast, banks play an active role in the corporate governance of their major borrowers, with bankers often sitting on company boards, thus permitting them to play a direct role in steering the policies of their borrowers in a way that will ensure they can maintain debt service. The relative virtues of these two approaches remains an unresolved issue, but some economists who believe that the Anglo-Saxon model is the most suitable one for advanced countries also believe that the German-Japanese model is preferable for countries where financial talent is spread thinly and hence most effectively deployed by placing qualified bankers on a number of company boards. One would only want government-appointed bankers sitting on company boards if one doubts the virtues of a market economy.

If a company fails to service its debt, then its creditors need to be prepared to collect on any collateral that may have been put up, and/or to enforce bankruptcy proceedings. This too is a very important function of the financial system: it is what ensures that enterprises are faced by hard budget constraints, which is what gives them an incentive to avoid wasting resources. Of course, it is perfectly proper for creditors to consider whether the circumstances that have led a company into difficulty may be temporary, and whether the existing management may be better able to make productive use of the firm's assets than any alternative potential managers. One advantage of the German-Japanese system is that it provides bankers with more insight into when that may be true, as well as an additional mechanism (taking an equity position in the firm) for supporting a deserving firm financially. But all too often policymakers seem to be under the impression that allowing a firm to go bankrupt means that its assets will vanish. This is simply not true: bankruptcy leads to their sale, normally to someone who is able to make better use of them than the original owner was (otherwise he would not have gone bankrupt).

Enforcing bankruptcy would seem to be a particularly difficult act for a publicly-owned bank. Politicians will normally be reluctant to take the responsibility for closing down a functioning firm and thereby throwing the labor force into unemployment, and will tend to use their pressure to insist on the provision of additional loans. The chance that they will be employed more productively under new management will typically carry little sway with the existing workers, specially where one reason for the existing firm's difficulties is that the workforce is enjoying above-market wages. Thus workers and managers are behaving rationally in resisting bankruptcy, and politicians are likely to respond to their concerns when banks are publicly owned. Private ownership of banks is needed inter alia in order to tighten financial discipline on bank borrowers.

But it is proper to recognize that this financial discipline may have effects that are unwelcome to some. Specifically, bank privatization is likely to lead to the closure of any loss-making rural branches that may have been maintained open as a social service by the public-sector banks. This will tend to reduce the proportion of saving that is intermediated through the formal financial system. While that may in itself be deemed undesirable, especially because of the evidence that the ability to draw on financial savings is about as important as the ability to borrow on reasonable terms as a mechanism for the poor to protect themselves against adverse temporary shocks, one should also recognize that there is a real economic cost to maintaining loss-making bank branches open. Someone has to pay — typically the depositors in a repressed financial system, through the low interest rates they receive. If the government believes the objective of maintaining rural branches open to be sufficiently important, it can presumably provide a direct subsidy to that end.

In this paper I will not go into the reasons for liberalizing international capital flows, or the dangers of doing this prematurely (close as those subjects are to my heart; but they are not the topics for today).

 

Prudential Supervision

Why not allow banks a completely free hand in maximizing profits? One reason stems from the unusual balance sheet of banks, coupled with the problem of asymmetric information. Because banks have a high debt/equity ratio, a relatively small loss of debt service can push a bank into a position of possible insolvency (negative net worth). Unless the bank has a high franchise value stemming from an expectation of being able to make a stream of profitable loans in the future, this creates an incentive for a banker to engage in what is known as "gambling for redemption". As a private banker sees it, his only hope of remaining a banker is to make high-risk, high-return loans. If the loans pay off, his bank will be solvent again ("will be redeemed"). If the loans go bad, he will be no worse off, since his bank will still go bust. Thus all the potential gains accrue to the banker and all the losses fall on someone else (the government if bank deposits are guaranteed either explicitly or because the bank is judged "too big to fail", or the depositors otherwise). A banker faced with these incentives would be irrational if he did not gamble with his depositors' money. Moreover, it is usually not obvious to outsiders when this first occurs (this is the asymmetric information), so that in the absence of prudential supervision there is no one to stop him gambling for redemption. Even a supervisor may have difficulty in judging whether new loans are being extended defensively rather than in support of promising new investment opportunities.

