BANKING INTERMEDIATION AND ITS IMPLICATIONS FOR

MONETARY POLICY

Joseph E. StiglitzBali, December 2004

OUTLINE

The importance of banks The incentives for disintermediation Consequences of disintermediation Leveling the playing field

THE IMPORTANCE OF FINANCE

Finance—banks and capital markets are like the brain of the economy- They gather, process, and disseminate

information- On the basis of which scarce capital is

allocated How well they perform their task has

much to do with how well the economy performs overall

THE IMPORTANCE OF BANKS

Even in developed countries, most finance (other than self-finance) is in the form of debt- Explained by information asymmetries which

limit the role of equity markets- Limitations even greater in developing

countries Banks are the major source of funding for

investments in small and medium enterprises- Especially important in developing countries

SOURCE OF FUNDING

Brazil 2.72% 1.53% 2.14% 93.61%Chile 2.63% 7.49% 4.73% 85.14%Czech Republic 4.20% 3.93% 1.14% 90.74%India 2.19% 0.50% 1.11% 96.20%Indonesia -2.64% 3.50% -0.83% 99.98%Kazakhstan -2.36% 11.88% -1.20% 91.67%Malaysia 0.27% 4.02% 0.00% 95.72%Mexico 3.66% 1.40% 3.38% 91.56%Philippines 1.06% -0.17% -0.04% 99.16%Poland 3.54% 1.86% 8.56% 86.04%Thailand 15.29% -3.28% 6.55% 81.44%

New Equity/Gross

Capital Formation

Bank Loan/Gross

Capital Formation

Bond/Gross

Capital Formation

Internal Sources/Gross Capital

Formation

Gross Capital Formation By Source in Select Countries (Average: 1991-2003)

Clearly most of the capital formation is financed through retained earnings!Equity is relatively small in all countries except ThailandOnly in Poland and Thailand is bond financing substantial

Source: Compiled from WDI data

SOURCE OF FUNDING

Change in Source of Funding in Select Countries (Un-weighted Average of 11 countries – Brazil, Chile, Czech Republic, India, Indonesia, Kazakhstan, Malaysia, Mexico, Philippines, Poland and Thailand):

1990 2002

1.66% -0.05%

2.10% 3.70%

0.40% 3.66%

New Equity/Gross Capital

Formation

Bank Loan/Gross Capital

Formation

Bond/Gross Capital

Formation

Source: Compiled from WDI data

WHY BANKS? Allocating resources—determining credit

worthiness—is information intensive Real market failures in information in

securities markets- Problems of appropriability

• In efficient markets, all information is efficiently transmitted through prices• Grossman-Stiglitz showed that markets could not be

fully efficient• Confirmed by empirical evidence• Still, there is important ‘free rider’ problem—others

benefiting from investments in information• Securities markets often ‘free ride’ off of banks

- Bonds will only be issued if firm has good credit line

Problems of conflict of interest• Analysts paid by investment banks• Who compete for business of issuers of securities• So evident in U.S. during the roaring 90s• Contributed to bubble:

– Which resulted in massive misallocation of resources during boom

– And massive wastage of resources in inevitable bust that followed

» Estimated cumulative gap between actual and potential output 2001-2004 $1.7 trillion

CONFLICT OF INTEREST

FURTHER ADVANTAGES OF BANKS

Greater information allows better adjustment to cyclical conditions- Distinguishing between firms that are

temporarily in trouble and those that have more long run problem

- More counter-cyclical lending than provided by capital markets

- Equity dependent firms may be more sensitive to equity prices, which are highly volatile

Monitoring– Key to ensuring economic efficiency– Banks are central part of corporate governance

• Check on management• More effective than shareholders when shares are

widely dispersed (free rider problem—all shareholders benefit when company is well managed)

– But can be undermined when there are too close links between corporations and banks or between commercial and investment banks (one of justifications of Glass-Steagall Act in U.S.)

