As the dust settled from the financial crises of 1997-98, the potentially disastrous consequences of weak financial markets were clearly apparent. But even when there are no crises, having a financial system that does a good job of delivering essential services can make a huge difference to a country's economic development. Ensuring robust financial sector development with the minimum of crises is essential for growth and poverty reduction, as has been repeatedly shown by recent research findings. Globalization further challenges the whole design of the financial sector, potentially replacing domestic with international providers of some of these services, and limiting the role that government can play – while making their remaining tasks that much more difficult.
The importance of getting the big financial policy decisions right has thus emerged as one of the central development challenges of the new century. However, the controversy stirred up by the crises has pointed to the weaknesses of doctrinaire policy views on how this is to be achieved. How then should financial policy-makers position themselves?
Finance for Growth: Policy Choices in a Volatile World seeks to provide a coherent approach to financial policy design – one which will help policy makers select wise policy choices adapted to local circumstances and grasping the opportunities offered by the international environment.
This is not a book that relies on the application of some abstract principles; rather our conclusions are based on an analysis of concrete evidence. Though much remains to be learnt, a huge volume of empirical analysis, drawing on a growing body of statistical data, has been conducted on these issues over the past few years. The findings of this research greatly help to clarify the choices that are involved. Many long-held beliefs have found detailed empirical confirmation for the first time; some new and perhaps surprising discoveries have been made.
The authors ask policy makers to face the facts about finance. It is now possible to define with some confidence the need for a refocusing and deepening of the financial sector policy agenda. In this study, the authors identify and synthesize key findings of recent financial sector research conducted at the World Bank and elsewhere, highlighting the policy choices that will maximize growth and enable the financial sector to cope with – rather than magnify – volatility. A few key messages have emerged from this research:
Finance contributes to long-term prosperity
It is obvious that advanced economies have sophisticated financial systems. What is not obvious, but is borne out by the evidence, is that the services delivered by these financial systems have contributed in an important way to the prosperity of those economies. Getting the financial systems of developing countries to function more effectively in providing the full range of financial services is a task that will be well rewarded with economic growth.
Governments are not good at providing financial services –
Government ownership of banks continues to be remarkably widespread, despite clear evidence that the goals of such ownership are rarely achieved, and that it weakens the financial system rather than the contrary. The desirability of reducing, even if not necessarily eliminating, state ownership in low- and middle-income countries where it is most widespread, follows from this evidence. However, privatization has to be designed carefully if the benefits are to be gained and the risks of an early collapse minimized.
– even when a crisis hits
Even governments averse to an ownership role in banking may find it foisted on them in a crisis. The authorities’ focus then must be on getting out as quickly as possible, using the market – rather than government agencies – to identify winners and losers. Drawing on public funds to re-capitalize some banks may be unavoidable in truly systemic crises, but they must be used sparingly to leverage private funds and incentives. Procrastination and half-measures – as reflected in lax policies involving regulatory forbearance, blanket guarantees, and their ilk – bear a high price tag that will affect the financial system and the economy for years to come.
But well functioning markets need legal and regulatory underpinning –
Achieving an efficient and secure financial market environment requires an infrastructure of legal rules and practice and timely and accurate information. This in turn should be supported by regulatory and supervisory arrangements that help ensure constructive incentives for financial market participants. Success here will promote growth in a way that is tilted towards the poor and will stabilize the economy around the higher growth path. Direct access to finance by many now excluded will also be expanded.
– and a strategy based on harnessing incentives
Incentives are key to limiting undue risk-taking and fraudulent behavior in the management and supervision of financial intermediaries – especially banks which are prone to costly failure. Instability and crashes are endemic to financial markets, but need not be as costly as they have been in recent years. They reflect the results of risk-taking going well beyond society's risk tolerance. These costs are very real: they represent a potentially persistent tax on growth. This can raise poverty in the near term, and can have longer-term affects on the poor, both through lower growth and through reduced spending on areas such as health and education.
Diversity is good for stability
Banks, securities markets, and a range of other types of intermediary and ancillary financial firms, can all contribute to balanced financial development. A radical preference in favor either of markets or of banks cannot be justified by the extensive evidence now available. Instead, development of different segments of the financial system challenges the other segments to innovate, to improve quality and efficiency, and to lower prices.
Open markets can spur development –
Most developing countries are too small to be able to afford to do without the benefits of access to global finance, including accessing financial services from foreign or foreign-owned financial firms. Facilitating the entry of reputable foreign financial firms to the local market should be welcomed too: they bring competition, improve efficiency, and lift the quality of the financial infrastructure. As such they are in important catalyst for the sort of financial development that promotes growth. Governments need to remember that access to financial services is what matters for development, not who provides them.
– as can technology
The financial sector has long been an early adopter of innovations in information and communications technology. Internationalization of finance (despite efforts to block it) has been one consequence. This has helped lower the cost of equity and loan capital on average, even if it has also heightened vulnerability to capital flows. The precise future role of e-finance in accelerating the process of internationalization is not easy to predict, but it will surely be substantial. If volatility may have increased, so too have risk-management technologies and their associated financial instruments. Some related credit information techniques, including scoring mechanisms, promise to expand access of small-scale borrowers to credit.
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