A second reason why supervision is needed is that private bankers would often be tempted to lend to themselves or their friends in the absence of any restraint, and again usually nobody would be any the wiser until it was too late, because of asymmetric information. Such "looting" (lending to oneself or one's friends without a reasonable expectation of repayment) can arise for several reasons. At the crudest, it may reflect an inability on the part of the banker to distinguish between funds entrusted to him as deposits and his own personal property, but it need not be that crude. It may happen because other enterprises in which the banker happens to have an equity stake are running into hard times, and the only hope he can see of saving them is to extend credit from his bank (this was an important factor in Argentina during their first liberalization attempt in 1978-82). Or it may result from a very human tendency to be over-optimistic about the probability that one's own investment projects, or those of one's friends, will turn out well. Whatever the reason, experience has shown that banks are all too likely to be subject to looting in the absence of supervision.

A supervisor can help avoid such situations arising in several ways. First, he may know more about the bank's situation than outsiders can normally be expected to know, which may enable him either to restrain the bank from making additional risky loans, or restrain it from paying dividends, or even to force it into making only specially safe loans (e.g. lending only to the government), when its net worth deteriorates. (This is known as requiring "prompt corrective action".) Second, he can require the bank to maintain a prescribed level of capital relative to its loans (such as the Basle minimum 8% capital adequacy standard), which means that there is an equity cushion before gambling for redemption becomes a rational policy choice, and again require prompt corrective action if capital falls below that level. In order to police whether a bank is maintaining adequate capital, a supervisor will want to satisfy itself that the bank is using appropriate accounting standards. Third, the supervisor may require the publication of certain information in order to increase transparency and diminish the information asymmetry. Fourth, he will limit the amount of insider lending that is permitted, and will conduct spot checks on the books of the banks in an attempt to ensure that those rules are observed.

A bank with a positive franchise value will find it in its own interest to act in the ways that are being prescribed by the supervisor, since that will avoid the threat that supervisory action can pose to continued profitable lending. Conversely, however, a bank that is on the edge may seek to mislead the supervisor, so as to be able to engage in gambling for redemption (risky lending) in the hope that it will be able to recover. This illustrates the importance of having both a strong banking system in which the franchise value of most of the banks is distinctly positive, as well as a strong supervisor who is in a position to identify the occasions when a bank is close to the margin and hence may be tempted to gamble or loot.

Who should the supervisor be? Most often this task has been assigned to the central bank, which would seem to have some advantage in this role, akin to that which commercial banks have in monitoring borrowers. That is, the central bank has daily knowledge of the credits and debits of each bank, and hence may be in a position to get some early warning when things are starting to go wrong. But several countries have in recent years assigned the task of bank supervision to a distinct specialized agency, which suggests that there is no overwhelming reason why this function needs to stay with the central bank if there is some important institutional reason pointing in the opposite direction.

The central bank also has a key role in forestalling one other problem that can arise in a private banking system. Because the liabilities of banks are much more liquid than most of their assets, specially loans to the private sector, a bank can experience a run if lenders come to doubt the ability of the bank to continue honoring its obligation to pay deposits on demand. If those suspicions arise because the bank's solvency is suspect, then the central bank has a difficult decision as to whether it should bail out the bank or not. But if the run reflects simply liquidity pressures, then the classic response is for the central bank to act as lender of last resort, lending freely (though at a penal interest rate). It is important to have a central bank able to play this role if the banks are to feel secure in their role of maturity transformation.

 

Concluding Remarks

It is not my task today to pinpoint the ways in which Nepali banks fall short of the picture of privately-owned banks with a positive franchise value and free to make their own lending and management decisions, subject only to the rules laid down by a supervisor and perhaps also some residual directed lending to broad sectors without a concessional interest rate and possibly a ceiling equal to the treasury bill rate on the bank deposit rate, that I have suggested should be the aim of policy. Others will doubtless fill in some of that information in the course of the morning, and this afternoon we look forward to learning about how several other Asian countries have progressed in their financial reforms.

