sou · GOB311d5 · 2001-01-01 00:00:00 — Our historical account shows that in time of crises a political backlash may occur and it can have very long-term consequences. Thus, even in times of prosperity (in fact, precisely in those times) it is wise to generate some forms of safety net, to minimize the strength of an anti-market revolt in a time of crisis. This is beneficial even if it has some cost in terms of efficiency. An interesting example of this is presented by (1998) in his analysis of the different methods of land privatization in the during the 19th century. sold state land in big lots. This generated large revenues and lead to the creation of latifundia, which at the time were the efficient method of farming. The , instead, donated small lots of land to those farmers who were willing to settle in. This form of organization was economically less efficient, but more stable politically. At the first agricultural crisis, Argentinean landlords fired a large number of workers who converged to in search of jobs. This large mass of unemployed became easy fuel for populist anti-market movements, with consequences that are well known. By contrast, American farmers held on to their piece of land, strongly supporting property rights and guaranteeing the survival of the market economy. The need for some safety net is even more important today, given the potential sources of political tensions looming in front of us. One is represented by the distributional consequences of technological change. While extremely beneficial, technological change has enormous distributional effects, which are amplified by markets. For example, in the the wage differential for college graduates has been increasing for the last thirty years. So has the return to talent. These differences are likely to increase redistributional conflict in the future. The other potential source of political tension is the progressive aging of the population (at least in the most developed economies), with the consequent need to pay for unfunded pension plans. This need will increase the demand for redistribution and, thus, the demand for a more centralized economy. As we already mentioned, in a command and control economy the costs of redistribution are lower, both from an economic and a political point of view, because cross subsidies become Politics, and Financial Development Volym D:121 less visible and easier to implement. Thus, the aging of the population could enhance the pressure for more intervention. In the face of these threats, the survival of financial markets, and in general of market economies, crucially depends upon the ability to preempt these sources of political tensions. Volym D:122 Supplement 24 The quest for the ultimate cause of financial backwardness is not another senseless academic exercise, but a first order question, which enormous policy consequences. The answer should shape any attempt to reform a financial system. Our conclusion that politics is the main villain both a hope and a warning. The hope is that the benefits of financial development are within every countrys reach. And today many forces are joining to ease the path to financial development. Increased international competition is eliminating the monopolistic rents of local producers not only weakening their opposition to financial development, but also transforming them into advocates for a better financial system. The large number of countries that in the last few years have introduced new laws in favor of investors supports this hope. The warning is that the dramatic progress that financial markets have made in the last decade is not irreversible. This has been a time of expansion. The market as an institution remains politically fragile and the inevitable contraction will highlight new political challenges. Only if promarket forces actively recognize these will researchers at the end of the 21st century not have to wonder what caused financial markets to retreat over the turn of the 20th century. Politics, and Financial Development Volym D:123 Bencivenga and , (1991), and . Financial Intermediation and Endogenous growth, Review of Economic Studies, April, 58, 195-209. , P., A. Breach, E. and S. , (1998), Corporate Governance and the Asian Financial Crisis, 1997-98, mimeo, MIT. Brealey, R. and S. , (1996), Principles of , , 5th edition. , R.C., (1986), Corporate , Corporate law, : , , c1986. , (1978), in the World Today: An Introduction to the Comparative Study of , ; : distributed in U.S.A. by Free Press of Glencoe. Easterbrook, F. and D. , (1991), The Economic Analysis of Corporate , . Engelbourg, and , (1996), The Man Who Found the Money: and the Financing of the Western Railroads, East : . Kroszner, R., (2000), Politically Independent? Perspectives on the Political Economy of Banking and Financial Regulation, Supplement No. 25 to the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. La Porta, , , , and , (1997), The Legal Determinants of , , 52. La Porta, R., Lopez-de-Silanes, F., A. Shleifer and R. Vishny, (1998), and Finance, , 106, 1113- 1155. , S., (1977), The determinants of corporate borrowing, , 5, 147-175. , , (1915), The Evolution of the Money Market 1385-1915, , . Prescott, E., (1986), Theory Ahead of Measurement, . , R., (1998), The Past and Future of Viewed through an , , Credit and Banking, vol. 30, (3), 524-550. Volym D:124 Supplement 24 , R. and L. Zingales, (1995), What Do We Know about Capital Structure? , (1995), 50, 1421-1460. , R. and L. Zingales, (1998a), Financial Dependence and Growth, , (1998), 88, 559-586. , R. and L. Zingales, (1998b), The Tyranny of the Inefficient: An Inquiry into the Adverse Consequences of Struggles, forthcoming in the . , R. and L. Zingales, (1998c), Which Capitalism? Lessons From the East , . , R. and L. Zingales, (1999), as a Dedicated Hierarchy: A Theory of the Origins and Growth of Firms, . , R. and L. Zingales, (2000), , Industrial Structure, and