metadata: authors: 0: author: Melecky,Martin
1: author: Podpiera,Anca Maria
count: World
docna: 0: docna: Financial sector strategies and financial
            sector outcomes : do the strategies perform?
docty: Policy Research Working Paper
subtopic: International Trade and Trade Rules,Economic Growth,Bankruptcy and Resolution of Financial Distress,Financial Sector Policy
teratopic: Industry,Science and Technology Development
abstracts: cdata!: Financial sector strategies enable
            financial policy makers and stakeholders to take a holistic
            view of the financial development needs in their country and
            formulate balanced financial policies. They help policy
            makers consider the systemic risk that different development
            policies involve and choose an informed way forward. This
            study constructed a new data set of historical financial
            sector strategies covering 150 countries over 1985-2014. It
            assesses the strategies using the rating criteria proposed
            by Maimbo and Melecky (2014). It further investigates how
            the quality of the strategies can affect financial sector
            outcomes, such as financial depth, inclusion, efficiency,
            and stability. The investigation finds that the use of
            financial sector strategies helped increase financial sector
            deepening, inclusion, and stability, and this impact could
            be greater for higher-quality strategies. However, a
            significant relationship between the use of strategies and
            the efficiency of banks is not confirmed. One way how
            financial sector strategies can improve financial sector
            outcomes is by improving the regulatory framework for finance.
repnme: repnme: Financial sector strategies and financial
            sector outcomes : do the strategies perform?
display_title: Financial sector strategies and
            financial sector outcomes : do the strategies perform
listing_relative_url: /research/2018/01/29528119/financial-sector-strategies-financial-sector-outcomes-strategies-perform
topicv3: Trade m1326924 698,Monetary and Financial Stability m1327169 1098,Financial Inclusion m1327456 363,Bankruptcy and Liquidation m1327467 1277,Financial Sector Development m1327681 1920
publishtoextweb_dt: 2018-01-23T00:00:00Z
historic_topic: Industry,Science and Technology Development
no_of_pages: 48
author_keys: 0: author_key: 915923
1: author_key: 1107242
model_extractions: WPS8315 Policy Research Working Paper 8315 Financial Sector Strategies and Financial Sector Outcomes Do the Strategies Perform?

_Martin Melecky Anca Maria Podpiera_ South Asia Chief Economist Office & Europe and Central Asia Chief Economist Office January 2018
Policy Research Working Paper 8315

# **Abstract**

Financial sector strategies enable financial policy makers and stakeholders to take a holistic view of the financial development needs in their country and formulate balanced financial policies. They help policy makers consider the systemic risk that different development policies involve and choose an informed way forward. This study constructed a new data set of historical financial sector strategies covering 150 countries over 1985–2014. It assesses the strategies using the rating criteria proposed by Maimbo and Melecky (2014). It further investigates how the quality of the strategies can affect financial sector outcomes, such as financial depth, inclusion, efficiency, and stability. The investigation finds that the use of financial sector strategies helped increase financial sector deepening, inclusion, and stability, and this impact could be greater for higher-quality strategies. However, a significant relationship between the use of strategies and the efficiency of banks is not confirmed. One way how financial sector strategies can improve financial sector outcomes is by improving the regulatory framework for finance.

This paper is a product of the the South Asia Chief Economist Office and Europe and the Central Asia Chief Economist Office. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The authors may be contacted at mmelecky@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Financial Sector Strategies and Financial Sector Outcomes:**

**_Do the Strategies Perform?_**

Martin Melecky Anca Maria Podpiera _World Bank World Bank and Technical University of Ostrava Czech Republic_

**Keyword** : Financial sector strategies; Financial depth, stability, efficiency, and inclusion; Policy coordination; Policy tradeoffs.

**JEL Classification** : G20, G28
# **1. Introduction**

When a group of people heads out for a hike, it is useful for them to have a travel map with marked directions and planned time for completing the trip. This does not guarantee that the group will not run into unexpected obstacles and must solve problems on the go, but it anchors the group’s expectations, avoids misunderstandings about which path to take at each crosssection, and gives everyone a sense of how fast the group needs to hike. Sectoral policy strategies, including for the financial sector, are like travel maps. A unique challenge faced by financial sector strategies is to weigh the systemic risk that advancing financial depth, efficiency, or inclusion entails. In other words, while aiming to better satisfy the demand of people, firms, and governments for financial services (payments, saving instruments, credit, equity, and insurance), the strategy needs to find ways for public policy to ensure prudent management of systemic risk in the supply of these services by the financial firms (banks, nonbank financial institutions, and capital markets). Not only are financial sector strategies used by low-income countries (Sierra Leone), lower and upper middle-income countries (India, Malaysia), they are also used by advanced countries (Switzerland).

This paper considers whether the existence of a national financial sector strategy over 1985– 2014, and its quality, had a significant impact on financial sector outcomes, such as financial depth, stability, efficiency, and inclusion. We do not focus on whether all financial sector strategies fulfilled their goals, because many of them do not set their goals using quantitative measures. Instead, we assess whether the existence of a comprehensive strategy can improve the development of the financial sector. In addition, we aim to understand how the strategies support sustained financial development. For the latter, we try to identify whether the strategies had a direct role in shaping the regulatory framework or an indirect effect by bringing together the main institutions involved in the financial sector in an inclusive and consultative manner, 2
ensuring a greater ownership of the agreed reform program, improving coordination within the public sector, and providing the private sector a clear view of policy intentions.

