Laeven, L.A.H.

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UvA-DARE is a service provided by the library of the University of Amsterdam (https://dare.uva.nl)UvA-DARE (Digital Academic Repository)Essays on financial intermediation in developing countriesLaeven, L.A.H.Publication date2001Link to publicationCitation for published version (APA):Laeven, L. A. H. (2001). Essays on financial intermediation in developing countries.General rightsIt is not permitted to download or to forward/distribute the text or part of it without the consent of the author(s)and/or copyright holder(s), other than for strictly personal, individual use, unless the work is under an opencontent license (like Creative Commons).Disclaimer/Complaints regulationsIf you believe that digital publication of certain material infringes any of your rights or (privacy) interests, pleaselet the Library know, stating your reasons. In case of a legitimate complaint, the Library will make the materialinaccessible and/or remove it from the website. Please Ask the Library: https://uba.uva.nl/en/contact, or a letterto: Library of the University of Amsterdam, Secretariat, Singel 425, 1012 WP Amsterdam, The Netherlands. Youwill be contacted as soon as possible.Download date:25 Jul 2022Introductionn and Outline 1.. Financial Intermediation in Developing Countries Financiall  intermediation in developing countries has been hampered by underdeveloped financiall  systems, that can generally be characterised by a limited availability of credit, a limitedd choice of financial products, and a misallocation of credit. The scarcity of credit hass the result that good projects may not be financed, at least not in the formal credit market.. Financial products lack both scope and depth: hedging instruments, foreign financiall  products and long-term debt instruments are often not available, and markets are illiquid.. Credit can be misallocated in the sense that unprofitable projects may be financed,, loans may be concentrated among a few borrowers, and insider loans may be extended.. Financial intermediaries in such systems are mostly inefficient and take excessivee risks. These imperfections are the result of a number of underlying factors. Thee main distortion in the financial systems of most developing countries is caused byy government interference. The financial systems in such countries have often been repressedd by a series of government interventions that have the effect of keeping at very loww levels interest rates on savings accounts of domestic banks. To a large extent, such interventionss are motivated by fiscal policy considerations. The government lacks the directt fiscal means to stimulate development, and uses the financial system to fund developmentt spending in two ways. First, by imposing large reserve and liquidity requirementss on banks, it creates a captive demand for its own debt instruments. Thus, it cann finance its own high-priority spending by issuing debt. Second, by keeping interest ratess low through the imposition of ceilings on lending rates, it creates an exces demand forr credit. It then requires the banking system to set aside a fraction of credit available to priorityy sectors. Otherr common factors contributing to the imperfections of financial systems in developingg countries are a weak corporate governance system, a poor legal and regulatoryy framework, and the poor availability and quality of information. In most developingg countries, weak corporate governance of banks is the result of concentrated ownershipp of banks by either the government or corporate conglomerates. Improper 2 2 IntroductionIntroduction and Outline bankingg regulations or weak enforcement of banking regulations in combination with weakk corporate governance may be conducive to insider lending. Poor quality of informationn in combination with poor credit skills, poor lending rules and the absence of wagee incentives for bankers may lead to the financing of bad projects, while poor informationn in combination with credit scarcity may result in credit rationing, in particularr for smal and medium-sized enterprises. In such an environment, where economicc institutions are weak, the existence of a deposit insurance scheme may lead to morall  hazard problems encouraging banks to take excessive risks at the expense of the depositors. . Ann underdeveloped financial system has implications for both economic efficiency andd the distribution of income. The implications for the economic efficiency are twofold. First,, the combination of low rates of return on assets and high reserve requirements impliess that even a competitive banking system will be forced to offer low interest rates onn its deposits. In many developing countries, the combination of low nominal deposit interestt rates and moderate to high inflation has often resulted in negative rates of return onn domestic financial assets, with an adverse effect on saving and the financial intermediationn process. Second, the introduction of interest rate ceilings induces savers to switchh from the acquisition of claims on the banking system to the accumulation of real assets,, assets traded in informal markets, and foreign assets. A standard response on the partt of policymakers in developing countries has been to declare illegal the holding of bothh foreign assets and assets in the informal sector. However, these restrictions have oftenn had limited success. Informal financial markets thrive in many developing countries,, and capital controls have proven rather ineffective. The induced incentive to holdd real assets, however, does not imply the achievement of high levels of investment. Thee poor legal framework and weak protection of creditor rights in many such countries deterr most potential investors from financing projects - both the ineffective court system andd the weak protection of secured creditors during bankruptcy procedures reduce the valuee of collateral. Also, the bribes that are often necessary in the proces of financing of projectss reduce economic rents. Moreover, many prospective investors will be unable to securee financing. Their own savings may be inadequate to finance large projects; the formall  system may not have the resources available, due to the government absorption of aa large part of the savings intermediated through commercial banks and other financial IntroductionIntroduction and Outline 3 3 institutions;; and the high potential costs of doing busines in informal markets, as well as thee cost of evading capital controls, may render financing through these channels uneconomical. . Thee consequences for the distribution of income arise because such a system transferss resources from actual and potential savers, as well as from excluded borrowers, too favoured borrowers who are able to acquire resources at the contracted interest rates. Thee most important of the latter is the public sector itself. In addition, enterprises in priorityy sectors and well-connected individuals will tend to benefit from privileged acces too credit. Too overcome the aforementioned imperfections in their financial systems, developingg countries world-wide are encouraged to liberalise their financial sectors. Such liberalisationss should be directed towards an efficient and fair allocation of resources and shouldd therefore include the removal of such restrictions as entry barriers, reserve requirements,, interest rate ceilings, and the abolishment of directed credit systems. In orderr