Growth, Supplement No. 23 to the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. , M., (1994), Strong Managers and Weak Owners: The Political Roots of , , , N.J. Seligman J., (1995), The Transformation of Wall Street, , 1995, p.42. Shleifer and R. Vishny. (1997), A Survey of Corporate Governance'', , , (1991), Corporate in R. Bauxbaum, G. , A. , and K. Hopt, eds. : European Business : Legal and Economic Analysis of Integration and Hamornization, de Gruyter, . Zingales, L., (1995), What Determines the Value of Corporate Votes?, 110: 1047-1073. Perspectives on The Political Economy of Banking and Financial Regulation Supplement number 25 to the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. Views, suggestions, and opinions expressed in this study represent the personal views of the author and not necessarily those of the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. * Professor of Economics, , , 1101 , , IL 60637, . Volym D:128 Supplement 25 Kort sammanfattning (in Swedish) ..................................................... Alternative Approaches to the Political Economy of 3Political-Economy Factors Driving the Recent Trend toward International Financial Liberalization and 4Public Finance Motives behind Financial Reform and Globalization: The Case of What is the Role of Crises in the Political-Economy of Regulatory Conclusions for Facilitating the Policy Reform Process ............ Kort sammanfattning (in Swedish) Syftet med studier i politisk ekonomi är att analysera hur regleringar tillkommer, vilka krafter som påverkar denna process och vilka krafter som verkar för att konservera respektive förändra existerande regle- ringar. Denna bilaga illustrerar a) att det finansiella systemet inte är oberoende av det politiska systemet, och b) vad detta ömsesidiga bero- ende betyder för regleringar och regleringsprocessen på det finansiella området. Detta innebär ett annat och kompletterande synsätt på regle- ringar i förhållande till en mer normativ analys av optimal reglering. I bilagan diskuteras fem olika motiv till finansiella regleringar och avregleringar. För det första finns det ett kollektivt motiv till regleringar där syftet är att maximera den samhällsekonomiska välfärden. Eftersom många regleringar inte kan förklaras på detta sätt behandlas för det andra olika privata intressen som drivkrafter i regleringsprocessen. Även om teorin om lobbying från privata intressegrupper kan förklara många former av regleringar har den svårt att förklara trenden mot avregleringar . Ideologiska skift bland lag- stiftare och väljare blir en tredje förklaring, även om orsakerna till dessa skift är svårfångade. För det fjärde kan den institutionella besluts- strukturen påverka både olika intressegruppers incitament att organisera sig och deras möjligheter att påverka besluten. Slutligen kan politikernas och byråkraternas budgetmässiga överväganden motivera regleringar som genererar offentliga inkomster. Dessa perspektiv underlättar en förståelse för hur teknologiska, juridiska och ekonomiska innovationer har drivit fram de globala finan- siella avregleringarna. De finansiella kriserna har också betytt mycket för att driva fram reformer och förändringar av regleringar. Bilagan avslutas med fem slutsatser om hur den politiska reform- arbetet kan underlättas. För det första kan väl genomförda konsekvens- analyser av olika förslag spela en viktig roll för att upplysa allmänheten och beslutsfattare. För det andra kan konkurrens mellan olika rivalise- rande intressegrupper minska risken att få regleringar som gynnar vissa grupper på det allmännas bekostnad. För det tredje, kan en reformering av regleringar underlättas om den offentliga beslutsprocessen stimulerar konkurrens mellan olika intressegrupper. För det fjärde skulle en större genomlysning av det statliga deltagandet och tillsynen möjliggöra en bättre utvärdering av statens roll i det finansiella systemet. För det femte kan ett inflöde av utländska aktörer vara en positiv kraft, eftersom dessa Volym D:130 Supplement 25 har färre politiska kontakter och mindre möjligheter att skaffa sig fördelar i regleringssystemet. Rather than take regulations as given, the political economy approach attempts to provide a positive analysis of how and why regulations evolve as they do and what forces can lead to their durability as well as their potential for change. The focus of this paper will be to illustrate how the banking and financial system is not independent of politics and what implications this interdependence has for understanding regulations and reform. This perspective provides an alternative lens through which to analyze regulation and which is complementary to the traditional normative analysis undertaken by economists studying optimal regulation. Five complementary positive political economy approaches are outlined and applied to understand the pattern of banking and financial regulation and deregulation. First, the public interest approach emphasizes the maximization of social welfare as the motivation for regulation. Since many regulations cannot be rationalized on such grounds, a second approach emphasizing private interests is then developed. This theory focuses on the strength and organization of special interests groups that compete to lobby for protections and privileges. While the private interest theory is able to explain many forms of regulation, it has only partial success in explaining the recent trend towards deregulation. Changing ideology of legislators and voters provides a third alternative. Pro- and anti- business ideological commitments may play a role, but it is difficult to understand exactly what drives ideological change. Fourth, the institutional structure of policy-making can affect both the incentives of interest groups to organize and their effectiveness in influencing policy outcomes. Finally, budgetary considerations of politicians and bureaucrats can