Our work contributes to the literature by constructing a new database of financial sector strategies, based on published documents across 150 low-, middle-, and high-income countries from all regions of the world. Using the assessment criteria proposed in Maimbo and Melecky (2014), we evaluate the quality of the strategies in our database. That is, we assess whether the strategy adequately covers the objectives of financial development and systemic risk management, whether the stated objectives are accompanied by an implementation plan, and to what extent the strategy addresses the potential trade-off between financial development and systemic risk management. Although determining how strategies were formulated is not a major goal of this paper, we provide some insight into the role of different actors in originating and formulating strategies. The origins of strategies are diverse, but good strategies often reflect the participation of major institutions involved in financial sector policy in one coordinated, consultative process.

To estimate the effect of financial sector strategies on financial sector outcomes, we control for several macroeconomic, social, and institutional factors commonly found in the literature (see Barajas et al. 2013; De la Torre, Feyen, and Ize 2013; De la Torre, Gozzi, and Schmukler 2007; Feyen, Lester, and Rocha 2011; and Yartey 2008). The set of macroeconomic indicators considered includes gross domestic product (GDP) per capita, GDP growth, the money market rate, inflation, and the change in exchange rate. To measure institutional development, we include the governance indicator developed by Kaufmann, Kraay, and Mastruzzi (2010) and the financial openness index of Chinn and Ito (2006). Socioeconomic indicators considered are the age dependency ratio and population density. A financial sector strategy is the highest-level policy document for the financial sector. Therefore, we do not include financial indicators as 3
independent variables in the estimation of the relationship between strategies and financial outcomes, because the development of financial sector indicators could have been directly influenced by the financial sector strategy. Because reforms can be implemented also in countries with no explicit financial sector strategies, we further analyze whether there is a direct connection between financial strategies and the evolution of financial policy reforms. To this end, we use several indicators compiled in the World Bank’s Doing Business database, including the distance to the frontier for getting credit, enforcing contracts, and resolving insolvency.

We find that the overall quality of financial sector strategies could be improved significantly. The strategies could pay greater attention to systemic risk associated with achieving the targeted development outcomes (financial depth, efficiency, and inclusion) as well as acknowledge and try to manage trade-offs in financial policy—particularly between the speed of financial development and systemic risk management. Financial sector strategies are more recent phenomena in ECA compared with East Asia and Pacific (EAP) or Latin America and the Caribbean (LAC). Nevertheless, ECA strategies do not address trade-offs between financial development and systemic risk management, and they fall behind EAP, LAC, and in particular Organization for Economic Co-operation and Development (OECD) economies in that respect.

Our regression analysis suggests that, overall, countries using financial sector strategies experienced stronger financial sector development over 1985–2014. Namely, the use of financial sector strategy was associated with increased financial deepening (the ratio of deposits to GDP), increased financial inclusion (deposit accounts per 1,000 adults), and reduced financial volatility (the standard deviation of deposits to GDP, and the output loss in case of banking crises). We did not find any significant effect of the strategies on financial efficiency (the ratio of overhead costs to income, or returns on bank assets). Interestingly, while the strategies significantly promoted the deepening and inclusion in bank deposits as well as the stability of deposit growth, they did 4
not significantly affect the deepening, inclusion, and stability of bank credit.

For deepening and inclusion in the use of deposits, as well as output losses during crises, we find that the quality of financial sector strategy could matter. However, the positive effect of having a quality strategy (its rating) is not greater than the positive effect of a simple strategy. One explanation could be that the proposed rating does not adequately consider or weight all relevant aspects of financial strategies for financial development.

Examining one possible transmission mechanism from strategies to financial sector outcomes, we find that using strategies has significantly improved the quality of regulatory policy. This result suggests that financial sector strategies could increase the deepening, inclusion and growth stability of bank deposits—as well as reduce output losses during crises— by improving the regulatory policy for getting credit, enforcing contracts, and resolving insolvencies, among others.

The remainder of the paper is organized as follows. Section 2 provides an overview of the financial sector strategies, how they were formulated, and an assessment of their quality. Section 3 presents the data and the model for the analysis of the effect of financial strategies on financial development. Section 4 discusses the estimation results, and section 5 concludes.

# **2. What has driven financial sector strategies and how can they be evaluated?**

# **2.a. Constructing a new database to assess financial sector strategies**

The database of financial strategies includes all published financial sector strategies for which implementation began by 2012.<sup>1</sup> Our primary sources were the websites of ministries of

> 1 That is, we consider the strategies that have been in place for at least two years.

5
finance, central banks, or financial sector supervisors. We contacted the country authorities if a strategy was not available on the Internet but was known to exist. We also included national development plans that contained comprehensive sections on financial sector development. Among the strategy documents, 39 are “financial sector development strategy” documents and 26 are “national development strategy” documents that include dedicated strategies for financial sector development.

