Financial Regulation and Development

# **Introduction**

Financial development promotes poverty-reduction and investment: plenty of evidence and associated mechanisms support this claim (e.g., Beck, Levine and Loayza 2000; Burgess and Pande 2005; Demirg ̈u ̧c-Kunt, 2004; Kaboski and Townsend 2005, 2011, 2012; Levine 2005; Karlan and Zinman 2010; etc.). However, there remains an unanswered key question: _how_ to promote financial systems in low-income countries and, in particular, financial inclusion via branch installation . In this paper, we argue that: 1) financial development is a story of banking; 2) a moderate degree of financial regulation can promote financial development and branch expansion in the context of underdevelopment. The first point is descriptive: banks manage around 90% of assets in most low- and middle-income countries, and hence understanding the determinants of banks’ outreach is key.<sup>1</sup> Furthermore, banks play a central role in financial development for at least three reasons beyond the classical intermediation activities: 1) to invest in reaching new customers, providing a public good (“the formal economy”); 2) to introduce alternative payment systems, facilitating within-country trade; 3) to manage liquidity risk, contributing to shape macroeconomic volatility.

Our second, and most important, contribution links a moderate degree of regulation to the promotion of financial development and branch expansion in a context of underdevelopment. We introduce a regulation puzzle: can financial regulation, as a mandatory safe asset purchase, promote lending? Figure 1 shows the monthly volume of private sector lending by all Ethiopian banks between January 2010 and June 2013. In April 2011 (vertical line), the National Bank of Ethiopia (NBE) introduced a directive forcing all private banks to purchase 0.27 negative-yield government bonds for every birr (Ethiopian currency) of private sector lending. The upper panel shows no slowdown after this measure, while the lower panel distinguishes between private banks (affected by the policy, blue) and the state-owned bank (not affected, red). Not only does lending not decline, but there also seems to be some increase in loan volume. In the empirical section of the paper (Section 2), we give evidence of such increase in lending and other bank variables using a more rigorous identification strategy.

In the theoretical section (Section 1), we explain this phenomenon by employing a microeconomic model of banking and introducing a coordination failure. Our core intuition follows: financial regulation can stimulate bank operations, and hence profits and loans, if the deposit increase, led by improved confidence in the financial system, exceeds the decline in the profit margin of the bank. Depositors are aware that the bank finds safe assets unattractive, because these lower profits, and for this reason they expect the bank to default in bad states, transferring all losses to them through limited liability. This results in a low optimal deposit level, accounting for the probability of bank

> 1The International Monetary Fund (IMF) produces a periodic document titled _Financial System Stability Assessment_ for all of its member countries, within which, for this purpose, a table “Financial System Structure” provides valuable statistical information. We summarize this finding for a few countries, as follows: in 2002, Bangladesh had 91.3% of its financial assets managed by banks, while the securities market managed 4.6%, finance companies 1.4%, and microfinance companies 2.7% (IMF 2010); Brazil had 96.2% of its financial assets managed by banks and asset managers (generally owned by banks), 0.5% by other financial institutions, and 3.6% by insurance companies (IMF 2012); in China, banks have been managing between 84% and 88% of financial assets between 2007 and 2010 (IMF 2011).

2