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Finance and Private Sector Development

A well-functioning financial system and a vigorous private sector are important drivers of growth and poverty reduction.  In the financial sector, our work has focused on understanding just how an effective financial system contributes to economic development and identifying which policies work best to improve the efficiency, stability and reach of the financial system in developing countries.  Our research on finance is organized around two dimensions—access to financial services and risk management and stability.

In the private sector, our work focused on understanding the determinants of firm entry, exit and performance, which are central to understanding the microeconomics of the growth process. With the recent worldwide collection of firm-level data and systematic measurement of the business environment, our research has begun to explore the role of policies in aiding private sector development at the micro level.  In our research program special areas of investigation are the determinants and consequences of entrepreneurship and innovation, informality, and corporate governance. Finally, we also study the impact of business environment and its reforms on firm performance to identify the most effective reforms and help prioritize them.

While our work in these areas will continue, responding to the recent global financial crisis, our future research in this area includes a special crisis focus.  Building blocks of this 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.

Understanding the Causes
Stimulating Recovery
Preventing Future Crises
Studying the Implications 

Asli Demirguc-Kunt Tel: (202) 473-7479Email:


Understanding the Causes

An important area of research is better understanding the root causes of this crisis.  The intensity of the crisis in the financial markets and the way it spread and became global surprised nearly everyone.  The crisis was also a shock to conventional thinking and led many researchers and policymakers to re-assess and re-evaluate their views.  Questions about what went wrong and the role of globalization, de-regulation, and the role of the state in this process abound.  A better understanding of the underlying causes of the crisis is an important starting point for our learning process. We intend to explore some new topics and take a fresh look at some others. For example, we want to explore whether there exists an optimal industrial and financial structure at different levels of the development process, and whether deviations from this optimal would make economies more vulnerable to crises. We will also investigate the impact of financial liberalization in general, and foreign bank entry in particular, in explaining the occurrence and extent of the crisis. Also of interest is the role of “credit crunch” in exacerbating the economic downturn.

Stimulating Recovery

Among the most hotly debated policy questions with respect to the current crisis is how to stimulate recovery. We will focus on the role of financial and private sector in this process.  First, because the crisis started in and severely affected the financial sector, the conventional assumption is that recovery of the financial sector is a precondition to recovery in the corporate sector.  However, studies of past crises have challenged this view emphasizing the possibility of creditless recoveries, showing that real sector recovery often precedes that of the financial sector.  In our research, we intend to dig deeper into this issue using firm-level as opposed to macroeconomic data, to better understand how these recoveries take place, whether they differ for different groups of firms and how they are financed.   We will also study supply chain finance to investigate if inter-firm financing can substitute for formal financing during bank crises.

Second, another area of significant interest is employment generation.  As the financial crisis has developed and spread, governments across the world are facing increasing demands for action on employment creation.  Yet little is known about which private sector development policies work in getting firms to start hiring workers again, and whether micro, small, or medium to large firms are the quickest to respond with hiring when policy actions step in.  We expect to provide answers through our research in India, Sri Lanka and Mexico.

Preventing Future Crises

Every crisis heightens the interest in crisis prevention.  How should we design policies so that we can minimize the risk and severity of future crises?  What are some of the most important policy reforms this crisis revealed as necessary?  We focus on three main areas of significant policy interest: financial regulation, financial literacy, and bankruptcy prediction and resolution.

One important implication of the recent crisis is the wide-spread calls for reforms of regulation and supervision.  But what exactly is good regulation and supervision? How can countries do it with limited resources? What should reforms focus on?  Related to these are issues around appropriate design of safety net policies, such as deposit insurance and bank resolution strategies.  We will continue our research in this area, improving and updating our databases, which will allow us to track and study how different countries are revising their policies. We will also study the determinants and implications of the institutional structure of financial sector supervision – i.e. multiple agencies vs. a single agency – for banking outcomes. 

Financial literacy is another policy issue that has come to the fore as a result of the recent crisis. The ability of consumers to make informed financial decisions is critical to developing sound personal finance, which contributes to efficient allocation of financial resources and financial stability.  Greater financial literacy can also be an important component to efforts to increase saving rates and lending to the poorest and most vulnerable consumers.  But while financial literacy is portrayed in global policy circles as a panacea for many recent crisis-related ills, with countries setting up Financial Literacy Panels that are charged with developing financial literacy programs for the general population, we know relatively little about whether such programs actually work.  In our research we will study the impact of financial literacy and business training on the use of financial services and financial vulnerability and behavior of individuals and firms during crises in countries such as Russia, India, Indonesia, Mexico and Bosnia-Herzegovina.

The recent crisis has also revealed significant weaknesses in the way financial risks are measured and managed.  Rapid growth of innovative products in structured finance has made default correlation an important component of portfolio credit risk and bankruptcy prediction.  Although there is a vast literature on statistical modeling of probability of bankruptcy, it is only recently that research has started studying unobservable common covariates (frailty) as drivers of stress.  Our work will study common factors and contagion in driving corporate defaults in emerging markets.  The results from this research will have important implications not only for how we define risk but also have practical use in calculating economic capital and in determining capital adequacy regulations. 

As the global economic downturn continues to worsen, prospects of illiquidity and potential insolvency are becoming more likely all around the world.  Hence one of the important concerns for policymakers is the effectiveness of existing bankruptcy regimes and bankruptcy resolution in systemic crises.  If bankruptcy laws are efficient, they should allow stronger firms to reorganize while liquidating unviable firms in a timely fashion.  A good bankruptcy regime also ensures availability of credit at a lower cost.  We will continue to learn from examining the impact of bankruptcy reforms and explore the role of different instruments and mechanisms to resolve financial distress.

 Studying the Implications 

There is no doubt that the crisis will have important implications affecting the livelihood of people and prospects of firms for many years.  Our research will study both the short term and longer term impact of the crisis on households, enterprises and financial institutions and markets. Using household surveys our research will explore how the crisis has affected access to finance by households, and “coping strategies” of individuals and households - such as reduction of consumption, use of financial products and dependence on informal finance and social insurance. In particular, we will explore whether better access to credit, reliance on formal financial instruments, and financial literacy/business training prior to the crisis made them better able to cope with the crisis, or more vulnerable to it.

Our research will also study the impact of the crisis on businesses, ranging from the impact on those owned by poor rural households to large corporations. Through the global entrepreneurship survey we conduct annually with the IFC, it will be possible to study the impact of the crisis and pre-crisis country characteristics on business creation rates. Using enterprise surveys, we will also study the impact of the crisis on individual countries, exploring whether crisis affects different regions, industries and firms differently; and which firm and business environment factors allow firms to better cope with the crisis.  Since crises affect the functioning of equity and debt markets significantly, we will also analyze the impact of the crisis on firms’ capital raising activities and corporate capital structure.

Finally, we will also study the impact of the crisis on financial institutions and financial structure, specifically, the changes in institutions’ size, activity and funding mix and risk-return trade-offs; and the structure of the financial system.  We will study the impact of the crisis on the microfinance sector, how the institutions and their clients are coping with the crisis, whether the crisis is affecting microfinance business models, and which types of institutions and contracts are proving to be more resilient or vulnerable to the crisis.  We will also study the implications of the crisis for institutional investors, whether fund managers see crises as buying opportunities, or become more risk averse, hoarding more cash or shifting to foreign assets.


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