Overall, we examined a sample of 150 countries around the world, with 42 of them having at least one financial sector strategy or a written plan for financial sector development. Of these 42 countries, 12 had two strategies (for example, Ghana had a four-year financial sector strategy starting in 2003 and a new six-year strategy starting in 2010) and three had three, so that a total of 60 documents were used in the analysis. The average implementation period of a strategy was about 5 years, with the minimum period 2 years and the maximum period 16 years.

The total number of strategies in place peaked around 2006–07 (Figure 1) and decreased substantially during the global crisis, when authorities likely focused more on crisis preparedness and resolution than on development strategies. At the same time, the lessons from the global crisis were only slowly emerging, as beliefs about finance were changing and new global regulation standards were being formulated. A smaller number of strategies were in place in 2012 because the implementation period for several finished in 2011, including strategies initiated during the crisis.

Whether financial sector strategies were originated independently by governments, or reflected the initiatives of international development organizations, has some bearing on our analysis. For example, if a strategy was formulated in the context of an International Monetary Fund (IMF) program, then subsequent changes in financial sector development may in part 6
reflect program requirements rather than strategy developed by the national authorities. Although it is difficult to account for this in our analysis, it appears that international organizations have played a role in the development of several strategies, although not necessarily in the context of an explicit program. Other strategies, however, reflect the initiative of national actors.

# **2.b. Tracing the origination of financial sector strategies**

Some early strategy documents resulted from the collaboration between national governments or central banks with international development organizations. For instance, Botswana’s 1989 _Financial Policies for Diversified Growth_ resulted from a collaborative effort between Botswana’s Ministry of Finance and Development Planning and the Bank of Botswana on one side, and the World Bank on the other side (World Bank 1989). Similarly, Madagascar’s 1993 financial strategy resulted from close collaboration between the Government of Madagascar and the World Bank (World Bank 1993). Cambodia’s “Financial Sector Blueprint for 2001–2010” was based on consultations between the national Financial Sector Steering Committee and the Asian Development Bank (ADB), which followed a preliminary financial sector “roadmap” drafted in 1999 by ADB at the request of the Cambodian government (Chun et al. 2001). The following 10-year financial sector strategy for Cambodia, which started in 2006, reflected the national effort to encourage a broader participatory approach involving stakeholders from the financial sector and consultations among line ministries, private sectors, and nongovernmental organizations. ADB, the International Monetary Fund (IMF), and the World Bank helped coordinate the consultations (Kingdom of Cambodia 2006).

Some recent strategies also benefitted from the support of international development organizations. Ghana’s 2003 Financial Sector Strategic Plan was supported by the U.S. Agency for International Development and benefitted from contributions of participants from the 7
financial sector, the private sector, and academia (Republic of Ghana 2003). However, the ensuing 2011 “Financial Sector Strategic Plan II,” outlined by the Ministry of Finance and Economic Planning, originated from the effort of more developed and capacitated national institutions and it was finalized after “extensive consultation with the regulatory agencies, financial institutions, and other public and private sector stakeholders” (Republic of Ghana 2011). Other examples include the African Development Bank’s support for the Arab Republic of Egypt’s “2006–10 Financial Sector Reform Programme” (African Development Bank 2012), the World Bank’s support for the Lao People’s Democratic Republic’s “Financial Institution Development Strategy 2009–20” (Governor of the Bank of Lao PDR 2006), and financial support provided by the multi-donor-funded Financial Sector Reform and Strengthening (FIRST) Initiative, and technical assistance from the German Development Cooperation for Sierra Leone’s “2009 Financial Sector Development Plan” (Bank of Sierra Leone 2009). The FIRST initiative also supported the development of Rwanda’s 2007 and 2012 strategies (Murgatroyd et al. 2007; Andrews et al. 2012).

Other developing countries prepared financial sector strategies after their participation in a Financial Sector Assessment Program (FSAP).<sup>2</sup> Burundi prepared its 2011–17 Financial Sector Strategy after the 2009 FSAP (Republic du Burundi 2010). Rwanda’s 2007 strategy is also based on the 2005 FSAP recommendations. Other strategies, for example by the National Bank of Georgia (2006) for the development of the banking sector over 2006–09, include among the featured tasks and goals the fulfillment of the recommendations of the FSAP. In other cases, for instance Ethiopia’s 2002 “Sustainable Development and Poverty Reduction Strategy”, the countries incorporated the recommendations from technical assistance by the IMF and World

> 2 The joint World Bank – IMF program provides countries with a comprehensive and in-depth analysis of their financial sector.

8
Bank (FDRE MOFED 2002).

On the other hand, many governments and central banks took the initiative to conduct consultations and prepare strategies for developing their financial sectors. Trinidad and Tobago’s Ministry of Finance (2001, 2004) prepared both the 2002 “Medium-Term Policy Framework” and the 2004 “Reform of the Financial System.” In 2004, Zambia’s Ministry of Finance and National Planning laid out the 2004–09 “Financial Sector Development Plan for Zambia” (Republic of Zambia 2004). In the Kyrgyz Republic, the 2006 and 2009 strategies were prepared by the central bank (National Bank of the Kyrgyz Republic 2011). Thailand’s Ministry of Finance and the Bank of Thailand designed the 2004 and 2010 “Financial Sector Master Plans I and II.” Turkey’s 2001 and 2010 Strategic Plans were formulated by the Banking Regulation and Supervision Agency (Banking Regulation and Supervision Agency 2001).

