Y   
 

V Y

 
 

 , in the circular flow model, receive savings from depositors
and allocate those savings to entrepreneurs to invest.

V n practice, Financial ntermediaries have a number of beneficial roles:

§ 



  to finance promising projects across sectors.

§ 

  

  .

|


   


by pooling it and repackaging.

Õ
   




by entrepreneurs.

Ê 
by borrowing short-term and lending long-term.

½





  
 matching depositors and investors.

V Further, can be divided into BANK financial intermediaries and NON-BANK financial
intermediaries (such as equity/stock markets).

V Gibson and Tskalotos (1994) notes that even in developed countries w/ developed
equity markets, •
 •
 

  •
 . Banks also have ••• 

 •
and therefore have
greater access to information.
 Y   
 

V Y

 ½
  where the Government borrows

from the sector or prints money to
V Before discussing  •• • finance a deficit - the resulting inflation
and   • 
, we need to reduces the efficiency of investment
note the initial conditions from which a (the level of growth for a given level of
financial system is to be liberated, or savings).
developed.
V The Government may also ͚crowd͛ out
V Financial repression is defined by the private sector by 
 
Gibson + Tsakolotos (1994): Ñ

  

 




.




  





 V Y ••

 •


Although they later suggest that §roliferation of 
  Õ


such a definition is too broad. Õ

V 


are kept low to try and istortions that make  •


stimulate investment (which means  
•• •
that
  have to be low as •
• 

•
, hurting
well, as the bank can͛t finance higher financial development.
ones).
½educed savings, investment and
V 
 can be either direct growth, as well as C½ T
or indirect (e.g., requiring a proportion ½ATONNG (Õ


|

).
of assets to be held as Government
bonds). There may also be an 


 Y   
 

V Ñ
 


 
Y

 ½


V Aside from attempting to:

|
••
•
 ••• 



•• 
•
•
•


V The Government also uses the financial sector to 
•

•• •

•.

V For example, ndustry Substituting ndustrialisation (S) requires that

resources be invested into industry.

V The Government could facilitate this allocation of resources by forcing banks

to lend to certain sectors either via

 (nationalising banks) or
using 
 



  

 


[owever, this can facilitate a culture of 
   



,
as investments may not be allocated to projects with the highest rate of
return.
 Y   
 

V Y

    
  


V Financial development is 
   


 

  

 
   
!  

 

 .

V Auerbach and Siddiki (2004) note that generally studies  














   

[onohan (2004) supports this claim, noting that, when using Y

  


(the quantity of money/assets to which a firm/individual has access) as a proxy for
financial development, the link between the two is significant and robust:

Õoving from the lowest decile of financial depth to the highest is associated with a
rise in G§ per capita growth of ~4%.

V Financial development is also associated with lower inequality ( "#$$%&), in

that it •
•
•

and allows for •
•

 . t is also
possible that a healthy financial system is an ••• 

•,
empowering small firms with credit.

V ½egarding poverty, financial development is important in that it •

•
•


•, which is more of a problem in developing countries than the cost of loans. An
example is  

   

  
  
   
.
 Y   
 

V The causality between financial V mpirically, they make 5 findings:

development is more confused:
# Y

 
  
 

V Ê



 "'(('& differentiate 
 
  in
between three hypotheses of both developing and developed
causality: countries.

|

: Y

  - ' ) 




6
 (financial
 

  

 
institutions provide financial  
 
services which permits and   
  
.
facilitates growth).
3. Financial development has a
 

Y  
: 6
 

 

  - Y

  (real  
 
economic growth raises the
demand for financial services). *   for financial
deepening to impact upon the
|     
: At early real economy.
stages of development, 


. This creates self- + Y

 
  

sustaining growth which 
   
 
instigates
 

  
 


Y§  ,
causality. which enhances economic
growth.
 Y   
 

V 

 
 
   

V Neoclassical perspective: Y S.

V Y • 
entails:

§  
, deregulating interest rates,  


  
 and removing Government control over credit allocation.

