José de Gregorio: What does society expect from the financial sector?
Panel discussion remarks by Mr José de Gregorio, Universidad de Chile and former
Governor of the Central Bank of Chile following the Per Jacobsson Lecture by Dr YV Reddy,
24 June 2012, Basel, Switzerland.
* * *
I would like to thank the BIS for the invitation to participate in this panel, which makes us look
at financial markets from a new perspective.
As policymakers, we are used to talking about how the financial system must operate in
order to fulfill its goals without threatening financial stability or imposing costs at the
aggregate level. In recent years, the discussion has focused on how to avoid excessive
procyclicality, contagion, moral hazard, and other important policy concerns.
As economists, we have been trying to explain the misbehavior of financial systems, and we
are still searching for answers. Although we may have some ideas, the policy implications
are not straightforward, but the answers cannot wait. Policy design needs answers as soon
as possible, and delays may cause well intentioned policies to be poorly implemented.
But what society really demands from financial systems is quite difficult to define. Society is a
collection of actors, with different interests and different needs. People want access to the
financial system at fair conditions. Therefore it is useful to think of society as everyone who is
not related directly to the financial industry or policymaking.
Starting from here, we can say that society is demanding safer and fairer financial systems.
The view that financial markets were big casinos, where the betting was done with other
people's money and gamblers walked away unpunished, is quite common around the world.
Public opinion has been dominated by that sentiment, which has also affected policymaking.
On financial development
Let me start by stressing that financial intermediation is good, and with the backlash from the
crisis it should be repeated that a well functioning financial system is key to prosperity. It
promotes economic growth by channeling investment funds from savers to borrowers
(Levine, 2006). It is central to promoting entrepreneurship and to facilitating investment,
including human capital accumulation. It provides financing to households in order to smooth
consumption, and provides insurance. It provides safe and cheap means of payment. The
difficulties faced by households and firms in many emerging market economies due to
underdeveloped financial institutions and markets should be a clear reminder of this positive
role. But financial depth may also be a source of great problems. As in many situations, more
is not always better.
There is plenty of research concluding that economies with deep financial systems grow
more. However, studying this issue in Latin America many years ago I came to the
conclusion that in Latin America growth during the eighties was lower in countries with more
developed financial systems, since the collapse of their economies during the debt crisis was
larger (De Gregorio and Guidotti, 1995). Indeed, it was Carlos Diaz-Alejandro, by the
mideighties, who eloquently said "good-bye financial repression, hello financial crash"
(DiazAlejandro, 1985). Some recent research also points in the same direction, as reviewed in
Dr. Reddy's lecture - beyond a certain level, financial depth has marginal contributions to
growth (Arcand et al., 2012; Cecchetti and Kharroubi, 2012).
In Chile we had a great financial crisis in the early eighties which led to an overhaul of
financial regulation. The country followed the prudent route, allowing only activities that could
be handled appropriately by financial intermediaries, but above all that could be understood
and monitored well by market participants and financial regulators. Since the country was
emerging from a deep financial crisis, the macro view of the financial system and its
regulation were a central part of the design.
But this seems not to have been the case in advanced economies.
The global financial crisis has revealed the perils of financial deepening. It has shown that
advanced economies are not different. This is not new in emerging markets, but is something
less common and more dramatic in advanced economies. Long ago we learned that when an
economic downturn comes with a financial crisis the costs are extremely high.
What went wrong?
It is important to recall that the crisis had its origins in a noble cause: providing housing to
low-income families. This was perhaps the response to rising income inequality, as
emphasized by Rajan (2010), and the lack of other policies to correct this problem in a fast
and efficient way. Ironically, the crisis affected more intensely precisely those that were
supposed to benefit from "financial inclusion."
There are many other cases in which well intentioned developments are implemented
through weak policies. Take the case of interest rate ceilings. In order to promote fairness,
many countries introduce limits on the interest rate on loans. This policy attempts principally
to protect people with disadvantages and allow them to participate in the financial system. If
this ceiling is set low enough, it may end up generating exclusion rather than lower financial
costs for households, who may end up paying much higher interest rates in informal credit
markets.
This is not the place to analyze all the causes and culprits of the crisis, but it is worth
discussing certain aspects that are frequently singled out by the general public.
First and foremost, the crisis was caused by the irresponsible behavior of the financial
industry. The structure of incentives was unsuitable. It led to excessive risk-taking without
proper risk management. Compensation was heavily biased towards deal-making,
regardless of the quality of the deals. Commissions and fees were a very important
component of the compensation scheme. In the end, all that mattered was granting credit
indiscriminately, maximizing packaging and selling securities, etc. This was at the foundation
of the originate-and-distribute model of financial services, and served to increase leverage to
unsustainable levels. We know that linking compensation to productivity is efficient, but the
devil is in the details.
Second, the regulation-making process, as very well discussed in Dr. Reddy's lecture, was
also distorted by comprehensive capture by the financial industry. As he explains, this was
not only capture of the regulators, but also capture of public policy relating to the financial
system. With a little bit of moral hazard, which is exacerbated by regulatory and policy
capture, the result was the creation of a very vulnerable financial system.