For some developed countries, the establishment of a particular institution was the trigger for laying down a strategic plan for future development of the financial sector. In Canada, the government established in 1996 the Task Force on the Future of the Canadian Financial Services Sector to provide advice on the future of the sector. After two years of study and consultations, the newly created institution proposed a number of measures to be implemented in a strategic document (Department of Finance Canada 1999). The global financial crisis prompted some countries to rethink the path for financial sector development. For instance, in Switzerland, the Federal Department of Finance in collaboration with the Swiss Financial Market Supervisory Authority and the Swiss National Bank formulated a set of objectives and strategic directions to strengthen the financial sector in the aftermath of the crisis (Federal Council of Switzerland 2009). In Ukraine, a program of reforms was developed by the working groups of the Economic Reform Committee (Committee on Economic Reforms under the President of Ukraine 2010).

9
Among the financial strategies in our database, 26 were part of national development strategies—comprehensive plans considering a wide area of development objectives. In Jordan, the financial strategy was included in the government’s “National Social and Economic Development Plan” for the years 2004–06. Similarly, the Governments of Uganda and Lesotho included objectives for financial sector development in Uganda’s “National Development Plan for 2010–14” and Lesotho’s “National Strategic Development Plan for 2002–16”. In Vietnam, the party congress laid out the strategy for socioeconomic development for 2001–10, while the State Bank of Vietnam formulated the 2011 “Banking Development Strategy.” In 2002, the Danish government adopted the “Danish Growth Reform Program” that also refers to financial sector areas that need strategic development. One important side benefit of developing the strategy was that the process brought together stakeholders involved in the financial sector for extensive consultations before and after the strategies were formulated.

Cambodia is a good example of how developing a strategy can trigger the needed policy dialogue. Although ADB played an important role in the formulation of the first financial sector strategy for Cambodia, the next strategy involved active contributions from key stakeholders in the financial sector. Ethiopia’s 2002 Sustainable Development and Poverty Reduction Strategy emphasizes that the document was prepared after conducting “extensive, transparent and inclusive consultations” (FDRE MOFED 2002). South Africa’s 2011 plan, “A Safer Financial Sector to Serve South Africa Better”, also highlights that the strategy is meant to be the “ [...] beginning of an important conversation with the society including all other stakeholders” (Republic of South Africa, National Treasury 2011). After China’s State Council approved _“_ The 12th Five-Year Plan for the Development and Reform of the Financial Industry” _,_ the People’s Bank of China conducted a series of surveys, organized expert seminars, solicited comments from the public, and carried out research on major issues regarding the development and reform 10
of the financial industry under the plan (People’s Bank of China et al. 2012).<sup>3</sup>

# **2.c. Assessing the quality of financial sector strategies**

The quality of financial sector strategies can be assessed on the basis of four categories of strategic objectives: financial development, systemic risk management, implementation arrangements, and policy trade-offs (Table 1 provides the rating criteria used, based on Maimbo and Melecky 2014).

Key evaluation criteria for the financial development objective are whether a strategy has clear and well-quantified objectives and whether it identifies tools to support its development goals. For instance, the financial strategy for Rwanda in 2007<sup>4</sup> states that “Rwanda seeks to develop a financial sector that is effective, in particular, by: (1) Expanding access to credit and financial services; (2) Enhancing savings mobilization, especially long-term savings; and (3) Mobilizing long-term capital for investment” (Murgatroyd et al. 2007). This description is clear, but it does not provide quantitative objectives or tools to achieve them. By contrast, to strengthen banks’ role in providing better access to financial services, Rwanda’s strategy quantifies the development objectives for the market shares and the pricing of bank products and supports them with one main action, namely the transformation of Union des Banques Populaires du Rwanda into a commercial bank, Banque Populaire du Rwanda.

Elements of an effective strategy to address systemic risk include: (a) the identification of potential risks, such as a significant increase in private sector indebtedness or imprudent behavior of financial institutions that could lay the foundations for instability; and (b)

> 3 China’s 12th five-year plan for the development and reform of the financial industry.

> 4 A FIRST initiative-funded team was recruited and prepared the Rwanda financial sector development strategy under the guidance of the central bank (BNR) and working closely with a national steering committee composed of key stakeholders in each of the areas addressed by the FSDP.

11
specification of an adequate set of measures or tools for mitigating and managing such risks. For instance, the 10-year financial sector strategy for Cambodia acknowledges that unsafe banking can lead to a systemic financial crisis, emphasizes the need for financial regulation and supervision to avoid future crises, and recognizes that rapid financial liberalization in the absence of appropriate sequencing and development of the legal and regulatory framework can increase the likelihood of crises. The strategy, initiated in 2011 by the Royal Government of Cambodia, states that “a crisis management framework will need to be established and will require periodic testing to ensure it fits the local economic and financial situation as well as designed to address increasing interconnections and new risks within the financial sector” (Kingdom of Cambodia 2011).

