sou · GOB311d5 · 2001-01-01 00:00:00 — In other words, when deadweight losses are high, an interest group faces greater opposition to 2 In addition, groups with completely unconnected interests may form support trading or log rolling coalitions. Two groups may agree to support each other even if the members of one group are not affected by the regulations that the other wants. Tariffs are a classic case of log rolling in which, say, lumber and glass producers support each others call for higher protection, thereby providing greater support for higher tariffs than otherwise would be (and Kroszner 1999). Volym D:138 Supplement 25 its protective regulation on the and hence is less likely to be successful.3 Similarly, politicians in electoral democracies are concerned about finding an optimal support coalition to promote their re-election chances, so they take into account the marginal costs and benefits to different groups. The rents generated by regulation in an electoral democracy thus are likely to be spread among different groups, even though one group may be the primary beneficiary (Peltzman 1976).4 Regulation that protects financial institutions from competition and subsidized government deposit insurance to banks generates rents for this sector that are then partially shared through directed credit allocation.5 The private interest theory thus helps to explain why the banking and financial system is particularly susceptible to political influence. The banking system provides an effective but off-balance-sheet way for the government to redistribute resources (Kroszner forthcoming). Few if any other sectors provide the same degree of flexibility to redistribute resources, whether implicitly through window guidance or explicitly through statutes such as the Community Reinvestment Act. Credit allocation through financial institutions can be an important implicit or explicit part of a governments industrial policy. 6 Banks and financial institutions may be induced to act, at least in part, as implicit fiscal arms of the state, but must be compensated through protective regulation. 3Becker (1983) argues that competition among lobbying groups thus will lead to the most efficient (lowest deadweight cost) regulations being chosen, so there is a tendency for regulation to be efficient in this sense. Wittman (1995) takes this argument further to conclude that both democratic institutions and outcomes are efficient. 4When the constraint of future elections is less binding on politicians, they may engage in less rent-sharing and provide windfalls to targeted groups. McGuire and (1996), however, argue that less democratic regimes may be better able to insulate themselves from rent-seeking and might find it in their own interest to pursue economic policies in the public interest. 5Also, flat rate deposit insurance tends to subsidize the smaller and riskier banks at the expense of the larger, better diversified, and safer banks. Lobbying for flat rate deposit insurance historically has been consistent with this pattern of relative benefits (e.g., Calomiris and and et al. 6Gershenkron (1962), for example, argued that the German government fostered the development of strong banks in , at the expense of financial market development, to promote rapid economic development in the nineteenth century. Since the government is so heavily involved in banking, it may be very difficult to have effective government regulation of the domestic banking and financial sector. In these circumstances, simply hiring more and better-trained supervisors and adopting good regulatory principles is not sufficient because the government may have incentive to enforce rules of sound banking, either on state-owned banks or privately- owned banks. The co-dependence of the banks on the government and of the politicians on the banking industry allows problems to grow unchecked, as the depth of the banking troubles in the Asian currency crisis countries illustrates. This linkage also may help to explain why governments cannot seem to avoid bail-outs of the financial sector, even as officials acknowledge and decry the moral hazard problems of the bail-outs themselves. These perverse incentives are not unique to developing countries, as the long delays in responding to the Savings and crisis in the U.S. and the banking problems in also show. In developing a political economy explanation of practices and regulations in corporate finance, Hellwig (1998) emphasizes the contrasting interests and organizational costs facing insiders versus outsiders. He explains, for example, the heavy reliance in firms on internally generated cash flows, rather than external sources of funds, to finance investment as arising not from failures in the capital markets but from the incentives of managers to avoid subjecting themselves to outside discipline. From this perspective, investment choices could be distorted by managers taking into account the potential loss of their private benefits associated with using outside sources of finance. Insiders, such as firm management and controlling shareholders, have incentives to try to insulate themselves from external pressures and to attempt to disenfranchise other shareholders (Hellwig 1998). Incumbent management and controlling shareholders of large and well-established firms, for example, have been effective in most countries in obtaining statutory and regulatory barriers to raise the costs of hostile takeovers. Part of the strong backlash against and junk bonds, for example, may be because Milken and these instruments permitted small and unknown outsiders to subject even the largest firms to the pressures of the market for corporate control (see 1997). In addition, the ubiquity of laws that make it difficult for small shareholders to remove directors and exercise other forms of control over managements decisions can be seen as arising from the greater cohesion and lower costs