Financial Development:
Structure and Dynamics
Augusto de la Torre, Erik Feyen, and Alain Ize
WB Conference
Washington DC, 16 June 2011
Chief Economist Office
Latin America and the Caribbean
The World Bank
1
We know surprisingly little about the process of financial
development (FD)
 Frictions determine structure

Merton and Bodie
 Function matters more than form
Demirguc-Kunt and Levine
 Allen and Gale

 But in the end:
How predictable is FD?
 Single or multiple paths?
 What is the sequence?
 What are the shapes of the development paths?

2
This paper
 Links FD to four basic frictions/paradigms

de la Torre and Ize (2010, 2011)
 Uses the frictions to connect the dark and bright sides of FD
 Corroborates empirically some predictable patterns

sequencing, shape, returns to scale
 Explores the unicity/multiplicity of paths
 Links differences in FD across countries to differences in frictions and/or
dark episodes
 Uses the framework to assess LAC’s FD
 Obvious caveats

The paper only suggests

More rigorous and systematic analysis is needed
3
The process of financial development
The Bright Side
4
A simple typology of paradigms
Bilateral focus
Multilateral focus
Full information /
Full rationality
Incomplete information /
Bounded rationality
Costly Enforcement
(CE)
Asymmetric Information
(AI)
Collective Action
(CA)
Collective Cognition
(CC)
5
Frictions, paradigms and failures
Contract stage Finance friction Underlying problem
Getting the
facts
Uncertainty,
information
and learning
costs
Paradigm
Asymmetric
confusion
Asymmetric
Information
AI
Symmetric
confusion
Collective
Cognition
CC
Failures
Collective
failures
Agreeing on
a contract
Enforcing
the contract
Bargaining
costs
Coordination
failures
Collective
Action
CA
Enforcement
costs
Limited
pledgeability,
commitment
and liability
Costly
Enforcement
CE
Agency
failures
6
Process of financial development
Finding the path of least resistance
Public
response
Needs
Frictions
Failures
Structure
Private
response
7
The private responses
 Lessening the frictions



Acquiring information, learning
Using collateral
Delegating
 Lessening the exposure



Diversifying and pooling
Buying insurance and hedges
Staying liquid
8
The public responses
 Providing public goods (lessening frictions; resolving coordination failures)





Macro-monetary environment
Legal and institutional framework
Information and analysis
Infrastructure
Oversight
 Regulating and taxing


consumer protection: resolving agency failures (big brother)
internalizing externalities: resolving collective failures
 Coordinating (resolving collective failures)



catalytic involvement
LOLR, RALR
mandated participation
 Spreading risk through public guarantees (resolving collective failures that
derive from agency frictions)
 Providing financial services (resolving collective failures through acquiring an
agency role)
9
The process of financial development
The supply side response
Scale effects
Network effects
Participation
Public
response
Needs
Frictions
Failures
Private
response
Structure
Innovation
Technological
progress
Enabling
environment
Regulatory
arbitrage
Competition
10
The limits of the bright side
 Failures to fully resolve
agency frictions

At the investor level
 Failures to fully resolve
participation frictions

• bounded rationality

At the borrower level
• governance

At the intermediary level

Early and intermediate finance:
developmental policies
Mature finance: tail and
systemic risk insurance?
• Anginer, de la Torre, Ize (2011)
• skin in the game
11
The process of financial development
The Dark Side
12
The process of financial development
The dark side
Scale effects
Network effects
Participation
Public
response
Needs
Frictions
Failures
Private
response
Structure
Innovation
Technological
progress
Enabling
environment
Regulatory
arbitrage
Competition
13
The modes of the dark side
 Easing of agency frictions triggers
Collective action failures (free riding)
 Agency failures (multiplication of agency problems)

 Easing of collective (participation) frictions builds up systemic
vulnerabilities that end up with collective failures: withdrawals give rise to
fire sales and liquidity spirals

The positive participation externalities of the bright side mutate on the dark side into
devastating negative externalities
 Easing of frictions, fueled by innovations, triggers problems of collective
cognition (mood swings)
14
The empirics of financial development
Patterns and paths
15
The econometric study
 The financial indicators: 13 depth, 2 efficiency-liquidity, 4 financial
globalization, 4 soundness
 The controls: GDP x capita (level and square), population and other
country-specific structural features
 The methodology:
Median regressions
 Cross-section path (collapses time in just one average point per country)
 Dynamic paths around the cross-section for group medians (grouped by initial income
or by region)