The quality of a strategy is also assessed on the basis of its plan for implementation of the strategy and the coordination mechanism that will be used, and whether the strategy assigns responsibilities and has a clear time frame for implementing both the development goals and systemic risk management. For instance, the 2006–09 strategy to develop the Georgian banking system sets 58 development actions with corresponding time frames for implementation (National Bank of Georgia 2006). In addition, the strategy declares that the National Bank of Georgia considers close cooperation with international financial institutions as one priority for successful implementation of the adopted strategy. Finally, an effective strategy should acknowledge, and have plans to address, the trade-off between development goals and systemic risks. In particular, strategies should recognize that overambitious development involves excessive risk-taking by the financial system. And conversely, that imposing more stringent requirements on bank capital adequacy and additional capital charges to reduce macroprudential and systemic risk could hinder banking sector development.

The strategy index assigns equal weights to each of the nine criteria that are assessed as fully 12
or largely met (scored 1) or not met (scored 0). The resulting total score is the overall index of the strategy. The median of the strategy index for our sample is 4.0, with a standard deviation of 2. On average, strategies focus more on development than on systemic risk—the median development index (including implementation of the development objective) is 3.05 whereas the median systemic risk index (including implementation of the systemic risk objective) is 1.15. Figure 2 shows the evolution of the subindexes for financial development and for systemic risk management separately across all strategies in our sample. Only 10 strategies focus on the tradeoff between development and systemic risk.<sup>5</sup> Figure 3 illustrates the country distributions of the overall index, development subindex, systemic risk subindex, and the trade-off subindex.

Most often the strategies were rated 3 on our 0–9 scale (Figure 3), so that the strategies of many countries are considered of a low quality. However, 13 strategies were rated around 6, which is above the midpoint of our scale. There is only one strategy (for Switzerland) in the database rated with the maximum index of 9. The ratings of the subindexes help to explain the poor results for the overall rating. Whereas more than 55 strategies focus on financial development outcomes and receive a rating of 3 or 4 on the development index, only 18 strategies have a subindex of 3 or 4 for systemic risk. Moreover, only 10 strategies have focused on the trade-offs between financial development and systemic risk management. Finally, although this cannot be seen in the distributions given in figure 3, most strategies lack measurable goals that would strengthen the ability to monitor their implementation and help increase accountability for results.

Figure 4 shows that ECA countries, followed by EAP and OECD economies, have the

> 5 Possibly, policy makers could intentionally disregard trade-offs in favor of synergies that they aim to achieve, for example, by advancing financial inclusion in deposits and diversifying the funding base of banks to make them more resilient (Han and Melecky, 2015). However, neglecting trade-offs, especially in developing credit markets, and hoping only for synergies may result in unbalanced strategies with unintended consequences for systemic risk.

13
highest scores on the overall index for financial sector strategies—that is, ECA leads on the quality of its strategies. This result is mainly due to the high scores that ECA achieves on the development index, including using measurable goals for development targets, and on the systemic risk index because of its much greater focus on financial stability. However, ECA scores very badly when it comes to considering trade-offs, for the most part disregarding tradeoffs between the returns from fast financial development and the risk of occasional financial crises.

# **3. How can we use reduce-form regressions to assess the impact of strategies?**

# **3.a. Using financial sector outcomes as dependent variables**

This section provides an estimate of the effect of the strategies on financial sector outcomes, as measured by indicators of financial depth, inclusion, efficiency, and stability. We focus on the measures that have been used in the literature and have good data coverage, so the maximum number of countries can be included: (i) To measure financial _depth_ , we use the change in the logarithm (the percentage change) of the deposit-to-GDP ratio and the ratio of private credit to GDP. These ratios are often used as measures of financial depth (Panizza 2014). The change in logarithm is used to control for possible trends and the impact of the initial level of an indicator to better isolate the effect on financial deepening due to the strategies.

(ii) To measure financial _inclusion_ , we use the logarithm of total number of deposit accounts per 1,000 adults and the logarithm of the total number of borrowers per 1,000 adults. The two indicators have annual data available since 2004, and thus offer a better coverage compared with 14
other measures of financial inclusion such as those from the Global Findex.

(iii) To measure financial _efficiency_ , we use the logarithm of the ratio of overhead costs to income (Bikker 2010), and a profitability indicator—the return on assets (ROA) ratio.<sup>6</sup> (iv) To measure financial stability, we use the volatility of the change in the logarithm of the deposits-to-GDP ratio and the credit-to-GDP ratio (volatility is measured by a moving five-year standard deviation for each of the two variables).<sup>7</sup> In addition, we use an alternative measure of financial stability, the output loss during banking crises computed by Laeven and Valencia (2013), to determine if our results are greatly affected by the particular measure used to represent stability.<sup>8</sup> Figure 5 illustrates the evolution of financial sector development indicators.

# **3.b. Describing the regression model and estimation methodology**

The estimations of whether financial sector strategies have had a meaningful effect on financial development are based on annual data for 150 countries over 1985-2014. Figures 6 (deposits to GDP ratio), 7 (overhead costs to income ratio), and 8 (volatility of the change in the private credit to GDP ratio) show that initiation of a strategy was associated with an improvement in financial development variables in several countries.