V Neoclassicists believe that financial liberalisation positively affects both

the


•
•and the
 
•
•. [ence,   • 

• •

•

V The typical model that is employed to show this, is the Õ


|

, shown on the next slide, where the level of savings is variant on
the interest rate and growth rate, and equilibrium is where 
S. t
considers financial repression where an interest rate ceiling (on lending
rates) has been imposed.
 Y   
 

nterest
½ate |" #&
 |" '&
|" ,&
r3

V¬
¬ r

r* 6
* V¬ 

Ê Ceiling 2
r2
¬
r1 )
Ceiling 1 À r

1 2 * 3 nvestment
 Y   
 

V |
 # Assume the free market ëending is likely to be of low-quality;

equilibrium is at point , with interest rate depositors will be more likely to invest
r*. Assume further that the Government in low-yielding projects than deposit in
holds down 6§| ½ 6| at ceiling 1, the bank, and investors with low
and leaves 6

 ½ 6| unregulated. yielding projects that wouldn͛t occur
under equilibrium, do go ahead
because the low interest rate gives
n this scenario, there is ͚1͛ level of them a positive rate of return.
savings and investment, and there is
excess demand for loans.
ëow interest rates also • •
• • •
 
   ,
This excess demand is met by charging distorting the input-mix.
͚r3͛ for the lending rate. There is
therefore a spread between lending
and deposit rates, and this spread mayV Y

  
 
implies a rise in
be used to finance non-price the ͚ceiling͛ from ceiling 1 - ceiling 2.
competition (such as establishing
branches in prestigious locations). As savings are a function of the
interest rate, the savings function
V |
 ': assume the Government now shifts outwards and we have 2 level of
makes ceiling 1 apply to BOT[ deposit and savings, although there is still credit
lending rates, which is more realistic. rationing.

[ere, there are still ͚1͛ levels of [owever, higher yielding projects now
savings in the economy, however go ahead and therefore •• 

there is Ê ! "! #$ $% of ͚3 ʹ 1͛ •

•&
due to excess demand for investment
at the prevailing lending rate.
 Y   
 

V 
 "#$--& offers a two-sector model where the efficacy of investment increases due to
liberalisation:

Traditional sector (with low rate of return on investments, and investments are self-
financed), and Õodern sector (with high rate of return and relies on loans from a bank -
hence, relies on savings from the traditional sector).

Y

 


   (low incentive to deposit money in a bank
rather than invest it) and leads to scarce credit for the modern sector.

Y

 
 
 

  , raising savings in the traditional sector and
alleviating the credit scarcity in the modern sector.

V ëiberalisation also entails   

due to high real interest rates and a higher
marginal productivity of capital in recently liberalised countries.

V 6   

 Õ6 for the predictions of the ÕcKinnon-Shaw model, as Gibson
and Tsakalotos (1994) conclude, due to difficulty in obtaining reliable data and
methodological problems.

V ÕcKinnon (1991) argues that there are two pre-requisites for Financial liberalisation:

Y Ê
 (bank taxes are no longer a revenue source, the Gov. Õust develop the tax
system to compensate).

Ê
  
 

for monetary policy purposes.
 Y   
 

V Õ 
    

V Can be divided into two camps: the §|6
6|
| (who focus on ••
•) and the
6|½Ê½ || (who focus on

 •).

V §ost-Keynesian critique:

V After liberalisation, A can fall for the following reasons:

ëiberalisation leads to a  
 
 
  , which

adversely impacts on A and therefore current and expected investment.

½
 
(high capital inflows).




 

 




.

)
 
 



 


 
  (higher
deposit rates w/ still low lending rates).

͚
Y

 ½
͛ where equilibrium interest rates are very low
(perhaps negative in real terms). This means that the bank faces high levels of
uncertainty when lending, however withholding funds reduces profits as the
bank becomes excessively liquid.
 Y   
 

V Neo-Structuralist critique:

V Financial liberalisation can lead to | Y 
(declining growth and inflation):

[•• ••
•

••
 , so aggregate supply declines. Assuming
supply falls faster than demand, then •'•


 •suggesting a rise in
inflation.

V Financial liberalisation may also lead to a 
 


:

n developing countries, there is an 
 


  


  which does not
have reserve requirements, but has • •
•
••• ••
•

(suggesting inefficiency) and also • ••
(due to high uncertainty).