Let me conclude instead by acknowledging the importance of another dimension of the financial system, namely its role in maintaining macroeconomic stability. Although we are not focusing on that role today, it is of course a critical one, and it is here that the role of the central bank is crucial. One of the fears voiced by early critics of financial liberalization was that, in the absence of the right to decree credit ceilings, the central bank would have no effective policy tool with which to limit bank lending, resulting in a loss of monetary control and hence macroeconomic instability. These fears have not been realized in most countries that have liberalized their financial system. On the contrary, most countries have found that after a rather short space of time they were able to utilize indirect methods of monetary control (i.e. open-market operations, management of an official discount rate, and perhaps variations in reserve requirements) to maintain more sensitive monetary control than had proved possible with the old direct methods, in which bankers so often had an interest in circumventing their orders. This is another reason why one may hope that Nepal will proceed to a liberalized financial system in the next few years.

 

References

Bennett, Lynn and Carlos Cuevas, eds. (1996), "Sustainable Banking with the Poor," Journal of International Development, Vol. 8, No.2, March-April.

Binswanger, Hans P. and Shahidur R. Khandker (1995), "The Impact of Formal Finance on the Rural Economy of India," Journal of Development Studies, Vol. 32, No. 2, December, pp. 234-262.

Hellmann, Thomas, and Kevin Murdock (1997), "Financial Sector Development Policy: The Importance of Reputational Capital and Governance", in I.P. Szekely and R. Sabot, eds., Development Strategy and Management of the Market Economy (Oxford: Clarendon Press).

McKinnon, Ronald I. (1973), Money and Capital in Economic Development (Washington: Brookings Institution).

Shaw, Edward S. (1973), Financial Deepening in Economic Development (New York: Oxford University Press).

Stiglitz, Joseph E. (1994), "The Role of the State in Financial Markets", in M. Bruno and B. Pleskovic, eds., Proceedings of the World Bank Conference on Development Economics, 1993 (Washington; World Bank).

Williamson, John, and Molly Mahar (1998), A Survey of Financial Liberalization, Princeton Essays in International Finance no. 211.

 

Notes

1. This is a key difference to the situation in a full-blooded socialist banking system of the character that prevailed in the Soviet Union before its dissolution. In that system the role of the banks was little more than a book-keeping one, since enterprises made their decisions on how much to produce and what inputs to buy according to the orders of the planners, and the banks automatically provided them with enough credit to implement those plans. This meant that enterprises faced a soft budget constraint, an arrangement that is extremely destructive of any incentive to seek efficiency beyond what may be demanded by the planners.

2. The evidence that is being referred to in this paragraph, as elsewhere in this paper, is summarized in Williamson and Mahar (1998).


RELATED LINKS

Paper: Flirting with Default: Issues Raised by Debt Confrontations in the United States February 2014

Op-ed: A Dose of Reality for the Dismal Science April 19, 2013

Op-ed: Five Myths about the Euro Crisis September 7, 2012

Policy Brief 12-18: The Coming Resolution of the European Crisis: An Update June 2012

Book: Resolving the European Debt Crisis March 2012

Policy Brief 12-20: Why a Breakup of the Euro Area Must Be Avoided: Lessons from Previous Breakups August 2012

Testimony: The Euro Area Crisis: Origin, Current Status, and European and US Responses October 27, 2011

Policy Brief 11-15: Sustainability of Greek Public Debt October 2011

Policy Brief 10-27: How Europe Can Muddle Through Its Crisis December 2010

Testimony: A New Regime for Regulating Large, Complex Financial Institutions December 7, 2011

Book: Sovereign Wealth Funds: Threat or Salvation? September 2010

Article: The Dollar and the Deficits: How Washington Can Prevent the Next Crisis November 2009

Policy Brief 09-13: A Solution for Europe's Banking Problem June 2009

Speech: Global Financial Surveillance and the Quest for Financial Stability June 15, 2009

Policy Brief 10-22: Not All Financial Regulation Is Global September 2010

Speech: Addressing the Current Financial Crisis October 7, 2008

Testimony: The Rise of Sovereign Wealth Funds: Impacts on US Foreign Policy and Economic Interests May 21, 2008

Policy Brief 08-3: A Blueprint for Sovereign Wealth Fund Best Practices April 2008

Paper: The Subprime and Credit Crisis April 3, 2008

Op-ed: A Proposal to Improve Regulatory Liquidity May 21, 2008

Book: Reforming the IMF for the 21st Century April 2006