To determine whether the apparent improvement in financial development is significantly related to initiation of a strategy, we use FE regression analysis to estimate the relationship between financial sector development and indicators of the existence and quality of a strategy,

> 6 We prefer these two measures over the net-interest-margin and lending-deposit rate spread because they are less controversial. An increase/decrease in the net interest margin can signal a rise or a fall in efficiency, depending on country circumstances. The same applies for the lending-deposit rate spread, as its evolution can be heavily influenced by changes in monetary policy.

> 7 The volatility at time _t_ is measured as the standard deviation of the variable for the [t-2, t+2] time period.

> 8 This is computed as the cumulative sum of the differences between actual and trend real GDP, expressed as a percentage of trend real GDP, over the period [T, t+3] where T is the start of the crisis.

15
<!-- Start of picture text --> Financial development indicator; = Financial strategy indicator;, +<br>» Macroeconomic indicator; + ¥ Socioeconomic indicator;, + }; Time dummies, + a; +<br>Uit<br>Qj U it<br><!-- End of picture text -->
previously discussed) during the strategy’s implementation period and 0 otherwise. The _index strategy_ for Mozambique has the value of 3 during 2001–05, 7 during 2010–13, and 0 otherwise.

(ii) The _shift_ variables measure the effects of strategies on financial development that may extend beyond the implementation period for the strategy. We do this by extending the nonzero values of the _impulse_ variables (both the _dummy strategy_ and the _index strategy_ ) over time until the implementation period of the next strategy, or until 2013 if no strategy follows in our sample. For instance, Denmark had a strategy during 2002–10, and the _dummy strategy_ indicator for the _shift_ variable takes the value of 1 from 2002 until 2013. We run separate regressions for all _impulse_ and _shift_ strategy variables.

We control for the impact on financial outcomes of several macroeconomic, institutional, demographic and social factors commonly found in the literature. The macroeconomic factors include GDP per capita, GDP growth, the interest rate, inflation, and the change in the exchange rate (De la Torre et al., 2007; and Barajas et al., 2013; Feyen et al., 2011). The set of institutional variables includes indicators of governance and financial openness. The governance indicator is the updated indicator of governance by Kaufman et al. (2010)<sup>11</sup> that measures the quality of the institutions and the legal and regulatory environment—all of which affect financial sector outcomes (Barajas et al., 2013; Feyen et al., 2011; Yartey, 2008). The financial openness indicator is the updated indicator by Chinn and Ito (2006) that measures the extent of regulatory controls over current or capital account transactions, the existence of multiple exchange rates, and the requirements of surrendering export proceeds. The socio-economic indicators considered are the age dependency ratio and population density.<sup>12</sup> The last two indicators are used as control variables

> 11 We consider the average of the six indices estimated by Kaufman et al. (2010) regarding the control of corruption, government effectiveness, political stability, regulatory stability, rule of law and voice and accountability. 12 Initially, we considered life expectancy and education level as well, but realized that these are highly correlated with the level of development measured by GDP per capita. For that reason, we dropped them.

17
when relevant, namely, in regressions for financial depth, inclusion and efficiency. The population density should have a positive effect, and the age dependency a negative effect, on financial depth and inclusion (De la Torre et al., 2013).<sup>13</sup> The possibility that the strategy indicator is endogenous, that is, in part affected by the dependent variable of financial development, is a concern for the estimation of the regression model. The level of financial development could influence the emergence of a strategy and its quality, although it is unclear whether lower or higher financial sector development would trigger the preparation of a financial sector strategy. As discussed in 2.a, the reason for initiating a strategy differed greatly across countries. Strategies have arisen from a close collaboration of countries with international development organizations, for example following recommendations from the Financial Sector Assessment Program, or may have been a reaction to measures taken after the global financial crisis, or may have primarily reflected the initiatives of governments and central banks to signal their commitment to give a financial sector a greater push and direction for development. The very diverse origins of the financial sector strategies, together with our several unsuccessful attempts to find a relevant instrument (FSAPs, Development Assistance—including FIRST, governance, economic freedom, distance to countries having a strategy) motivate our rationale for treating the strategies as a weakly exogenous variable in our regression model. The other approach employed to address this problem is to use the lagged value of the strategy variable in the analysis, rather than the concurrent value.

We also briefly examine the mechanisms through which the strategies worked. Namely, we examine whether they led to implementation of broad-based regulatory reforms. Ideally, we would like to determine whether the implementation plan for each strategy, including deployment of tools

> 13 GDP per capita and population density are expressed in logarithms.

18
and measures, was followed. But we are unable to do this analysis because of data limitations, especially on earlier strategies. Instead, we analyze whether the strategies in our sample have an impact on the development of regulatory policy, while including as many strategies as possible in the analysis. The quantitative analysis of the impact of strategies on regulatory reforms focuses on three indicators from the World Bank’s Doing Business (DB) database that are relevant for financial sector development: getting credit, enforcing contracts, and resolving insolvency. The coverage of the DB database starts in 2004, so this part of the analysis considers a more limited period than in our extensive historical database on strategies. Nevertheless, this exercise can provide some insight into whether the more recent strategies have affected the implementation of regulatory policies in the financial sector.

