Financial structure and incentives.

Cihak, Martin ; Demirguc-Kunt, Asli

The article connects two streams of recent research on the financial sector. The first is the regulation literature, which emphasises the central role of incentives in the financial sector. It points out that the challenge of financial sector regulation, highlighted by the global financial crisis, is to align private incentives with public interest without taxing or subsidising private risk-taking. The second stream of research relates to financial structures and examines the mix of financial institutions and financial markets in an economy. It finds that, as economies develop, services provided by financial markets become comparatively more important than those provided by banks. The article brings these two streams together, pointing out that--as financial systems develop from bank-based to market-based--a traditional regulatory approach that relies on banking ratios becomes less effective. There is thus a greater need for properly monitoring and addressing the underlying incentive weaknesses in market-based systems.

Keywords: Financial sector; financial systems; economic development

JEL Classifications: G00; GOI; G10; G20; O16

Introduction

This article addresses the theme of this Review- financial structure--from the viewpoint of incentives. The field of financial structure has generated many interesting debates over the past few decades, one of them being the relative benefits of bank-based as opposed to market-based financial systems. This article focuses on reassessing the received wisdom on this topic in the light of the global financial crisis.

One issue brought into relief in the global financial crisis is that, in the financial sector, incentives play a crucial role. The challenge of financial sector regulation is to align private incentives with public interest without taxing or subsidising private risk-taking. Credible threats of market entry and exit, healthy competition, robust corporate governance, and disclosure of quality information are essential in getting this balance right. The incentive breakdowns during the global financial crisis led to calls for regulatory approaches to be re- oriented to have at their core identification of the underlying incentive problems in the financial sector (Cihak, Demirguc-Kunt and Johnston, 2012).

What does this mean from the viewpoint of financial structure? A wide body of theoretical and empirical literature suggests that, as economies develop, services provided by financial markets become relatively more important than those provided by banks. In the current article, we provide updated empirical evidence to support this finding and also illustrate that less bank- centric financial systems tend to be less prone to systemic financial crises. We point out that, as financial sectors develop from bank-based to market-based systems, the 'Basel-style' regulatory approach, which largely relies on requiring compliance with regulatory ratios, becomes less and less effective. There is therefore a greater need for properly monitoring and addressing the underlying incentive weaknesses in market-based systems, as illustrated for example by the incentive breakdowns that contributed to the sub-prime meltdown.

The remainder of the article proceeds as follows. First, we review and present findings on financial structure, indicating that, with economic development, services provided by financial markets become comparatively more important than those provided by banks. Second, we summarise lessons from the crisis, highlighting the importance of incentives in the financial sector. Finally, we bring these two lines of literature together, pointing out the increasing importance of incentive issues as financial systems develop towards more market-based systems.

Financial structure

Several strands of economic theory suggest that financial institutions provide services to the economy that are different from--though sometimes complementary to--those delivered by financial markets. These theories suggest that financial institutions (and in particular banks as a key subset of financial institutions) have a comparative advantage in reducing the market frictions associated with financing standardised, shorter-term, lower-risk, well-collateralised endeavours, while decentralised markets are relatively more effective in custom-designing arrangements to finance more novel, longer-run, higher-risk projects relying more on intangible inputs. In sum, these theories predict that both financial institutions and financial markets have independent impact on economic development (Acemoglu and Zilibotti, 1997; Allen and Gale, 1999; Boot and Thakor, 1997, 2000; Dewatripont and Maskin, 1995; and Rajan, 1992). In line with these theories, empirical literature (Demirguc-Kunt and Maksimovic, 1998; Levine and Zervos, 1998; and Beck and Levine, 2004) provide evidence that better functioning banks and securities markets exert robust, independent positive effects on economic activity.

A substantial body of economic theory also emphasises that the comparative importance of banks and markets for economic activity changes during economic development, with markets becoming relatively more important for economic activity. For example, Allen and Gale (2000), Boot and Thakor (1997, 2000), Boyd and Smith (1998), and Song and Thakor (2012) suggest that the services provided by markets become comparatively more important as economies develop. These theories suggest that, at higher levels of economic development, economies require the types of custom-designed financial arrangements that ease the financing of more novel, longer-run investment that often employ more intangible inputs than the types of projects that dominate economic activity at lower levels of economic development. These theories predict that securities markets are better than banks at financing such activities, and that therefore the services provided by securities markets will become more important for fostering economic activity as economies grow, while those provided by banks will tend to become less important.