to be effective, financial liberalisation should include the privatisation of state bankss to improve corporate governance, and should coincide with the introduction of properr banking regulation. Thiss book contains a collection of essays on financial intermediation in developing countries.. Although the various topics discussed here differ widely, the central theme of thee essays in this thesis is that underdeveloped financial systems lead to imperfections in thee financial intermediation process. Such a study is of economic importance, because thesee imperfections impede economic growth. Wee study how weak corporate governance structures and weak enforcement of bankingg regulation may lead to favoured lending to insiders. We also investigate whether financiall  liberalisation measures, guided towards installing prudent regulation, abolishing directedd credit systems and improving corporate governance through the privatisation of bankss may lead to more balanced distribution of credit resources. Finally, we explain howw the existence of deposit insurance schemes in countries with weak economic institutionss may lead to excessive risk taking by banks, and we study whether such moral hazardd behaviour differs between different types of banks. Thee different essays highlight that financial intermediation in developing countries oftenn suffers from wrong incentives that arise from weak corporate governance structures 4 4 IntroductionIntroduction and Outline andd weak legal systems. They also show that liberalisation of the financial intermediation sectorss has in general a positive impact on the performance of a country's corporate sector,, especially on smal and medium-sized companies, because it reduces distortions in thee allocation of capital. Financial liberalisation is, however, only effective if countries introducee both measures to reduce distortions in the financial system and prudential regulations.. Without a proper enforcement of prudent laws a liberalised financial system cann pose systemic risks to a country's economy, its depositors and taxpayers. It is, therefore,, essential to asses the different risk-taking behaviours of financial institutions. Ourr final essay proposes a way to asses the degre of risk-taking of a deposit-taking institution.. This methodology could be part of an early warning system, that could be usedd to signal future vulnerabilities of a country's financial sector. 2.. Outline of the Book Inn Chapter 1, we develop a model of insider lending, in which a borrower can give incentivess to a bank manager to misuse his right of control by extending a loan at favourablee rates to the borrower at the expense of the equity value of the bank. The modell  explains why insider loans often occur to borrowers that are also large shareholderss of the bank. The reason is that, although in principle every borrower can bribee the bank manager for insider loans, large shareholders have the power to fire the bankk manager, and will use this power if the bank manager extends insider loans to others.. Therefore, a bank manager has a reason to favour large shareholders if engaging intoo insider lending. Using a World Bank survey of Russian enterprises, we provide evidencee of our model. We find that Russian banks and their majority shareholders engagedd into insider lending on the basis of loan volume. To limit insider lending we proposee to give proper incentives to bank managers, such as high penalties or equity incentivee schemes. Inn Chapter 2, we review the literature on estimating financing constraints and presentt a structural model of firm investment that we use in the following chapters to assess the impact of financial liberalisation on the financing constraints of firms. The chapterr also describes the econometric techniques we employ to estimate the structural modell  of firm investment. IntroductionIntroduction and Outline 5 5 Inn Chapter 3, we use panel data on a large number of firms in 13 developing countriess to find out whether financial liberalisation relaxes financing constraints of firms.. We find that liberalisation affects smal and large firms differently. Smal firms are financiallyy constrained before the start of the liberalisation process, but become less so afterr liberalisation. In other words, smal firms tend to benefit from (re)gained acces to credit.. Financing constraints of large firms, however, are low both before and after financiall  liberalisation. The initial difference between large and smal firms disappears overr time. We also find that financial liberalisation reduces financial market imperfections,, particularly the informational asymmetries with respect to the financial leveragee of firms. We hypothesise that financial liberalisation has littl e effects on the financingg constraints of large firms, because these firms had better acces to preferential directedd credit during the period before financial liberalisation. Inn Chapter 4, we apply the techniques in Chapter 2 to the special case of Korea. Thee Korean financial system has been characterised by government interference and a chronicc shortage of funds. Since the 1960s the government has promoted the financing of large,, chaebol-affiliated firms. Towards the end of the 1980s, the government changed its focuss from targe firms to smal and medium-sized enterprises. We asses the impact of thiss change in government policy on the financing constraints of different types of Koreann firms. We find that Korean firms suffered from informational asymmetries and severee financing constraints during this period, and that these imperfections differ acros firms.. Our findings also suggest that the government's change in focus towards smal and medium-sizedd enterprises has been successful in the sense that it has reduced financing constraintss for these type of firms. We also find some evidence that firms with concentratedd ownership are more financially constrained than firms with dispersed ownership. . Inn Chapter 5, we calculate the cost of deposit insurance for a large sample of banks inn twelve countries to asses the relationship between risk taking behaviour of banks and theirr corporate governance structure. We find that the cost of deposit insurance has been highestt for banks with concentrated ownership, especially for banks that are predominantlyy owned by either a single company or another financial institution, and to a smallerr extent for banks that are predominantly owned by a family or the state. Banks withh dispersed ownership, on the other hand, are found to engage into a relatively low 6 6 IntroductionIntroduction and Outline degreee of risk-taking. We also find that the cost of deposit insurance is higher for banks thatt are affiliated to a busines group, that are small, and/or have high credit growth, and forr banks in countries with low levels of GDP per capita, high inflation rates, and/or poor qualityy and enforcement of the legal systems. Finally, we find that measuring bank risk byy calculating the cost of deposit insurance has some power in predicting bank distress. Ourr findings suggest that moral hazard and other incentive problems created by existing governmentall  deposit insurance schemes differ in magnitude between different types of banks,, in particular between banks that differ in governance structure. 

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Essays on financial intermediation in developing countries

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