# **4. What do the estimation results suggest?**

# **4.a. Strategies help increase financial depth**

Financial deepening, particularly the ratio of deposits to GDP, is positively affected by the presence and the quality of a strategy. The coefficients of all four strategy variables (the _dummy_ and _index_ strategy indicators for both the _impulse_ and _shift_ variables—see above) are significant and positively related to the change in the deposits-to-GDP ratio (Table 2), thus showing that the presence and quality of a strategy have an important impact on financial deepening. The estimated relationships between our four strategy indicators and the change in the credit-to-GDP ratio are positive, but the coefficients are not significantly different from zero. One possible explanation is that the ratio of credit to GDP is an ambiguous measure of sustainable financial deepening because it also can be a predictor of crises, and in particular a rise in credit to GDP from an already high level can increase instability. Also, increases in credit-to-GDP ratios can 19
have opposite effects on growth in the short run and the long run (Loayza and Ranciere 2006; Arcand, Berkes, and Panizza 2012; and Ranciere, Tornell, and Westermann 2008).

Most of the control variables also have important effects on financial development. Governance has a positive effect on financial depth, highlighting the importance of strong institutions for supporting the provision of, and demand for, financial services. GDP growth is negatively associated to the growth in deposits to GDP as well as credit to GDP, which suggests that deposits as well as credit grew, in general, at a slower pace than GDP. One possible explanation of these estimated effects is that higher GDP growth is associated with higher returns on investment, which means that individuals and firms are more likely to invest than to place their assets in low-return bank deposits. Furthermore, inflation can slow the rise in credit compared to GDP because of the uncertainty associated with it. High inflation and price uncertainty increase the risk that the value of bank deposits will decline in real terms, which encourages individuals and firms to hold real assets (for example, durable goods). Both depth variables are also positively associated with population density and negatively associated with the age dependency ratio. Finally, the level of development is negatively correlated with financial deepening, with less-developed countries experiencing more rapid increases in financial depth. The coefficients of time dummies indicate structural changes in some of the years: the 2007 year dummy impacted positively the change in deposits to GDP, while the 2011 dummy marked a negative change as a result of the financial crisis. The coefficients of the 2005-2008 time dummies are significant and positive in explaining the changes in credit to GPD, with the largest effect displayed in the year 2008. The year 2010, on the other hand, marked a negative impact of this depth variable.

# **4.b. Strategies can improve some aspects of financial inclusion**

20
The use and quality of financial sector strategies tend to increase financial inclusion, as measured by the total number of deposit accounts; and this effect persists beyond the implementation period for the strategy. However, strategies do not appear to have a significant effect on the number of borrowers. Table 3 displays the results of the regressions in which the dependent variables are the number of deposit accounts per 1,000 adults and of borrowers per 1,000 adults (both variables in logarithms). The data coverage for the two variables is different; hence the results are not fully comparable.

The levels of development, governance, and population density have positive effects on both financial inclusion indicators. Changes in the exchange rate tend to increase the number of borrowers as well as of deposit accounts. The depreciation of the local currency can make people open accounts in foreign currency. At the same time, the depreciation can give people incentive to substitute future consumption for current consumption of durable goods and hence make them borrow relatively more in the present. GDP growth is negatively correlated with financial inclusion. One explanation could be that richer countries with greater levels of financial inclusion may have experienced lower growth on average. Finally, a higher age dependency ratio significantly increases the number of deposit accounts among the adult population. The coefficients of time dummies are not significant, indicating no structural change in financial inclusion during the 2004-13 period.

# **4.c. Strategies do not appear to have an important impact on the efficiency of financial**

# **systems**

Neither the presence of a strategy nor its quality has a significant impact on bank efficiency, as measured by the ratio of overhead costs to income and the return on assets (Table 4). One possible explanation is that strategies have so far lacked specific measures focused on reducing 21
banks’ operational costs or raising profitability.

The control variables have various effects on efficiency. As anticipated, GDP growth helps decrease cost inefficiencies and increase bank profitability. The size of overhead costs in relation to income is positively associated with the change in the exchange rate. Local currency depreciation can erode profitability by increasing the cost of credit and of debt financing. Finally, bank profitability is negatively associated with the interest rate, indicating that banks may not be able to pass the increased cost of financing on to borrowers, in particular in a more competitive banking sector. The conditions during the years 2000 and 2001 seem to have influenced positively the bank profitability.

# **4.d. Strategies can improve financial stability**

Table 5 shows the results of the regressions with the volatility of the changes in the credit-toGDP ratio and in the deposits-to-GDP ratio as dependent variables (columns (1)-(8)). The results suggest that financial sector strategies can foster financial stability by helping to reduce the volatility of financial cycles.<sup>14</sup> The presence of a strategy (the dummy strategy indicator) and the quality of the strategy (the index strategy indicator) significantly reduce the volatility of deposits to GDP, but only during the implementation period of the strategy (the impulse variables previously defined). Simply, the presence of a strategy may help reduce volatility by improving financial sector participants’ ability to understand and anticipate, and thus act upon, authorities’ financial sector policies. By contrast, the estimated relationships between the strategy variables and the volatility of changes in credit to GDP are not significantly different from zero.

> 14 Both variables are expressed as the change in the logarithmic value.