In what follows, we use several measures of the financial system. We would like to have indicators of the degree to which the mixture of financial institutions and markets affect the provision of financial services and thereby help to ameliorate market frictions. But, such empirical proxies do not exist for a broad cross-section of countries over the past few decades. Instead, we rely on standard measures of the size and activity of banks and securities markets. These measures are constructed for 190 economies over the period from 1970 to 2010. To approximate 'bank' development, we use private credit, which is deposit money bank credit to the private sector as a share of GDP. To measure 'market' development, we primarily use stock value traded, which is the value of stock market transactions as a share of GDP. This market development indicator incorporates information on the size and activity of the stock market, not simply on the value of listed shares. Additionally, as a robustness check, we examine stock market capitalisation, which is the value of listed shares on a country's stock exchanges as a share of GDP and securities market capitalisation, which equals the capitalisation of the stock market plus the capitalisation of the private domestic bond markets, divided by GDP. There is substantial variation across countries (table 1).

[FIGURE 1 OMITTED]

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The increasing importance of financial markets, relative to financial institutions, for economic activity, is brought out quite clearly by the empirical data. Figure 1 demonstrates this by plotting the ratio of stock market capitalisation to financial institutions' assets (a proxy for financial structure) versus gross domestic product (GDP) per capita (a proxy for economic development), showing the strong positive correlation between the two. This strong positive relationship, while of course not a proof of causality, is consistent with the theoretical predictions discussed above.

To understand better the mechanics of the relationship between financial structure and economic development illustrated in figure 1, it is useful to decompose the financial structure indicator, and to examine the relationship between financial institution size and economic development separately from the relationship between financial market size and economic development. Figure 2 illustrates such a decomposition, showing that both financial institution size as well as stock market size increases, relative to GDP, with economic development (the estimated regression slopes being positive). The difference is that with growing GDP per capita, stock market size increases faster (relative to GDP), resulting in a shift of the overall financial structure towards a more market-based system.

Were the relationships between the size of banks, size of markets, and economic development affected by the recent crisis? To address this question, figures 2 and 3 show scatter plots for the same variables, but in different time periods. Specifically, figure 2 relates to the more recent period of global financial crisis (2008-10), while figure 3 covers the pre-crisis period (1990-2007). The figures confirm the relative stability of the relationships between financial system development and economic development. The finding that both financial institution size and stock market size increase, relative to GDP, with economic development, is valid both for pre-crisis and for crisis observations. It also holds for both samples that stock market size increases faster (relative to GDP) with increasing GDP per capita. This result does not weaken during the crisis--if anything, the estimated slope is higher in the more recent data.

Figures 1,2 and 3 show correlations and basic regressions, but these findings are consistent with more elaborate regression results. In particular, Demirguc-Kunt, Feyen and Levine (2012) estimate quantile regressions (1) of economic activity on both bank and securities market depth relative to GDP, finding that both banks and securities markets become larger relative to the size of the overall economy as countries develop economically. These findings hold across various measures of bank and securities market development, including measures incorporating private domestic bond markets. They find that the association between economic activity and bank development decreases with economic development, but the association between economic activity and securities market development increases as countries grow. In other words, as economies develop, the marginal increase in economic activity associated with an increase in bank development falls, while the marginal increase in economic activity associated with an increase in securities market development goes up. These results are in line with the correlations presented here in figures 1, 2 and 3, and they are also consistent with predictions from the theoretical literature discussed above.

[FIGURE 3 OMITTED]

The global financial crisis experience has also (re)opened the question of whether crises are more or less likely in bank-based versus market-based systems. Of course, the United States and the United Kingdom, both examples of market-based financial systems, were at the epicentre of the recent crisis. But that does not necessarily mean that market-based systems are more prone to crises over longer periods of time. Figure 4 illustrates this issue graphically for cross-country data from 1970-2010, that is, combining data from the current crisis with those from earlier crisis episodes. The figure juxtaposes the data on financial structures with the often-used financial crisis database by Laeven and Valencia (2010).

Figure 4 suggests that bank-based systems may be relatively more prone to systemic crises. To illustrate this, consider for example all financial systems above the 45 degree line, that is, systems in which the financial structure ratio (defined as stock market value traded divided by private credit) is below 1. For those systems, the frequency of crisis observations is 13.1 per cent, while for the systems below the 45 degree line the crisis frequency is 6.9 per cent.

Is there a link between financial structure and the likelihood of a financial crisis? Fully addressing this question would deserve in-depth analysis that would go beyond the scope of this article and would require controlling for variables that may make poorer countries, which tend to be bank- based, more subject to crises. Nevertheless, when we numerically solve for the financial structure ratio that maximises the signal-to-noise ratio, that is, minimises the frequency of misclassified observations, we get some interesting clues. Based on the sample in figure 4, that 'maximum signal-to-noise' financial structure ratio equals 0.5. For systems with a financial structure ratio below 0.5 (that is, systems where stock market value traded is less than half of the private sector credit), crisis frequency is 14.7 per cent, while it is only 5.5 per cent in the other systems (a difference that is statistically significant at the 1 per cent level). (2) Of course, this does not mean that market-based systems are crisis-free--they still have crises on average every eighteen years. But it means that overall they tend to be relatively less prone to costly systemic crises. These findings are consistent with some of the recent literature suggesting that there may be 'too much finance' if private credit exceeds a certain percentage of GDP (e.g., Arcand, Berkes and Panizza, 2011); our findings provide suggestive evidence that in many financial systems, stock market development may have stability advantages over further growth in private credit. We intend to explore these relationships in our further work.