of organizing incumbent management relative to dispersed shareholders (see La Porta et al. Volym D:140 Supplement 25 While the private interest theory has had much success in explaining a wide variety of regulatory interventions that are difficult to rationalize on public interest grounds, it has been less effective in explaining the widespread economic deregulation that has taken place in many countries during the last two decades (Peltzman 1989 and Noll 1989 but see Kroszner and Strahan ). Many political scientists and some economists emphasize the importance of beliefs and ideology of voters and politicians to explain regulation and deregulation (e.g., Kalt and Zupan 1984, 1988, and Poole and 1997). Difference across countries or among citizens over time in their general beliefs about the appropriate role of the government in economic affairs might affect the extent of intervention. (1994), for example, has argued that populist fears of excessive concentration of power in the hands of financial elites was an important driving force behind many banking and financial regulations in the early part of this century (but see Hellwig 1998 for an alternative interpretation). Poole and (1997) have developed a useful measure of ideology based on roll-call voting that rates legislators on a simple left- right scale. This ideology measure has had much success in accounting for a wide variety of economic regulation and deregulation not well explained by private interest group variables or party politics. Berglof and (1999), for example, analyze bankruptcy law in the and find that this measure of ideology is a key element for understanding the voting patterns on bankruptcy legislation during the last two centuries. Poole and (1993) find an important role for ideology in the battles over the origins of economic legislator in the during the nineteenth century. Identifying the driving forces behind changes in ideology over time, however, have been difficult. What constitutes ideology and whether it can be measured independent of economic interests is the subject of an extensive and ongoing controversy (see Peltzman 1984 and overviews by and 1996 and Poole and 1996). The new institutional economics approach emphasizes transactions costs and institutional arrangements for decision-making as key factors influencing the outcome of the policy process (e.g., McCubbins, Noll, and Weingast 1988, North 1990, 1996, , Eggerston, and North 1996, Dixit 1996, and and Kroszner 1999). approach examines how alternative policy-making structures (e.g., delegation to an independent agency versus a parliamentary vote versus an executive order) influence the incentives of both special interests and governmental actors to shape policy. Opportunities for vote-trading and issue-linkages, for example, may differ under alternative structures and can confer advantages (e.g., agenda control) to particular players. These institutional and transactions costs features can in turn affect the incentives for interest groups to organize and the effectiveness of their lobbying efforts. Interest group size and strength, thus, is not given but may be endogenous and it is important to take such considerations into account if one wishes to make a durable policy change (e.g., and Kroszner 1999). The regulation of bank powers illustrates the endogeneity of interests with respect to the regulatory framework (e.g., Kroszner 1996). In 1933, the U.S. adopted the Glass-Steagall Act which fragmented the U.S. financial system by strictly limiting the powers of commercial banks. In particular, commercial banks could not engage in securities underwriting, much in contrast to classic German banks and banks in many parts of Europe. While there does not appear to be an economic justification for such a separation (see Kroszner and 1994 and 1997), there may be a redeeming feature in terms of the political economy of financial regulation. The silver lining in the cloud of Glass-Steagall is that in the U.S. a rich variety of alternative financial services providers have developed and they compete in both the financial market and the market for financial regulation. In , for example, the early implicit state fostering of strong, banks allowed them to capture the regulatory system and thwart the development of alternative institutions and markets. In the U.S., well-organized groups have helped to establish competing regulatory bodies that are likely to keep the market for financial regulation far from being a monopoly even if the Glass-Steagall Act is relaxed today. The financial services sector is the largest source of political action committee (PAC) campaign contributions in the U.S., giving roughly 20 percent of total PAC contributions, but most of these funds are spent on battles among the rival interests rather than on battling the consumer (Kroszner and Stratmann 1998). The initial regulation and the existence of the regulatory bodies helped to provide incentives for the alternative groups to organize and lobby. Volym D:142 Supplement 25 Politicians and the bureaucracy may be considered a distinct interest group concerned about expanding their size and influence over the economy. Niskanen (1971) and Brennan and (1977) suggest that an objective of the government may be to maximize or, on the , increase its size and expenditures and discuss institutional structures that can mitigate the tendency toward growth. This view has been characterized as the Leviathan approach. The fiscal demands of the government help to explain some of the close relation between politics and the banking and financial sector and the origins of numerous regulations. Geographic restrictions on banks in the U.S., for example, arose in the early nineteenth century as a way for state governments to maximize revenues from the sale of bank charters by providing a series of local monopolies (Kroszner 1997). The federal government began to grant bank charters during the U.S. Civil War to create a new class of banks that would hold federal debt and, thereby, facilitate the financing of the war effort. was founded as a way to aid in the financing of the Crown in . recently, as governments have come to rely more heavily on deficit financing through the issue of sovereign debt, reforms of the government securities markets around the world can be understood from this perspective (as will be discussed below).7 Debt moratoria, debt abrogation, and changes bankruptcy law also can be seen in this light (e.g., Berglof and 1999, Bolton and 1999, and Kroszner 1999). 