• Again, problems manifested in U.S. during roaring 90s

FURTHER ADVANTAGES OF BANKS

FURTHER ADVANTAGES OF BANKS

Countries with good banking systems have had faster economic growth Portugal and Ireland But bad lending practices may hinder growth

Importance of local information– Reason for restrictions on national banks in U.S.– Criticism of financial market liberalization in

developing countries• International banks often less interested in lending to

small and medium size firm

– Regions in U.S. with weak banking system have not done as well as those with strong banking

FURTHER ADVANTAGES OF BANKS

Banks play central role in economic stabilization– Major channel of monetary policy is

availability of credit to small and medium size enterprises

– Probably much more important than effect of real interest rates

– If banking base is narrow, then impact of monetary authorities is more narrow• Monetary policy more distortionary• Direct impact more concentrated

BUT LIMITS TO BANKING Limited diversification/spreading of risks Limited secondary market for bank loans

- Related to information asymmetries Information cost is high

– Securities markets seem to avoid costs– But either information is poor quality

• With poorer resource allocations– Or information costs have to be borne

somewhere in economic system– Securities markets may free ride off of banks– But then banks have to charge higher margins

—just shifting of burden of information costs

SHARE OF BANKING HAS DECLINED IN MANY COUNTRIES

Partly due to real disadvantages of banks in risk Partly due to false disadvantages arising from free rider problems Partly due to implicit taxes imposed on banks In some countries, increase in bank lending as percentage of GDP as a

result of expansion into consumer sector Will this undermine long term growth, as banks shift focus away from

investment?

Bank Credit as % of GDP:

1997 1998 1999 2000 2001 2002 2003

Indonesia 59.9% 60.1% 62.5% 67.4% 62.7% 59.4% 55.7%

Philippines 84.5% 75.6% 69.2% 66.9% 62.6% 60.5% 59.4%

Malaysia 168.7% 167.2% 156.7% 148.2% 155.5% 154.2% 152.9%

Thailand 162.7% 164.1% 143.9% 121.2% 111.3% 116.0% 112.8%

Singapore NA 101.4% 98.8% 90.4% 102.9% 83.5% 88.4%

Korea 73.8% 84.0% 88.3% 93.0% 96.7% 101.9% 105.6%

IMPLICIT TAXES• Reserve requirements (when reserves do not pay

market interest)• Other requirements

– In U.S. CRA requirements– Capital adequacy requirements

• Greater regulation– Because of concern about systemic consequences of

bank failure– Especially when banks are too large to fail, and

government bears the cost of bail-out

• Those that rely on bank lending most affected by use of monetary policy to control economy– May face greater volatility in credit availability

CONSEQUENCES OF DISINTERMEDIATION

Central bank still able to use monetary policy to control economy (especially to dampen inflationary pressures)– Small and medium size enterprises do not have

alternative sources of finance– But there may have to be more ‘tightening’ to

have desired effect• Those who have direct access to capital markets shift

borrowing, freeing up funds for those who do not have access

But monetary policy is more distortionary– Effects felt more narrowly– On those who have to rely on banking system

for finance

CONSEQUENCES OF DISINTERMEDIATION

Quality of information in capital markets may deteriorate– Deterioration in quality of corporate governance– So resources will be less well allocated– And growth may be impaired– And there may be more pro-cyclical lending

Social objectives pursued by banks (community reinvestment requirements) not as effectively pursued in securities markets

LEVELING THE PLAYING FIELD

Some of disintermediation is a result of special burdens (implicit tax) imposed on banks

Banks do have some advantages in some countries—deposit insurance

But not large enough to offset disadvantages

Important to level the playing field

LEVELING THE PLAYING FIELD

Paying interest on reserves Strengthening deposit insurance Strengthening regulation on securities

markets Imposing transactions taxes in securities

markets Separating out policy lending from

commercial banks Helping banks restart with a ‘clean slate’

IMPORTANT LESSON Old ‘wisdom’ that securities markets are

better than banks because they allow better diversification of risk ignored the importance of information

But the collection, processing, and use of information is the central function of financial system

New view sees banking institutions as central to the success of any economy, but especially in developing economies- Even though there will inevitably be some

disintermediation as economies grow and markets develop

CENTRAL BANKS Have an important role not only in macro-

economic management But also in ensuring that the financial

system overall is functioning well Including providing credit to all segments

of society– Especially to small and medium sized

enterprises This will require maintaining a vibrant

banking system Which will require sound regulation But also a more level playing field