Finally, there was indifference in policy circles. None of us saw it coming, at least not with the
intensity with which it arrived, which still persists. Indeed, it was difficult for those of us from
emerging markets to think that this could happen in the advanced world. Whenever we had
raised a concern we had been told that "these are developed countries," as an argument that
"this time is different". There were, of course, calls for prudence, in particular from this
institution, but we never thought that the consequences would be so dramatic. Markets
should provide enough discipline to balance risk and return, but that was not exactly the
case. The market functioned poorly. In addition, we had a sense of security given the
"decoupling" that took place in the 2000s, in part due to good macroeconomic management,
and which became a recoupling by mid-2008 (Dooley and Hutchison, 2009; Korinek et al.,
2010).
It is easy to put the blame on the behavior of the financial industry, but the policy implications
are not straightforward. But from the three points I have raised - misbehavior of market
participants, comprehensive capture, and policymakers' indifference - there are three simple
conclusions: we need tight regulation, transparency and disclosure of conflicts of interest,
and permanent monitoring of financial stability.
What else may go wrong?
Financial systems in emerging markets escaped from the crisis due to some extent to
prudent regulation, built on a history of recurrent crises. But perhaps it was also due to the
fact that we are somewhat slow to adapt to financial innovation. Indeed, many issues, such
as the use of derivatives by the banking industry, were being discussed in emerging markets
on the eve of the crisis. Of course, we are much more aware of the risks of financial
innovation. It is particularly important to understand innovations - something that I think very
few understood before the crisis. A simple rule for policymaking is that if you cannot
understand what is really being proposed and you do not see the benefits, it is better steer
clear. We used this simple dictum at the Central Bank of Chile.
Not everything is bright in emerging markets. There are many challenges. One issue that has
not been a problem so far, but presents potential risks, is the role of public banks. Some
research has shown that in Latin America public banks are less procyclical than private
banks (Micco and Panizza, 2006), but this could be for good or bad reasons. If public banks
are prudent and avoid jumping on the bandwagon of optimism during the upturn this is good
- they may even soften credit constraints during the downturn. However, public banks may
also be an instrument to pay back supporters of politicians, and certainly this is unfair and
inefficient. Public banks may also be subject to capture by the electoral cycle (Micco et al.,
2007), or used as an instrument to implement industrial policy. Given the lack of other
instruments, providing credit for selected economic activities may be a way to promote
specific sectors. There are certainly better tools for promoting specific sectors, especially
from efficiency, fiscal, transparency and accountability points of view.
An issue that has been on the agenda in most countries is financial consumer protection.
This is, of course, a welcome development, and is a clear demand from society.
Transparency in financial charges and the nature of the contracts, the ability to change
across financial agents, assigning clear responsibilities in this area to regulators, and
improving financial literacy are among the issues being discussed. It is important, however,
for consumer protection to form an integral part of the regulatory infrastructure in order to
avoid inconsistencies among agencies and risks to depositors and overall financial stability in
the name of protecting consumers. Consumer protection also has a high risk of being
captured by the political cycle. This could be specially damaging in the financial system -
and therefore every effort should be made to make the institutions safeguarding financial
consumers autonomous and technical.
For macroeconomists and financial economists, today it is difficult to focus on something
other than the European crisis. The health of the global economy depends on a good
resolution to this crisis. However, we cannot forget the duty of building a safer and fairer
financial system. Today we have the opportunity to tackle this task, but we also have to avoid
shortcuts that may end up rebuilding a weaker financial system.
References
Arcand, Jean-Louis, Enrico Berkes and Ugo Panizza (2012), "Too Much Finance?,"
International Monetary Fund Working Paper, WP/12/161.
Cecchetti, Stephen and Enisse Kharroubi (2012), "Reassessing the Impact of Finance on
Growth," mimeo, BIS.
De Gregorio, José and Pablo Guidotti (1995), "Financial Development and Economic
Growth," World Development, Vol. 23, No. 3, pp. 433-448.
Diaz-Alejandro, Carlos (1985), "Good-bye Financial Repression, Hello Financial Crash,"
Journal of Development
Economics, Vol. 19, Issues 1-2, pp. 1-24.
Dooley, Michael P. and Michael M. Hutchison (2009), "Transmission of the U.S. Subprime
Crisis to Emerging Markets: Evidence on the Decoupling-Recoupling Hypothesis," NBER
Working Paper 15120.
Korinek, Anton, Agustin Roitman and Carlos A. Vegh (2010), "Decoupling and Recoupling,"
American Economic Review, Papers and Proceedings, pp. 393-397.
Levine, Ross (2006), "Finance and Growth: Theory and Evidence," in Philippe Aghion and
Steven Durlauf (eds.) Handbook of Economic Growth, pp. 865-934, New York: Elsevier
North-Holland.
Micco, Alejandro and Ugo Panizza (2006), "Bank Ownership and Lending Behavior,"
Economic Letters, Vol. 93, Issue 2, pp. 248-254.
Micco, Alejandro, Ugo Panizza and Monica Yanez (2007) "Bank Ownership and
Performance. Does Politics Matter?," Journal of Banking and Finance, Vol. 31, No. 1, pp.
219-241.
Rajan, Raghuram (2010), Fault Lines: How Hidden Fractures Still Threaten the World
Economy, Princeton, NJ: Princeton University Press.
Reddy, Y.V. (2012), "Society, Economic Policies and the Financial Sector," Per-Jacobsson
Lecture, BIS. www.bis.org/events/agm2012/sp120624.htm.