7 The government also raises revenues thorough seniorage, and the ability to tax through inflation is another reason for the governments long involvement with money and banking affairs. 3Political-Economy Factors Driving the Recent Trend toward International Financial Liberalization and Regulatory Reform The interest-group competition framework outlined above suggests a number of factors to explore when trying to understand how financial reform can become politically feasible. In this framework, technological, legal, and/or economic shocks must occur in order to change the relative strengths of interest groups that would then alter the previous political- economy equilibrium. Identifying and analyzing these factors can provide a basis for facilitating and perhaps shaping future reforms (see 1984, 1987, and 1988, Kroszner 1997a, and Kroszner and Strahan ). Technological change is often cited as a key force behind the innovations in financial markets and institutions during the last two decades. In the political-economy framework, technological improvement does more than simply shift the production possibility frontier for an industry. Technical change can have significant distributional consequences, completely independent of its effects on the costs and efficiency of production, that is, such change is rarely distributionally neutral. New products and markets bring forth new constituencies. Innovations affect the pre-existing markets and institutions and cause shifts in the interests and alliances. Changing the relative strength of competing interests can then lead to regulatory reform. From the political-economy perspective, we must try to identify shocks to the old equilibrium that would lead to regulatory reform fostering globalization and liberalization (see Kroszner and Strahan ). A number of shocks, for example, have increased the elasticity of the supply of investors and depositors funds and thereby have eroded the value of regulation protecting geographic monopolies, whether local or national. First, the invention of the automatic () in the early 1970s was one factor that began to reduce the value to the local banks of geographic protections. In countries like the , legal challenges about whether an ATM constituted a branch slowed the spread of the ATMs until the courts determined that an ATM was not a Volym D:144 Supplement 25 branch, thereby permitted the growth of interstate ATM networks. ATM networks then rapidly spread worldwide. Second, consumer-oriented money market mutual funds and accounts offered by investment banks arose in the last two decades. These types of new opportunities for individuals demonstrated that banking by mail and telephone, using toll free numbers, provided a feasible and convenient alternative to local banks. Third, technological innovation and deregulation have reduced transportation and communication costs, particularly since the 1970s, thereby lowering the cost for to use distant and foreign banks. Since the increasing elasticity of deposits supplied to banks reduces the value of geographical restrictions to their traditional beneficiaries, these beneficiaries had less incentive to fight strenuously to maintain them. Also, as elasticities increase, there are fewer rents to share among competing groups so regulation becomes less likely (Peltzman 1989). While any deregulation that eliminates inefficient regulation is broadly consistent with the public interest theory, the timing of the deregulation is difficult to explain by that approach. The opening of banking markets occurs precisely when the geographic restrictions are becoming less burdensome for the public, due to the elasticity-increasing innovations discussed above. On the lending side, increasing sophistication of credit-scoring techniques, following innovations in information processing technology, financial theory, and the development of large credit data bases, has begun to change the relationship-character of bank lending towards less personal and more standardized evaluation. As a result of these innovations, for example, securitization of mortgages, loans, and consumer credits have become commonplace in the developed countries and are becoming increasingly so in emerging markets. In recent years even banks lending to small businesses has become increasingly automated, relying less on the judgement of loan officers and more on standardized credit scoring programs. Technological change thus has diminished the value of specialized local knowledge that long-established local bankers might have about the risks of borrowers in the community. Such changes have increased the feasibility and potential profitability for large and foreign banks to enter what had traditionally been the core of small, local bank activities. The large and foreign banks have therefore had an incentive to increase their lobbying pressure to attain the freedom to expand into these markets. In terms of the (1983) model, the deadweight costs of preventing the large and foreign entry is increasing, so the small, local banks are less likely to be able to maintain the restrictions. In addition, as the value of a local banking relationship declined, local firms that were the main borrowers from the local banks also would be more likely to favor the entry of large and foreign banks into local