16
Two predictable patterns
 Financial activities that are the least affected by frictions should appear
first

Thus, we should expect credit to the sovereign to develop before credit to private
agents, banking before capital markets, deposits before credit, etc.
 Financial activities that are subject to collective frictions should have
convex-shaped development paths and, possibly, returns to scale

Thus, activities that are hindered by the highest collective frictions will appear later but,
once they appear, should be the most convex

We should also find some correlation between convexity and returns to scale
17
Order of appearance, convexity and returns to scale
Order of Appearance, Convexity and Returns to Scale
Foreing Private
Debt
Domestic Private
Debt
Mutual Funds
Assets
Life Insurance
Premia
Stock Maket
Capitalization
Bank Claims on
Fin. Institutions
Bank Private
Credit
Bank Wholesale
Funding
Non-Life Insurance
Premia
Bank Deposits
Pension Fund
Assets
Domestic Public
Debt
Foreign Public
Debt
-2,000
Returns to Scale
Convexity
Appearance
2,500
2,000
1,500
1,000
500
0
-500
-1,000
-1,500
18
Public debt
19
0
20
40
60
80
Banking
4
6
8
GROUP MEDIAN LGDPPC
10
PRIVATE CREDIT / GDP (IFS)
DMB DOMESTIC DEPOSITS / GDP (IFS)
NON-DEPOSIT FUNDING / GDP (IFS)
20
Many reasons for the dynamic paths to deviate from the
cross-section
 Country-specific policies: enabling environment, growth, cycles
 Crashes: dark side
 Path dependence: initial conditions matter (today’s FD depends on
output, which depends on past FD)
 Leap frogging: importable innovations
 Threshold effects: endogenous quantum jumps
21
Multiple dynamics paths around very smooth cross-sections
22
The empirics of financial development
Linking back to the frictions and the dark side
23
The grinding down of frictions
Credit Information Creditor Rights
LGDPPC
LGDPPC2
LPOP
Observations
Pseudo R2
Property Rights
0.344***
(3.438)
-0.164**
(-2.465)
0.500***
-1.998
(-1.416)
0.169*
(1.798)
-0.028
-20.370***
(-2.859)
1.837***
(3.869)
-0.355
158
0.392
158
0.233
162
0.501
t-statistics in parentheses
*** p<0.01, ** p<0.05, * p<0.1
Note: LPOP, LPOP_DENSITY, LAGEDEP_YOUNG, LAGEDEP_OLD, OFFSHORE, TRANSITION DUMMY, FUEL EXPORTER DUMMY, and constant were estimated but are omitted.
24
Explaining the developmental differences: frictions,
dark episodes, demand effects
ENFORCEMENT
LEGAL RIGHTS
CREDIT INFO
PROPERTY RIGHTS
BANK PRIVATE
CREDIT
BANK PRIVATE
CREDIT
STOCK MARKET
TURNOVER
STOCK MARKET
TURNOVER
-4.047*
(-1.864)
1.662
(1.547)
-0.526
(-0.379)
0.235
(1.301)
-5.318**
(-2.358)
1.671
(1.385)
-4.701***
(-4.508)
-1.067*
(-1.981)
3.318***
(4.625)
0.545***
(6.499)
1.016
(0.234)
0.570
(0.274)
156
0.497
118
0.571
GDP GROWTH
CREDIT CRASH DUMMY
Observations
Pseudo R2
t-statistics in parentheses
*** p<0.01, ** p<0.05, * p<0.1
0.0690
(0.335)
5.590**
(2.433)
-77.69**
(-2.042)
103
0.456
0.380
(1.188)
3.029
(1.102)
-157.1*
(-1.950)
84
0.525
25
Can there be too much finance?
 The convexity of development paths necessarily implies
decreasing returns from FD on growth

Arcand et al (2011)
 The forces of the dark side probably gather strength with FD

interconnectedness-linked collective failures

Can there can be too much finance? (can the costs of instability—or the costs
maintaining stability—overcome the benefits of finance?)
26
Thank you
27