March 2011, Asli Demirguc-Kunt (DECFP)
This has been another productive year for the Finance and Private Sector Development group with 60 published and forthcoming journal articles, 20 chapters in books, and 35 working papers. We continued to generate data sets, organize seminars and training courses in 2010.
In our research group our over-all mission is to understand the role of the financial and private sectors in promoting economic growth and reducing poverty, and identifying policies to improve their effectiveness. Our research is always driven by policy questions and we respond to current policy needs. After the recent financial crisis, we have initiated a research program, “Crisis and Beyond” which revolves around learning from and responding to the crisis. Building blocks of our research program are (i) understanding the causes of the crisis; (ii) the recovery process and the important role finance and private sector play in it; (iii) key policy areas for preventing/minimizing risks in the future, namely financial regulation, financial literacy, and bankruptcy prediction and resolution; and (iv) implications of the crisis for households, enterprises and financial institutions and markets.
Our on-going research on access to finance includes documenting and benchmarking access to financial services by small firms and poor households, and identifying underserved groups and analyzing barriers to building more inclusive financial systems. In 2010, Bill and Melinda Gates Foundation has given a grant to the Development Research Group to construct a new public database on “Global Financial Inclusion Indicators,” to help us achieve this goal. Our evaluative research is studying the channels through which access to finance can contribute to growth through promoting entrepreneurship, innovation, and the process of technology adoption.
Research on the private sector focuses on firm dynamics—changes in the composition of the private sector and entry and exit over time—and performance, and how this affects firm productivity and growth. Special areas of focus include research on the determinants and consequences of informality, innovation, and governance as well as the impact of the business environment and its reforms. The following are just a few examples from our on-going research program in 2010.
What does the recent financial crisis imply for the feasibility of different banking models?
On the funding side, the crisis has clearly exposed the dangers of a bank’s excessive reliance on wholesale funding. Similarly asset side weaknesses were exposed when large U.S. investment banks completely disappeared from the banking scene during the crisis. A look at bank activity and short-term funding strategies using an international sample of 1,334 banks in 101 countries leading up to the 2007 financial crisis suggest that banking strategies that rely predominantly on non-interest income or non-deposit funding are very risky. Banks should not completely eschew non-interest income generating activities and non-deposit funding, as universal banking can be beneficial. Nevertheless, evidence of diversification benefits is weak. While a universal banking model may be the best way to conduct investment banking business in a safe and sound manner, there may be limits to how far banks can steer away from the traditional banking model.
Role of financial literacy in raising demand for formal financial services in emerging markets
Financial literacy campaigns are increasingly heralded as the best way to increase demand for formal financial services in emerging markets. But do they work and for whom? One view argues that limited financial literacy stifles demand. A second view argues that demand is rationally low, because formal financial services are expensive and of relatively low value to the poor. Original surveys and a field experiment in India and Indonesia shows that financial literacy is a powerful predictor of demand for financial services. The relative importance of literacy and price was tested in a field experiment that offered randomly selected unbanked households financial literacy education crossed with a small incentive (ranging from US $3 to $14) to open a bank savings account. The financial literacy program had no effect on the likelihood of opening a bank savings account in the full sample, but showed modest effects for uneducated and financially illiterate households. In contrast, small subsidy payments had a large effect on the likelihood of opening a savings account. These payments proved to be more than two times more cost-effective than the financial literacy training. Further studies on larger ancillary benefits of financial education are underway.
Emerging economies need to monitor and reduce agency costs to attract and retain capital
Why do emerging markets find it difficult to attract and retain capital? An unexpected liquidity boom in Pakistan following the events of September 11, 2001, helps to answer this question. An analysis of a comprehensive loan-level dataset suggests that backward-looking credit limit constraints imposed by banks make it difficult for firms to borrow, despite readily available bank liquidity, healthy aggregate demand, and sharply falling interest rates during this period. The resulting failure of the banking sector to extend and retain capital in the economy suggests that agency costs that force banks to rely on “sticky” balance-sheet-based credit limits prevent emerging economies from effectively distributing available capital to firms. A series of further checks show that the result is not driven by concerns about firm quality, and that the effect is stronger for firms with larger potential agency costs.
What explains firm innovation in developing countries?
While existing finance literature on innovation is limited to large publicly listed firms in developed markets such as the United States, research using enterprise surveys makes it possible to investigate publicly listed as well as private firms, including small and medium enterprises. Researchers investigated which firm characteristics are associated with innovation using data for over 19,000 firms across 47 developing economies and defining innovation broadly to include introduction of new products and technologies, knowledge transfers, and new production processes. The results indicate that access to external financing is associated with greater firm innovation. Further, having highly educated managers, ownership by families, individuals or managers, and exposure to foreign competition is associated with greater firm innovation.
