This chapter surveys possible factors explaining cross-country variation in the development and stability of the financial system. Specifically, it distinguishes between the (1) policy view, which focuses on specific policies and institutions to strengthen and deepen the financial sector; (2) the political economy view, which regards the level and structure of financial development and the underlying institutional infrastructure a function of political decision processes; and (3) the historical view, which focuses on exogenous determinants of financial sector development related to geographic endowments and history and the persistence in the level and structure of financial systems.
Do efficient financial markets and institutions promote economic growth? Have they done so in the past? In this chapter the author surveys a large and diverse historical literature that explores the connection between finance and growth in US history. The US financial system was important in mobilizing savings, allocating capital, exerting corporate control, and mitigating borrower opportunism. A wide variety of intermediaries characterized US finance – commercial banks, savings banks, building and loan associations, mortgage companies, investment banks and securities markets – which emerged to fill specific financial niches, compete with and complement the activities of existing intermediaries. The weight of the evidence is consistent with the interpretation that finance facilitated and encouraged growth. Despite the breadth and diversity of approaches, there remain many potentially fruitful lines of further inquiry.
Thorsten Beck and W. Scott Frame
This chapter discusses financial innovation fueled by technological change over the past decades in both developing and developed countries. We discuss the positive growth effects but also possible fragility risks from different types of financial innovations. We critically review the experience with different product, process and organizational innovations.
Following independence, the government of Brazil borrowed repeatedly without default. Not only did it obtain long-term loans in London, it defied “original sin” by borrowing significant amounts from the domestic market. Most of the internal debt was in paper currency without a fixed maturity, and by the 1850s was larger than the external debt. Parliamentary authority over fiscal and debt policy helped to credibly commit the government to repay. Commitment did not, however, lead to a financial revolution. On the contrary, private interest rates remained high even as the government’s cost of borrowing fell. Highly centralized political institutions concentrated authority in the hands of a narrow political elite, which restricted incorporation in general and the creation of banks in particular. The result was successful sovereign borrowing with financial underdevelopment.
James R. Barth and Gerard Caprio, Jr.
This chapter re-examines the role of financial regulation and supervision in economic development, which, given concerns over international agreements and skepticism about the efficacy of regulation in banking in particular, seems timely. Historically, banking has developed and attempts have been made to stabilize it through a few rules, notably those that encouraged diversification and contained disincentives toward excessively risky activities, so that bankers were not just gambling with “other people’s money”. After reviewing the economic rationale for interventions in finance and briefly discussing the role of political economy factors in the policies adopted, the chapter reviews regulations to assess what has worked or failed, both historically and recently. It also examines differences in bank structure and regulatory environment across countries at different income levels and discusses recent innovations in finance that might affect the role banks play in the years ahead, noting significant variation in many conditioning factors and outcomes. Last, the chapter puts forth some principles and approaches that bank regulators might adopt to achieve the goal of deep, liquid and stable banking systems, avoiding the overly complex, one-size-fits-all approach that is now popular in high-income countries. Changing technology offers new possibilities to increase access to financial services for people worldwide and with it financial and economic development. While the regulatory community views safety and soundness considerations as primary, those without access to finance understandably want to gain entry, and officials should be alert to increasing the benefits to such persons from new financial technology and not just focus on the risks.
Robert Cull and Jonathan Morduch
Microfinance is generally seen as a way to fix credit markets and unleash the productive capacities of poor people dependent on self-employment. The microfinance sector grew quickly since the 1990s, paving the way for other forms of social enterprise and social investment. But recent evidence shows only modest average impacts on customers, generating a backlash against microfinance. We reconsider the claims about microfinance, highlighting the diversity in evidence on impacts and the important (but limited) role of subsidy. We conclude by describing an evolution of thinking: from microfinance as narrowly construed entrepreneurial finance toward microfinance as broadly construed household finance. In this vision, microfinance yields benefits by providing liquidity for a wide range of needs rather than solely by boosting business income.
Over the past half-century, the severity of systemic banking crises has tended to increase, first in developing countries and then in a sudden and remarkable wave of failures in the advanced economies. The Global Financial Crisis, with its protracted sequel in the euro area, was marked by rapid and extensive contagion between banks and between national banking systems, and by the so-called sovereign bank doom loop, where weaknesses in the balance sheets of the banks and the sovereign fed back onto one another. Drawing on the recent experience, this chapter describes lessons learnt about the best policy approaches to management and resolution of such crises, emphasizing issues of bail-in and sovereign vulnerability. It concludes by considering the role of higher equity capital and bailable debt requirements and of other macroprudential policy measures in helping reduce the frequency of systemic banking crises.