The launch of the World Bank’s new annual study, the Global Financial Development Report 2013 (GFDR), and an IMF conference on financial crises, both in September, have renewed scrutiny of the Bank and the IMF’s support for the development of private sector financial systems and the role their policy advice played in the global financial crisis.
The debate over whether it was valid for IFIs to champion private capital markets and discourage state involvement in lending and investment (see Update 80) is the motivation for the report, as the Bank staffer and GFDR project director Asli Demirguç-Künt explained: “the crisis has prompted many people to reassess state interventions in financial systems … It is important to use the crisis experience to examine what went wrong and how to fix it.”
Imposing “speed limits”
The report sets out to comprehensively assess the role of the state in finance. Noting the bailouts by developed countries of their private financial sectors, the report acknowledges the “sound economic reasons” for the state to play an active role in financial systems. However, it cautioned that the long-term benefit of bailouts may be compromised given that the track record of state-owned banks is “unimpressive”, adding that one should be “wary” of “too active a role” for the state. It concludes that the state’s role should be to ensure “strong supervision, healthy competition, [and] enhanced financial infrastructure”.
In a blog post introducing the report, Demirguç-Künt employs the analogy of the financial system as a “highway”; and that government intervention should be akin to the imposition of speed limits. The report itself argued that “if the state does not have the capacity to monitor and police such complex [finance sector] rules, the likely result is more speeding and more crashes”.
The report findings reflect the Bank’s history of advocating reforms of financial structure in order to support economic development, which were criticised in 2007 by an independent panel of experts (see Update 54).
Paulo dos Santos, an economist at the University of London, stated that “the report does raise the important question of what governance mechanisms and incentive structures could help state banks deliver on their mandates, but finds that the necessary oversight is ‘challenging, particularly in weak institutional environments’. While presenting this assessment as a ‘main message’, the report provides neither evidence in its support, nor any discussion of how institutions like the Bank could help improve the institutional environments in state banks.”
Dos Santos added that, "instead of offering an open, self-critical reassessment in light of the events of the last four years, the GFDR is in effect a rearguard action seeking to defend old policy shibboleths, published by an institution that spent much of the past twenty years promoting the virtues of ‘sophisticated’ banks like Citi and HSBC, and their ‘advanced’ financial practices, against state involvement in banking markets”.
The panel’s assessment of the Bank’s work on financial structure and economic development was particularly critical. University of Chicago economist Marianne Bertrand, a panel member, rated half of the research quality indicators as “below average”. These included the “extent to which conclusions are based on analytic evidence” and “appropriateness of the recommendations”. Also rated below average was the extent to which research increased knowledge and understanding, provided a sound basis for policy and its likely impact on government policy. The evaluation particularly criticised the financial market policy recommendations as predicated on methodologies which had “serious limitations”, and the policy takeaways of research on financial structure were found to be “often quite limited due to obvious interpretational issues”.
More of the same from the Fund?
The IMF’s position on financial markets and the role of the state has also been recently re-examined. The 2011 Triennial Surveillance Review (see Update 78) called on the Fund to better account for the interplay of financial stability with financial deepening, the increasing efficiency of the financial sector and improved provision of financial products which the Fund has long championed (see Updates 68, 63).
In April, an IMF paper prepared by an interdepartmental team in direct response to the review accepted that “deepening is related to crisis incidence, with rapid, insufficiently supervised liberalisation associated with higher crisis risks”. Nevertheless, it concluded that enhanced competition, improved market infrastructure and limiting intrusive public sector interventions would benefit developing countries’ development. Furthermore, a June working paper by Jean-Louis Arcand, Enrico Berkes and Ugo Panizza on the relation of financial depth and economic growth found evidence that “there can indeed be ‘too much’ finance”, cautioning that policy prescriptions fostering financial deepening may be counter-productive because larger financial sectors are not necessarily beneficial for economic growth.
Policy advice from the Fund has largely been consistent with increasing reliance on capital markets to generate investment, and advocating financial deepening. In September, the head of the IMF mission to India Laura Papi urged further liberalisation of investment rules. An IMF study on China, published in November 2011, called for the end of state controls on banking, the liberalisation of interest rates and the concession of greater control over lending and risk management to banks themselves. One of the report authors, Jonathan Fiechter, told the New York Times that China should allow “banks to operate according to market forces” and to “take the training wheels off and let the banking system work”.
The August 2012 Financial System Stability Assessment for Tunisia highlighted two key issues. It argued that Tunisia should “revisit the rationale for and the modes of state intervention”, calling into question the continued role for public banks. It also described the reliance on bank finance in Tunisia as a “key constraint” given the limited role capital markets play in mobilising savings to finance the real economy. Moreover it proposed a comprehensive capital market reform to support long-term investment.