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Development Finance Lecture Summary
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Comprehensive bullet-point summary of the lectures of the course Development Finance at the RUG. Includes summary of lecture 1-6 and the guest lecture.
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THEORIES ON FINANCIAL DEVELOPMENT, GROWTH AND INEQUALITYLecture One
Do countries with better developed banks and financial markets enjoy
substantially greater economic success?
Economists hold different views about
the impact of banks and markets on
long-run economic growth.
Theoretical Approach
How finance and development can
affect economic growth. In general, the
financial sector reduces the effect of
market frictions (information and
transaction costs).
Functions Financial Markets:
Why financial markets may be important.
1) Mobilize Savings: more abilities to save and
savings will increase. However, but if financial
markets are very well developed this may lead
to a reduction in savings. If something happens
you can borrow on the spot, no savings
needed.
2) Screen and Allocate Resources: economic
models assume that saving goes automatically
to the most profitable firms. The assumption is
that investors have good information about
firms, managers and market conditions. In
practice this is often not the case. Financial
intermediaries, by economizing on information
acquisition costs, improve assessment of
investment opportunities. They identify
entrepreneurs with best chances of
successfully initiating new production
processes.
3) Exert Corporate Control: Managers act in the
interest of the shareholders (maximize firm
value) of a firm to optimize resource allocation.
However, because of moral hazard behaviour
managers may not do so. Reasons are:
Insufficient effort
Extravagant investments
Entrenchment strategies invest in
activities that make managers indispensable
Moral hazard can be reduced by stock-based compensations and bonuses and/or
debt is disciplining device (free cash flow idea).
4) Facilitate Risk Management (diversifying and pooling risk):
- Improve cross-sectional risk diversification
o High return projects riskier than low-return projects, and require
large initial investments
o Without financial markets, saving in low return projects
, - Financial systems may improve intertemporal risk sharing
o It can facilitate intergenerational risk sharing by investing with long-
run perspective.
5) Facilitate Exchange Goods/Services (easy exchange): Financial arrangements
that lower transaction costs may promote specialization. This stimulates
technological innovation and growth.
- Adam Smith: money lowers transaction costs, permitting greater
specialization
- Greenwood and Smith: more specialization requires more transactions.
Each transaction is costly. Financial arrangements lower transaction costs
and hence stimulates specialization.
The five functions link to growth because all the functions lead either to more
savings and thus investments (capital accumulation) or they have an effect on
technological innovation.
There are conflicting views on impact of finance on inequality
- Financial development operated on extensive margin: the direct use of
financial services by individuals who had not been using these services
(Leads to more inclusion of people who before did not have access to
finance (inequality going down)). These models predict that financial
development reduces inequality.
- Financial development operates on intensive margin: Better finance for
those who already have access to finance. This financial development
increases inequality.
Inequality and poverty is not the same.
Financial Development Indicators
1. Financial Depth:
a. The importance of a financial sector is measured by M/GDP. M is a
measure for currency + savings deposit
b. Nowadays almost everyone uses: Private credit/GDP (=PRIVATE):
importance credit to private sector
c. Total assets commercial banks/total assets central bank:
importance commercial banks
2. Financial Access (Financial Inclusion): Looking more at the poor people.
a. Number of bank accounts per 1000 adults
b. Number of bank branches per 100000 adults
c. Percentage of firms with line of credit (possibility to borrow
immediately) for all firms or only small firms
3. Financial Efficiency:
a. Overhead costs to total assets
b. Net interest margin (loan rate minus deposit rate)
c. Cost to income ratio
d. Return on assets
4. Financial Stability:
a. Z-Score: liquidity of a bank
b. Excessive credit growth
c. Nonperforming loans to total gross loans
All indicators refer to either
- Financial institutions (banks; pension funds)
- Financial markets (equity markets)
, Empirical studies show that the outcomes
depend on the political views of the
authors. Cross-country studies are
positive. Time dimension with country
specific constants/individual countries are
less positive.
Recent literature shows negative or weak relationships after 2000.
- People argue that financial development in general is not the main thing
to look at. You should look at the role of different types of credit:
o Enterprise credit (+)
o Household credit (-)
Too much household credit starting from the 1990s. Moreover, benefits of
financial deepening disappear in financial crisis periods.
Furthermore, people argue that there is an optimal level of the positive
relationship. Some countries may have financial systems which are “too
large” compared to the size of the domestic economy. Too much finance!
Marginal effect of financial depth on growth becomes negative when credit
to the private sector reaches 80-100% of GDP
SUB-SAHARA AFRICA: A SPECIAL CASE?
- Banks: One common feature of the
banking system in Africa is that a
large number of banks invest in
government securities, primarily
treasury bills. Credit to the private
sector provided by the banking
sector as a percentage of GDP has
been declining over the years, even
recently. (see figure). Nonetheless,
the banking system in Nigeria and
the Southern African countries of
Malawi, Botswana, South-Africa and
the Seychelles is relatively well developed.
- Stock Markets: Stock exchanges have proliferated over the last two
decades. There were only 5 stock exchanges in SSA 20 years, but now
there are about 20 in operation. SSA witnessed an establishment of a
regional stock exchange domiciled in Abidjan, which currently Serves the
Francophone countries of West Africa. Yet, African stock markets remain
the smallest of any region
- Bond Markets: a key feature of financial market in Africa is the dearth of
bond markets for both government and corporate bonds. Southern Africa
is the only region with a well-developed government bond market.
RECENT DEVELOPMENTS REGARDING FINANCIAL INCLUSION
The Global Findex database launched by the
World Bank shows that today, 69% of adults
around the world have a bank account.
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