Assume an individual can store wealth either in non-productive assets (like Gold), or in
the informal market, O½ they can deposit in formal sector banks.

A rise in the deposit rate due to liberalisation leads to a substitution away from the prior 2
stores of wealth - 
•

•• 

•••

(thus creating
credit) and  
••

•
••• 
•.



* This is because formal sector banks have to have a
reserve requirement; neo-structuralists believe that this effect dominates in developing
countries with large informal money markets.
 Y   
 
V Õ  
 §
  2. With assets still in domestic currency, asset value
does not also rise -     

 
   
6 ѽ
V The most significant market failures in the financial
sector are Õ [( and "•
• |• •.
3. Net worth acts as collateral; • $) •

•
•
• • 
•
(banks are unable to
Adverse selection arises because of the presence of differentiate between good and bad risks) 
͚bad͛ lending risks in the marketplace and the  ( 
•
(firms can undertake riskier
inability of the bank to differentiate between behaviour as they have less to lose).
riskiness of investors.
*  

 

 

Õoral hazard arises because monitoring the use of



 , creating a BANKNG C½SS.
loaned funds is often costly and difficult to
implement.
5. The usual response to such a crisis is to restrict
lending to increase capital stocks; however, banks
Both lead to less lending and therefore reduce play a key role in emerging markets due to  
financial development. 
 
  allowing them access to
information curtailing adverse selection, and  
V Õ 
"#$$$& outlines how A.S and Õ.[ problems 

     


preventing moral
can create financial instability and perpetuate crises: hazard.

V merging market debt is likely to be: |½ 6½Õ  !  


 
  
 

Y½6
ʽ½6
Ê 6
Õ
6  

 

V Therefore, an    
  




 Therefore, Y   

6
  


  

  

 

, aided by information asymmetries:   !   

  
  



 
   
1. When debt is foreign-denominated,  •



 
• • 
•  • •&
 Y   
 

V Õishkin therefore recommends   selection and moral hazard problems.

  
 








 

   
V !•%••

•





(due to high interest 
•
rates or capital inflows) from allowing 
••
:
banks loading up on too much risk.
§ 
  

V Ê "#$%.& suggests developing equity
 !


 
 


markets as another measure for dealing 






 (

with adverse selection, however equity
markets are focused on short-term
profits (high-frequency trading) and
neglect the establishment of long-term
"'(('&find that a less
discretionary intervention in this
role is more beneficial for growth).
high-trust relationships. § 

" 

!

 

 
&


ven in developed markets, only a  
"
 & 


small proportion of total finance is  

(allocates the
created by equity markets. share of risk between the two
groups).
V Financial liberalisation, therefore, may
not only instigate financial instability 6
 








(higher interest rates and lending 
 






   
!
booms due to capital inflows), but also


 

 



may not impact greatly on actual  
  

.
investment levels due to adverse
 Y   
 

V 

  
via privatization

via fixation on
and liberalisation has two effects: short-term profits and neglect of
long term investments.
V 


|

 "'(('& note that it




••
 V This reinforces the need for sound
•
••
, •••
 monitoring + screening processes, and a




and •'
• satisfactory legal framework.
•

••
, improving the
efficiency of investment. t also reduces V Ê 
  may be a source of
the deposit/lending rate spread. instability insomuch that they cause
lending booms (see case study on the
V [owever, 



   "#$$*& 2007+ crisis), however, the underlying
caution that the presence of market fundamental problem is §OO½
failures (information asymmetries,
externalities (investment creates jobs)
and the public good nature of
information) facilitates instability, even if
it increases operational efficiency.
½ GUëATO½Y NF½AST½UCTU½ N T[
[OST COUNT½Y. With good
infrastructure, a lending boom need not
occur, or at least bad debt need not be
taken on in large quantities.

Ê••
•

•  [owever, 


 

• '•
•

 
 
 
 
(facilitating a lending boom) and
 
 
due to its
note that it 


•
• •
••

•
•& •
 •

; if before, then there will be
capital flight due to low real interest
n net, competition could lead to rates and domestic banks will be


  in the financial uncompetitive internationally.
system and have an 
 
 Y   
 

V Ê



V Y

 
  
  (and growth causes financial
development).