Workers’ remittances can broaden and deepen the banking sector in recipient countries
A study of household remittances in Mexico shows that they lead to sizeable increases in the number of branches and accounts per capita and the amount of deposits to GDP. For example, a one standard deviation change in the percentage of households receiving remittances—roughly a doubling of the mean remittance rate—leads to an increase of 1 branch per 100,000 inhabitants (against a mean of 1.79), 31 accounts per 1,000 residents (relative to mean of 42 accounts), and an increase of 3.4 percentage points in the deposit/GDP ratio (compared to a mean of 4.2). These effects are significant both statistically and economically, and are robust to the potential endogeneity of remittances, inclusion of a wide range of controls, and even municipal fixed effects specifications using an alternative sample of municipalities. These findings add another channel through which remittances can affect the development of recipient economies.
Trade credit contracting is a way for both sellers and buyers to manage business risk
This conclusion is based on data from almost 30,000 supplier contracts for 56 large buyers and more than 24,000 suppliers in Europe and North America. The sample of buyers and suppliers includes firms of varying size, investment grade, and sectors. The evidence supports four important, and not mutually exclusive, reasons trade credit helps to manage risk: it provides a method of financing, a means of price discrimination, a bond assuring buyers of product quality, and a screening mechanism to gauge buyer default risk. In particular, the largest and most creditworthy buyers receive contracts with the longest maturities, as measured by net days, from smaller, investment grade suppliers. In comparison, early payment discounts seem to be used as a risk management tool to limit the potential nonpayment risk of trade credit. Early payment discounts are generally offered to smaller, non-investment grade buyers. The results suggest that contract terms are jointly determined by supplier and buyer characteristics.
Countries affected by the financial crisis experienced a sharp drop in new business registration
Survey data collected on new firm registrations sheds light on the relationship between the regulatory environment, institutional quality, and entrepreneurship for 95 countries, as well as the impact of the 2008-2009 global financial crisis. The findings suggest that formal business registration occurs at a faster rate in countries with good governance, a strong legal and regulatory environment, low corporate taxes, and less red tape. For example, the pace of new registration was the fastest where the cost and number of procedures of starting a business was the lowest. The findings also show new firm registrations dropped sharply first in developed countries and then in the rest of the world as the financial crisis spread. While nearly all countries experienced a drop in business entry during the crisis, this drop was more pronounced in countries with higher levels of financial development, most likely because of the credit crunch that has characterized this crisis and the contraction in formal start-up capital. The drop in new business registration was less pronounced in lower-income countries, which tend to have lower rates of new business creation to begin with and where economic shocks tend to bring smaller changes.
What lessons can the recent financial crisis teach us on bank capital regulation?
Existing capital regulation, in its design or implementation, was clearly inadequate to prevent a panic in the financial sector. This investigation looks at whether better-capitalized banks experienced a smaller decline in their stock market value during the financial crisis to inform regulatory reform. What type of capital will ensure that banks can better withstand economic and financial stress? And should a simple leverage ratio be introduced to reduce regulatory arbitrage and improve transparency? Several types of capital ratios are explored: the Basel risk-adjusted ratio, the leverage ratio, the Tier I and Tier II ratios, and the common equity ratio. Before the crisis, differences in capital did not affect subsequent stock returns. During the crisis, higher capital resulted in better stock performance, mostly for larger banks and less well-capitalized banks, suggesting that calls to strengthen capital requirements is broadly appropriate. The relationship between stock returns and capital is stronger when capital is measured by the leverage ratio rather than the risk-adjusted capital ratio, indicating how difficult it is to properly measure risk exposure for large and complex financial organizations. Finally, higher quality forms of capital, such as Tier 1 capital and tangible common equity are likely to provide more effective protection.
Quality and Impact
Policy relevance of our research is very important to us. Indeed, all our research staff spend thirty percent of their time involved in operational activities to ensure continued policy relevance and impact of our research. At the same time, our research work is credible and influential in policymaking precisely because it meets the requirements of high quality research. Hence, rigor is as important as relevance. Publishing in highly recognized economics and finance journals is a way of screening and disciplining us, improving our credibility and measuring the quality of our work. Ultimately, development impact of our work is what matters, which is very difficult to measure. One imperfect way of doing this is to look at citations of our research in Google Scholar. Our papers published in the last 5 years with 100 or more citations and those with 500 or more citations overall suggest that we are having lasting impact in many areas.
ASLI DEMIRGÜÇ-KUNT is the Chief Economist of the Financial and Private Sector Development Network and Senior Research Manager of the Finance and Private Sector Team, in the World Bank’s Development Research Group.