motivate regulations that can help to generate funding for government operations. These approaches then help to identify technological, legal, and economic innovations that have been driving the global move toward financial liberalization and regulatory reform. Changes in the government securities markets world-wide during the last two decades provide an illustration of the political economy factors at work. The role of financial crises in motivating regulatory reform is interpreted as involving important distributional effects and providing information on the costs of the existing regulatory policies. Volym D:132 Supplement 25 The paper concludes with five lessons from the positive political economy approaches for ways to facilitate the policy reform process. First, careful cost-benefit analyses of regulations can play an important role in educating the public and policy-makers. Academic studies and arguments can be thought of as equivalent to technological shocks that can change the productivity and effectiveness of different interest group expenditures. Second, competition among rival interest groups can help to dissipate their efforts and reduce the likelihood of narrow special interest regulation. Third, structuring regulatory and governmental decision-making in ways to encourage competition rather than capture by one particular group also can help to remove obstacles to reform. Fourth, greater transparency and disclosure in government supervision and involvement would permit greater monitoring of the governments role in the financial system. Finally, foreign entry can be a positive force since the outsiders typically will not have the same extent of political connections and be less able to capture the regulatory process for private benefits. 1 Introduction** The structure and regulation of a countrys financial markets and institutions are the focus of much policy attention for a number of economic and political reasons. Banks and other financial institutions encourage and collect savings that finance a countrys economic growth. By allocating the savings to enterprises and monitoring the use of the funds, these institutions and markets play an integral part of the corporate governance system that ultimately affects the productivity of resources throughout the economy (see and Zingales 2000a and 2000b). Banks and other financial institutions also play a key role in transmitting the governments monetary and credit policies to the rest of the economy. Parts of the financial sector are effectively regulated as means to provide subsidized credit or services to targeted groups (including the government itself) and to protect particular groups (from, for example, competition, hostile takeovers, or expropriation). While the economics of financial regulation have been studied extensively (see, e.g., Herring and Santomero 2000 and Kroszner 1998a), the politics have received less – albeit increasing – attention. Rather than take regulations as given, the political economy approach attempts to provide a positive analysis of how and why regulations evolve as they do and what forces can lead to their durability as well as their potential for change. The focus of this study will be to illustrate how the banking and financial system is not independent of politics and what implications this interdependence has for understanding regulations and reform. This perspective provides an alternative lens through which to analyze regulation and which is complementary to the traditional normative analysis undertaken by economists studying optimal regulation. When the infamous American bank robber was asked why he robbed banks, he replied Thats where the money is. The same might be said for why there is such involvement of the government with the banking and financial system – thats where the money is. ** An earlier version of this study was presented at Symposium on the International Competitiveness of the , organized by , , , 25-26, 1999. I would like to thank , , and for helpful comments. Volym D:134 Supplement 25 manifests itself in a number of ways, related to the positive political economy analysis. In the next section, I briefly outline a number of approaches to understanding the political economy of government involvement in the economy and then try to understand why the banking and financial system appears to be particularly vulnerable to politicization. I then examine the technological, legal, and economic shocks that the political economy approach would suggest are the primary factors that disturb a regulatory equilibrium in banking and financial markets. A case analysis of the world-wide reforms in government securities markets then illustrates the motivations for and outcomes of financial regulatory change. The next section then examines the role of crises in regulatory change, emphasizing the redistributional aspects of crises that result in rapid shifts in the strength of different interest groups. The final section draws some tentative lessons from the political economy approaches concerning how to make more likely the incentive compatibility of incentive compatible regulation. This will also include a brief discussion of the role that academic advocates can play in the process of regulation and its reform. 