V Y

 
     

 (see South
Korea), but also has the potential for Government failure and a stagnant
economy (see Chile/Õexico pre-reforms).

V 








    
•• •••



•
 

••
••
 •&

V | 
  Y

 
 
 
!

  




 
    ; there needs to be a Government
presence to deal with market failures and potential adverse impacts of
competition. There also needs to be a stable macroeconomic environment, a
shrinking informal money market, and correct sequencing of liberalisation
reforms and introduction of equity markets.
 

   
   
V Ê ile ca e se as a exa le f a fi a cial sect r ig lig te t e str ct ral eakesses
f t e ref
r s,
t at s cc e t  • 
   • • •  a × /  0   "#$$$& / :
    • 
 ( r se e ci g a
it ri g), a t e • •
  • 
 ••  T ere a ee c
siera le acc lati

f 
llar-
    • 
 & e
iate e t at c ea iterest rates, icreasig
t e sesitivity
f firs t

rl iterest rates.
V §re-§i c et (1973), t e Ê ilea fi a cial sect r as
ty ical f t e average ëati erica c try; T e e t crisis (a a fixe exc age rate
licy)
lea t
a large a reciati

f t e §es
t
t e D
llar,
/  reflecti g Ú
 
  •   creatig a large eficit a triggerig a fiacial

• , ig ly re resse fi a cial sect r c iti s crisis.
a    •  ڕ •&
V G 1/  // "#$$*& 
te t at  ilst t ere
T e ver e t rr e fr t e sect r y as a

 i fiacial e t ( / 
×   / /   ×  t als × //1 /#!(((2#$-,3 %#), it
/ /  / /  as͛t a efficiecy ir
veet:

V §i c et,
ever, i cl e s sta tial fi a cial Õ
st
f t e l
as ere  / .

ereg lati
 ( • •
••  • • • 

 (  

••'•   • (  ) i is Desite large real iterest rate rises,    /
asket
f arket- ase ref
r strategies, a    ×     .
s statial li eralisati
 as ae (it gr
t
icreasig as er t e e
-classical
el). Õ c
f t e ivestet as sec lative a /×//
 
V [/ ! #$%'      
V /!0 / |  /   /
V ! •*+,-


•'•    •,
ever, it   14  ×  
       
V Ñ
 information.


ëarge conglomerates (Grupos) were
V 
 
  

 formed due to the widespread
liberalisation policies and lack of
anti-monopoly regulation, and they
6 #((  indulged in self-financing; banks
under their control would provide
eposit insurance removes liquidity to firm under the same
incentives for depositors to use all grupo.
available information to monitor
banks and punish excessively risky V  

  

behaviour.

[ence, overly-generous deposit  






insurance encourages moral hazard. 5
 







 

 


 

 



V 6  



  

   

 A regulator, the |



 
 


 
 
  
 )


Y

 
 

 

 
   "|)Y& did exist, but its powers were
not sufficient to enforce substantial
With this backing, they loaded up regulation that was needed to
on risky assets; generous deposit prevent moral hazard and adverse
insurance meant that depositors selection problems.
wouldn͛t have punished this
behaviour even if they had the
   

V Ñ××     exacer
ate t e 
t r, leaig t

V T e fiacial li eralisati
 t at as
ileete as r
aly r
lle ack; V
referetial exc age rate f
r

llar e t
rs as exec te, a


r gr
t a gr
ig iflati
.
§i
c et evet ally settle
 a
restr ct re f
r
f arket-
ase

licies, f
c se
:
t e cetral ak
g t ak͛s a  6  // / ×/  t


rtf
li
s at face val e. es re sta
ility.

ëarge ail
ts a ati
alisati
  4/ /  / / 

f aks y t e
veret a /     / 
Êetral ak, leaig t
a starte i t e 70͛s.
s
statial asi-fiscal eficit.
 /  1   
T e st
ck arket cease t
trae. ×/   (e
t-f
r e ity sas).