markets (Kroszner and Strahan ). The method of opening up of the banking markets also is consistent with the private interest theory (see Kroszner 1997). Typically, new foreign entry is first permitted through investment in existing banks and mergers, rather than de novo entry (particularly of institutions that are in financial distress, as Citicorps new entry into illustrates). By removing the geographic barriers in this way, the small, local banks have an opportunity to share in the benefits of deregulation by selling out at a premium rather than being competed out of existence. The smaller banks in the country thus would tend to lobby for foreign entry through mergers because they would prefer to have more potential bidders in the market, which tends to increase the premium paid for small banks (Brickley and 1987). An increase in foreign financial institution penetration can generate a virtuous circle in that foreign banks tend to be less politically connected and less likely to be able to capture the regulatory authorities. In addition, they are less likely to succumb to pressure for directed lending by the government. With capture less likely and fewer direct benefits to the politicians of bank regulation (e.g., through quid pro quos for directed lending), regulatory reform becomes more likely. , for example, began its reform process when roughly 30 percent of the banking system was already foreign owned. By the end of the reform process, a very large fraction of the banks had become foreign owned. This helps to increase the likelihood that the reforms are sustainable and not simply temporary. In sum, technological change was a shock to the old political-economy equilibrium and had important distributional consequences that are typically ignored in economists emphasis on efficiency issues but are extremely important to a positive explanation of regulatory change. Volym D:146 Supplement 25 4Public Finance Motives behind Financial Reform and Globalization: The Case of Markets Reform Since the late 1970s, there has been dramatic growth in the use of publicly-traded debt as a financing tool for both emerging as well as developed countries (Kroszner 1997b). Before this time most countries, with the exception of the US, typically placed a large share of their debt with domestic banks, either directly or through a bank syndicate arrangement.8 While the banks were to some extent captive financers of the government, they typically received compensation through protective regulation, below market discount loans from the central bank, and implicit lender-of-last-resort or deposit insurance subsidies.9 With government debt growing much more rapidly than bank assets, however, it was no longer feasible for governments to rely so heavily upon direct funding by the banks. Motivated by a to keep financing costs on their rapidly mounting debt relatively low, politicians thus had incentives to broaden their sources of funding. Consistent with our deadweight cost analysis above, politicians would like to engage in their redistributive activities but must take into account the losses associated with the transfers. The worldwide reforms of the structure and operation of government securities markets during the last two decades, particularly in emerging markets, can be explained in terms of this motive. Auctions replaced or significantly supplemented the traditional placement of securities with 8This form of financing could be seen as a mild form of financial repression (1997). 9There is a long and rich history linking a government's financing and financial regulation. During the first fiscal revolution in the U.S. when state governments began to rely heavily on debt financing in the 1840s, for example, many states adopted free banking statutes. This legal change eased entry into banking but required the banks to hold state government securities as reserves, thereby boosting the demand for the state's bonds (see Kroszner 1997a and Kroszner and Strahan ). Simultaneously, the government created or formalized a primary dealer system in which it authorizes specially designated dealers to have the exclusive right to bid directly in the auctions and to have the responsibility of distributing the securities to investors. An important feature of these reforms was that foreign-controlled financial firms were permitted to enter the market and become primary dealers, thereby encouraging the globalization of the investor base.10 Previously, developing countries typically had shielded their domestic banking and financial markets from foreign competition. The politicians had a strong incentive to broaden their investor base to finance their growing deficits, and the percent of government debt owned by foreigners has grown rapidly during the last two decades (see Kroszner 1997b). The internationalization of the government debt markets also has been associated with an increase in the liquidity of these markets. The primary dealers have an obligation to the government, as well as their own private incentive, to the growth of a liquid secondary market in government bonds. Liquid secondary markets help to reduce the government's financing costs, by fostering demand by investors (especially foreign investors) who are more willing to hold instruments which have easily observable market prices and can be easily traded. Liquidity also facilitates the dealers' distribution of the securities to investors. The depth of the government securities markets typically has been associated with an increase in the depth and development of other securities in these countries and increased foreign involvement. As the economic theory of regulatory reform would suggest, the changes which began the opening of domestic financial markets to foreign competition and created liquid debt markets, providing another form of competition to the banking sector, did not occur without some quid pro quo for the banking industry.