2Alternative Approaches to the Political Economy of Regulation Both policy-reformers trying to effect change as well as researchers trying to develop positive theories of government policy-making have struggled to understand how government intervention and regulation occurs and how and whether it can be subsequently sustained (1996). Five related approaches have been taken to analyzing these phenomena: Public Interest, Private Interest, Ideology, Institutions, and Leviathan. While these approaches are not mutually exclusive, they emphasize different aspects of the interaction between economics and politics. Each captures an important element in the process. I will briefly discuss each and apply them to understand aspects of banking and financial regulation. The traditional approach that economists took to explaining the existence of regulation emphasized that regulations exist to correct market failures and protect poorly informed consumers from harm.1 From this perspective, regulatory intervention occurs primarily to maximize social welfare, so this approach is often called the public interest theory of regulation. Public interest rationales are given for capital regulation and deposit insurance to provide a sound banking system because stability of the financial system can have spillover effects for general macroeconomic performance (e.g., and Kroszner 1997). Statutory protections of shareholders and creditors from ex post appropriation and supervisory agencies in like a Securities and Exchange Commission are rationalized on the grounds of investor and consumer protection. A key challenge to the public interest view is that many forms of regulation have or no redeeming social value. Entry restrictions that protect banks or other financial institutions from competition, portfolio restrictions that hinder diversification, and geographic restrictions that have prevented expansion within a country or across national borders are 1 Joskow and Noll (1981) call this normative analysis as positive theory. Volym D:136 Supplement 25 generally difficult to rationalize on public interest grounds. Statutes or regulatory procedures that protect incumbent management from many forms of discipline by shareholders or outsiders provide additional examples. Regulation that does not appear to serve a public interest also is ubiquitous in other sectors (see , 1988). Virtually all regulation, regardless of whether it may have a public interest rationale, has significant distributional consequences. The parties affected by the regulation thus have an incentive to try to ensure that the government structures the regulation in such a way as to benefit them. A public interest argument often is used to mask the private interests that the intervention serves. Private interests may try to confuse the public debate by providing false or misleading information to make it difficult to discern what policy would improve social welfare (e.g., 1996 and Dewatripont and Tirole 1999). The private interest theory of regulation, also called the economic theory of regulation, characterizes the regulatory process as one of interest group competition in which compact, well-organized groups are able to use the coercive power of the state to capture rents for those groups at the expense of more dispersed groups (e.g., 1965, 1971, Peltzman 1976 and 1989, and 1983). Changes in the size, strength, and organization of interest groups thus provide the key to understanding policy changes. Regulated groups may be sufficiently powerful that they influence the politicians and the regulatory bureaucracy to serve primarily the interests of those subject to the regulation. In other words, the regulated group captures the regulators, hence this is sometimes called the capture theory of regulation. The incentives for such regulatory behavior may be direct or indirect. Pressure may be exerted directly on politicians, though campaign contributions or votes. The politicians then pass a new statute or pressure the regulators to act sympathetically towards the interest group. Indirect incentives may come through regulators understanding that cooperative behavior may be rewarded with lucrative employment opportunities in the industry after leaving the government, a practice so common in the past with Japanese officials that it is euphemistically called amakudari or the descent from heaven. The effectiveness of the interest groups depends upon a number of factors. First, cohesive groups will find it easier to organize and overcome free-rider problems in lobbying for regulations that may Producers of goods and services tend to be more compact and better organized than consumers, so there is a tendency for regulation on net to benefit producers more than consumers (1971). The parallel in corporate finance is that incumbent managements tend to be better organized and more effective than dispersed shareholders, so there is a tendency for regulation to benefit incumbent management against small shareholders (see Hellwig 1998 and below). The ability of a group to organize is often inversely related to its size, but many labor unions and trade organizations have been able to develop effective lobbying bodies through carefully crafted incentives that provide a variety of information and support services in return for membership (see 1965). Second, groups tend to be more effective not only when the benefits are concentrated among group members but also when the costs of the regulation are relatively diffuse. A compact group of potential losers each of whom would experience high losses associated with the regulation will be likely to form a lobby that will try to counteract the original interest groups pressure. Interest groups most directly affected by the regulation may build a coalition to lobby for or against the regulation.2 Third, in addition to the diffusion of the costs across different groups, the level of the costs relative to the benefits obtained by the interest group play an important role (1983). Deadweight loss is defined as precisely the difference between the winners benefit minus the losers cost from the change in output generated by the regulation. Factors affecting the efficiency of the regulatory or transfer mechanism thus may have an important impact on political outcomes. As the deadweight loss of grows, for example, the losers are losing more for each krona of the winners gain. When this gap widens, losers have a greater incentive to fight each krona of the winners gain and the winners have less incentive to fight for each krona of the losers loss.