V Ñ××   V ps art
f t e c
s
liati
, t ere as

a ee t
re
il t e fiacial sect
r .
V T ere as a attet t
revert t

iscreti
ary 
licies,
t t at sily
       
V 
 
  
Ê 
 was reduced from 100% of all funds (in


   effect), to *../



•
&This meant that whilst there was
some security, it was not so generous
V |)Y "

!  as to erode incentives for depositors to
5
& punish risky behaviour.

The SBF was granted with •



•




substantially more power to    • •&

   


, rate quality
of investments and 
  
  
 

  ʹ to be effective,
firms and banks must perceive bailouts
to be both rare and at great personal
The SBF was also charged with cost. Also, the ëOë½ must not target
•••
  specific firms, but lend aid to solvent,
•
•
. collateral ʹ rich banks 
 
  

 
SBF regulated that

 
 

 
  
  The recent Ê#Y# •  affair
 , allowing depositors to precipitated a liquidity crisis in which
access information that would let them Ê
)


 


discern the riskiness of a bank. f a  

bank is being excessively risky, then
they may punish it by withdrawing
deposits. Ê

  has been built by the
Chilean Government  


•••
V |
" 5
& •

*+,,*+,+; this
lent credibility to the statement that it
  

 ʹ deposit insurance would not it would not bailout banks
as it did in 1982.
   
    

V §

|
"'((,& note that a major problem during the build up to the Argentine
financial crisis of 2001 was a structural weakness of the banking sector:

V Surprising, since *++,•) 0  •"•

••



•;
in the wake of the Tequila crisis (1994/5), 


  
  
 



V The liquidity buffer served well initially; 

•
•  

 •


*+++
•   .

V [owever, 
 
  


 






, which
raised the risk of financial collapse if the currency board collapsed.

V §erry and Serven note three weaknesses in the regulatory framework:

Y  
5    
 


 


 , which would
appear when there was a deflationary policy to achieve the equilibrium ½ ½. (Adverse
Selection).



   
 

    
 
 

(Government was running large deficits and had a high interest payments, so
borrowed heavily from the financial sector).


 




   



,
they help buy time, but ultimately, a credible lender of last resort is needed. Under a
currency board system, the Central Bank can͛t credibly commit to ëOë½ duties as its priority
is to keep the exchange rate fixed.
  
   
V Õ 
 "#$$$& story of a Y   
   

(as that raises the


   
    
   ! value of debtor͛s debt). Speculator͛s will then attack
 








 the currency, triggering a FX crisis: )

ʽ||
Õ  #$$*    - Yʽ||- )

ʽ||

V ndeed, it is more or less the same story as in Chile; V Õ

Y

 
 5
:
  

  (͚Washington
consensus͛), with  
 
   Although financial liberalization is necessary for

 ! a combination of poor supervision, lending financial development + therefore growth, 


booms and FX crisis served to create a financial crisis.  


 






V Õishkin notes the following policy lessons from the
crisis: 







 
(a
measure of financial development), due to the
higher Õ§K in emerging markets as well as more
V 

 § 

  opportunities in emerging markets. [owever, this


•  
Fixed regimes are susceptible to speculative attacks •
• 

 •
which cause a FX crisis - Financial crisis.
••
&

They also



 ͛; a floating V

     
   
exchange rate will depreciate if Government  


borrowing is too high or inflation is too high, sending
signals to policymakers. nstead of promoting the central bank to be a ëOë½
and pursuing expansionary monetary policies, use
V

 §

 | 
 context-specific policies.

§oor supervision can foster 


  The problem w/ ëOë½ + xpansionary monetary
 
 
 Y  : a banking sector policy is that it drives up inflation and thus
with high foreign-denominated debt   depreciates the currency (affecting firms͛ net worth
Ê
)

     and prolonging the crisis).
   

V  

½ "'(#(& also argue that Õexico
had  



  
that precluded contract enforcement.
V This exacerbated Adverse Selection problems,
lead to misallocation of resources and acted as a
drag on TF§ growth.
V Thus, in addition to specific financial sector
reforms that Õishkin stated, Õexico needs to
shore up its legal institutions as well to reduce
uncertainty (and transaction costs).