Leopard about to change its spots? IFIs debate role of financial sector

20 November 2009

The financial crisis has divided perceptions within the IFIs about the role of the financial sector in development. While some parts of the World Bank and IMF highlight the merits of small banks, others continue to push globalised finance.

An article by World Bank chief economist Justin Lin in The Economist in June stirred the waters, arguing that East Asian countries were successful in avoiding financial crises because “they adhered to simple banking systems (rather than rushing to develop their stock markets and integrate into international financial networks).” He insisted that, “gigantic banks are not the way to go” and “smaller domestic banks are much better suited to providing finance to the small businesses that dominate the manufacturing, farming and services sectors in developing countries. There is evidence to suggest that growth is faster in countries where these kinds of banks have larger market shares, in part because of improved financing for just these kind of enterprises.”

In sharp contrast, World Bank researchers Asli Demirgüç-Kunt, George Clarke, and Robert Cull, have made a career of using cross-country regression and microeconomic research about bank efficiency to justify the view, often pushed through World Bank and IMF conditionality and advice, that foreign banks should be allowed to operate in developing countries and that the public sector should divest itself of bank ownership. In a speech in London in October Lin was careful to avoid overtly saying that foreign banks should be excluded from developing countries.

moderating and where necessary rolling back the globalisation of finance would be essential for both growth and stability of the global economy

The Growth Commission, a high-powered group of academics and developing country policy makers partially funded by the World Bank (see Update 61, 51), entered the debate in early October. The commission, which is chaired by economist Michael Spence, includes Danny Leipziger, former World Bank vice president and head of the Bank’s poverty reduction and economic management team. Its forthcoming special report on the crisis, which was discussed in Istanbul, is expected to argue that developing countries should ensure that some banks remain domestically owned, going expressly against decades of advice from the IMF and the private sector development department of the Bank.

Dr YV Reddy, the former governor of the Reserve Bank of India, expressed the view of some emerging market policy makers when he told a G20 counter conference in London in early November that the assumed benefits of financial globalisation are questionable, adding that “moderating and where necessary rolling back the globalisation of finance would be essential for both growth and stability of the global economy.”

IFC’s toxic plan

The World Bank’s private sector arm, the International Financial Corporation (IFC), seems intent on introducing complexities into developing country financial systems rather than following Lin’s call for smiplicity. More than one-quarter of outstanding IFC investment, a total of more than $12 billion, has been channelled through financial intermediaries — traditionally banks, but increasingly unregulated and opaque investment vehicles such as private equity funds and hedge funds (see Update 66). This puts the IFC at odds with the increased transparency promised by the World Bank (see Update 68) and the G20’s calls for more transparent finance.

Through its new Debt and Asset Recovery Program (DARP), announced in early October, the IFC will invest $1.55 billion into a fund, which it hopes will attract a further $5 billion in private capital. That fund will then invest “directly in businesses that need to restructure debt and in pools of distressed assets and indirectly via investment funds targeting pools of distressed assets and companies.” The programme will channel money to hedge funds and private equity groups that focus on Europe and Central Asia, Latin America and the Caribbean, and East Asia.

The summary of the proposed investment, produced in May, claimed that “the development impact of well-structured distressed asset transactions is well recognised,” including stating that this would lead to “transparency in balance sheets as the true value of distressed assets is determined by market value paid by the buyers of [non-performing loans].” However these concepts have been hotly disputed in the United States, where a similar domestic programme was established underneath the umbrella of the Troubled Asset Relief Programme (TARP).

The Congressional Oversight Panel, an independent body appointed by the legislature to monitor the TARP, has issued numerous reports criticising the design of the programme, which funds private actors to purchase troubled assets with public money. In an August report the panel wrote “one barrier to the success of the [programme] is a simple lack of information. There remains only fragmentary knowledge about the size of the supply pool for legacy securities because there is little or no transparency in the troubled asset markets. … The question is whether steps could be taken to increase the level of information about troubled assets on bank balance sheets, to facilitate the success of the legacy loan and securities programs, without creating a risk of market instability.”

Effective design would be even more complicated at the international level where there is no global regulatory body to force publication of detailed information about the underlying assets, making true valuations of the distressed assets unlikely. The assets are expected to be bought at fire sale prices, meaning the IFC, hedge funds and private equity vehicles will be making profits from developing country companies and banks that have been damaged as a result of a financial crisis that began in the US.

The debt movement has had success in fighting so-called vulture funds, investment funds that buy up the sovereign debt of developing countries at discounted prices and then press for full payment of the debt. Now, the IFC programme will help a different kind of vulture fund that buys up private sector and household debt in developing countries. Sargon Nissan, of the UK-based new economics foundation, likens these distressed asset investors to loan-sharks. “While some will justify this on the grounds that businesses and people in developing countries need to restructure their debts, the real question is, at what cost? This is especially important to ask when their financial distress was caused by bad policies in the US and made worse by pro-cyclical IMF policies in response to the crisis.”

Mixed ideas on public banks

The lack of uniform thinking on the banking sector in IFIs is evident in recent loans. The IMF loan to Belarus (see Update 63) included conditions on fully or partially privatising state-owned banks, as did the 2009 Fund loan to Togo. In Latvia and Sri Lanka, the IMF is requiring governments to begin selling rescued banks back to the private sector.

On the other hand, the IMF loan to Ukraine (see Update 68) included provisions for strengthening the stability of state banks, without reference to privatisation. A $2 billion World Bank loan for capital injections into public sector banks in India was finalised in October, with no mention of privatisation. There seems to have been no attempt by the IFIs to force these countries to privatise their banks, which had been the IMF response to the need for capital injections into banks in East and Southeast Asia at the time of the Asian Financial Crisis.

Worrying, though, is the World Bank’s continued work on financialising developing countries. For example, a $300 million loan to Egypt, approved in June, aims to reduce public spending on housing, and instead expand the role of private mortgage finance with government subsidies. Similar policies ultimately fuelled speculative housing bubbles in Eastern Europe (see Update 63) that burst in the financial crisis, causing enormous economic damage.

In a candid moment at a seminar in Istanbul, IMF staffer Tam Bayoumi admitted that, whereas in the past the Fund had just accepted the common wisdom that rich countries were well regulated, as a result of the financial crisis, the IFIs’ approach to the financial sector and regulation would have to change. Lin’s thinking on the financial sector may open the first cracks in Bank support for unfettered financial globalisation.