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Rethinking the Role of the State in Finance

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  • New report measures financial systems before and during global crisis, reexamines the role of the state in the financial sector
  • As the crisis subsides, the state’s role should focus less on direct interventions and more on improving supervision, competition and financial infrastructure
  • Governments should aim to better align private incentives with public interest without taxing or subsidizing private risk-taking

September 13, 2012—In the wake of the worldwide financial crisis, many are asking what governments can do to better balance the need for creating stable financial systems without overly constraining healthy risk-taking and competition - which are essential for promoting greater prosperity. The Global Financial Development Report 2013: Rethinking the Role of the State in Finance, attempts to answer this question.

The World Bank report, the first in a new Global Financial Development Report series, comes just ahead of the fourth anniversary of the collapse of Lehman Brothers, which marked the nadir of the global financial crisis. The report, released on September 13, re-examines the role of the state as owner, regulator and supervisor, and promoter of the financial sector to distill lessons from the crisis in the light of new data, analysis, and operational experience.

“Governments need to provide strong supervision and ensure healthy competition in the sector. They also need to support financial infrastructure, such as better quality credit information that is shared more systematically,” says World Bank Group Managing Director Mahmoud Mohieldin.  

The report examines how financial systems around the world fared during the global financial crisis, drawing on several new global surveys as well as compiling unique country-level data covering 205 economies since 1960s. It includes information on financial development, banking regulation, the structure of financial sector supervision, credit reporting systems, and development banks around the world. The report is available through an interactive Web site, the underlying data are free to download through the Bank’s Open Data initiative, and a pocket version of the main dataset is made available as a Little Data Book on Financial Development.

Financial systems are tracked along four characteristics—size of financial institutions and markets, financial access, efficiency, and stability. The authors confirm that developing economy financial systems are less deep and provide less access than those in developed economies, but they do not differ much in terms of stability.

One of the report’s original contributions is on competition policy in banking. The report refutes the view that there was “too much competition” in the financial sector of the crisis countries.

“Research presented in the report suggests that with good supervision, more competition can actually help improve efficiency and enhance access to financial services, without undermining stability,” says Asli Demirgüç-Kunt, the World Bank’s director of development policy and chief economist for financial and private sector development.

Another original contribution of the report is an analysis of how state-owned banks performed during the financial crisis. At that time, many countries turned to state-owned banks to overcome the credit crunch and jumpstart recovery. Governments pumped capital into those banks or set up new credit lines for them to encourage lending to vulnerable firms, especially exporters and smaller entities. In Chile and Tunisia, for example, governments pumped capital into state banks to cover existing loans or provide new credit to exporters and small- or medium-sized firms. South Korea, among others, raised the credit ceilings of its state-owned banks. India, meanwhile, set up credit lines for those banks. And in Brazil, a large state-owned development bank played an important role in expanding credit during the crisis.

While some of these interventions worked in the short run to ease the impact of the crisis, the report warns this may backfire in the long run, contributing to a portfolio of bad loans. Evidence to date suggests that politically-motivated lending with lower-quality loans initially exacerbated the crisis in many instances. During the crisis, state-owned banks tended to lend more to large borrowers that may not have been most in need, while smaller players faced more limited access to credit. And the banks often continued to issue loans even after the economic recovery, raising concerns that they may eventually crowd out private banks.

Reminding the readers of the extensive research that finds government ownership of banks is associated with lower financial development, more financial instability and slower economic growth, the report recommends that countries carefully consider the risks posed by state-owned banks and pay attention to how they are governed, which is especially challenging in weak institutional environments.

The report also reviews recent successes and failures of the state as a regulator and supervisor using new data for 143 countries.  The authors analyze common traits among countries that were hit hard by the crisis versus those that fared better. Non-crisis countries tended to have less complex but better enforced regulations. Crisis countries allowed for less stringent definitions of capital, were not as rigorous in calculating their capital requirements for credit risks, and only 25 percent of them required general provisions on loans and advances (versus close to 70 percent in non-crisis countries). “Incentives are crucial in the design of financial sector policy” says Martin Cihak, lead author of the study and lead economist in the World Bank ’s Financial and Private Sector Development Network, “and the challenge of regulation is to align private sector incentives with public interest without hampering growth.”

The World Bank Group is working with member countries to support the development and stability of their financial systems, along with economic growth and poverty reduction. About 16 percent of the Bank’s lending during the global financial crisis went to the financial sector, up from 8 percent before the crisis began. The Global Financial Development Report incorporates country lessons from the Financial Sector Assessment Program and other operational work.

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