22
Columns (9)-(12) show that countries with financial sector strategies are less vulnerable to banking crises or experience lower output losses from banking crises. More comprehensive strategies can reduce the cost of financial crises even further. For instance, a country that was hit by a banking crisis and did not have a strategy suffered on average some 23% GDP loss,<sup>15</sup> but had it used a quality strategy with a rating of 9 (the maximum in our sample), the loss would be almost halved (-1.011*9 = -9.099 percentage point of GDP).

The coefficients on the control variables provide interesting insights into the effect of macroeconomic and institutional variables on stability. Good governance can help reduce the volatility of both variables, whereas financial openness is associated with lower volatility only of deposits to GDP. High inflation as well as interest rates can increase the volatility of credit to GDP.

Time dummies signal year-specific effects across the countries in our panel. All time dummies are positive and significant in the regression that explains the volatility of credit to GDP, with the years 2000-2003 displaying the largest effects, while for the volatility of deposits to GDP only the 2007-2011 dummies positively have affected the volatility, very likely due to the conditions during the financial crisis.

# **4.e. The impact of strategies can partly work through improvements in the regulatory framework**

Table 6 presents the results of regressions that measure the effect of strategies on the quality of regulatory policies governing finance (each regression relates one strategy indicator to one regulatory indicator). We use the distance to the frontier DTF<sup>16</sup> measure for the three regulatory

> 15 Median output loss during banking crises calculated using Laeven and Valancia (2013) data set. The corresponding average output loss is about 30.1% of GDP.

> 16 An economy’s distance to the frontier is the difference between a financial sector outcome for that economy and

23
frameworks. The _shift_ variables for both the existence and the quality of a strategy have a significant and positive impact on the quality of the regulatory framework for getting credit. Moreover, the _shift_ variable for the existence of a strategy is also positively associated with the regulatory framework for resolving insolvency and enforcing contracts.

Overall, if we consider the potential for strategies to affect the financial regulatory framework beyond their implementation period, the strategies appear to help significantly improve the regulatory framework for getting credit, resolving insolvency, and enforcing contracts. This could be one transmission mechanism through which the use of strategies can help improve the ultimate financial outcomes (depth, inclusion, efficiency, stability).

As discussed previously, one issue is whether financial strategies affect financial development only by improving the regulatory framework. To examine this, we include indicators of regulatory reform (instead of the strategy variables) as independent variables in our main regression model explaining financial outcomes. In a few cases, regulatory reform variables have a significant impact on financial outcomes, in the expected direction: the DTF for enforcing contracts has a significant impact on financial depth, and the DTF for resolving insolvency is significant in the regressions for efficiency and stability. In the remaining regressions, however, the regulatory variables lack significance.

These results suggest that, although the strategies could improve financial sector outcomes by improving regulations, there could be additional channels through which the positive impact of strategies on financial development works. One possibility is through the positive effect of the strategies on overall coordination of financial policy, for instance, across the central bank,

> the outcome of the most successful economies. The distance to the frontier is measured on a scale from 0 to 100, where 0 represents the lowest performance and 100 represents the frontier.

24
ministry of finance, and other financial sector regulators. Another way that strategies could have a direct positive impact on financial development is by reducing uncertainty: private sector financial institutions, firms, and individuals can improve their planning because they gain a better understanding of policy intentions.

# **5. Conclusion**

Our review of the origination of strategies reveals that, although the preparations of early strategies were often supported by international development organizations, in many cases government institutions, including the central bank, took the initiative to consult public and private entities involved in the financial sector and formulate the national financial sector strategy. The number of adopted strategies around the world peaked around 2006–07 and then decreased substantially during the global financial crisis. One possible explanation is that during the crisis period countries focused more on crisis preparedness and resolution and other shortterm issues, rather than on medium-term strategies. However, as summarized below, using financial sector strategy can help countries avoid banking crises or reduce the loss from banking crises.

Our assessment suggests that overall the quality of strategies could be improved substantially. The strategies could pay greater attention to the systemic risk associated with advancing financial depth, efficiency, or inclusion, as well as acknowledge and try to manage various policy trade-offs—in particular, those that can arise between the efforts to speed up financial development and foster financial stability.

The estimation results show that financial sector strategies support financial sector deepening, inclusion, and stability, and more so if the strategies are of a better quality. This 25
effect is more evident when assuming the impact of the strategy on financial outcomes continues beyond the implementation period for the strategy. We do not find any significant effect of the strategies on cost efficiency and profitability of banks.

Examining one potential transmission channel from strategies to financial outcomes, we find that the strategies can significantly improve the regulatory framework for getting credit, resolving insolvency, and enforcing contracts. The analysis also indicates that the strategies’ positive impact on financial development is not limited to their role in improving the regulatory framework. Other ways in which strategies may improve financial development are through improving coordination of financial policy and reducing policy uncertainty for the private financial and real sectors.

Our preliminary results should encourage a greater number of countries to use financial sector strategies to plan, communicate, and coordinate their financial sector policies. However, the quality of strategies needs to improve across all countries, as the average rating of the quality of strategies is low. Only a few high-quality strategies, such as those for Malaysia and Switzerland, can serve as role models for other countries in their efforts to deploy financial strategies effectively.

26