[FIGURE 4 OMITTED]

Policy implications and the importance of incentives

These findings have two important policy implications.

First, in line with previous theory and empirical literature, we show that, as economies develop, services provided by securities markets become more important than those provided by banks. This was true before the global financial crisis, and still holds even for the crisis data. We also provide suggestive evidence that, despite the fact that the recent financial crisis started in market- based financial systems, bank-based financial systems generally suffer more from crises. These finding advertise the costs of policy and institutional impediments to the evolution of the financial system.

Second, as countries develop and their financial systems move from bank-based towards market-based, the traditional regulatory approach, which emphasises compliance with regulatory ratios, becomes less and less effective. Such a 'Basel-style' approach, which focuses on symptoms rather than on addressing underlying incentive issues in the financial sector, can work to some extent in bank-based systems with a small number of players, but it is increasingly likely to break down in complex financial systems with developed financial markets and a multitude of market players. There is therefore a greater need for properly monitoring and addressing the underlying incentive weaknesses in market-based systems.

Illustrations of the incentive breakdowns

The need for monitoring and addressing the underlying incentive issues was illustrated by the incentive breakdowns that contributed to the sub-prime meltdown. A wide body of literature illustrates that distorted incentives, at several levels, were a key cause of the US subprime mortgage crisis. For example, Wallison and Calomiris (2009) and Calomiris (2011) show that the policies to promote home ownership in the United States created perverse incentives within official and quasi-official agencies, contributing to the build-up of exposures in subprime mortgages, and to forbearance in the regulatory oversight of the risks. Similarly, Levine (2010) finds that the design, implementation, and maintenance of financial policies in 1996-2006 were primary causes of the US financial system's demise. He examines and rejects the view that the collapse was only due to the popping of the housing bubble and the herding behaviour of financiers selling increasingly complex and questionable financial products. Rather, the evidence indicates that regulatory agencies were aware of the growing fragility of the financial system associated with their policies during the decade before the crisis and yet chose not to modify those policies, under pressure from industry and politicians.

The incentive breakdowns were not exclusive to the US subprime market, of course. Barth, Caprio and Levine (2012), using a broader sample of developed financial systems, note that regulators often failed to implement the regulations and powers that they already had. They point out that, amongst other factors, psychological bias in favour of the industry, similar to that prevailing in sport, where referees regularly call games in favour of home teams, operates in finance (see also the literature on regulatory capture, eg Kane, 2001). In the authors' view, therefore, the key issue to address is not necessarily more regulation (although some additional regulations may be appropriate), but how to get regulators to enforce the rules.

The global financial crisis was thus a stark reminder of the crucial role of incentives in the financial market. In the run-up to the crisis, market discipline did not play its role because the underlying conditions for it to work were not met. In particular, market players' incentives were distorted and they did not have access to the necessary information. Many instruments were allowed to become highly complex and non transparent. Many institutions were also allowed to become too complex, too interconnected, and too big to fail (Otker-Robe et al., 2011; Blundell-Wignall et al., 2012). Information on interconnections and exposures of financial institutions was lacking. The increasing use of over-the-counter financial derivatives enabled financial institutions to transfer or to take on risk in non transparent ways, and to do so rapidly. Within financial institutions, there were serious principal/ agent problems related to the nature of ownership and the structure of executive compensation that favoured risk-taking and higher short-term returns to the longer-term detriment of shareholders. The assessment of the risks of the entities and instruments fell to specialised bodies, such as the rating agencies and auditing firms, but the ability of these agencies to conduct independent due diligence was limited in large part by conflicts of interest. In such a situation, effective market discipline could not function (Rajan, 2010).

Compounding the incentive problems in the financial market, financial regulators themselves also continue to face important conflicts of interest. For some, this arises from conflicting mandates; for example, some regulators are mandated to promote financial system development as well as to prudentially supervise it. Some regulators lack independence, and even regulators that are legally independent find it often difficult to withstand pressures from the industry. (3) The 'revolving door' of staff between the regulatory authorities and the industry- unavoidable to some extent, because industry background and familiarity with the instruments and activities help in understanding risks--resulted in the perception of conflicts of interest for some individual supervisors (Kane, 2007).

Issues with the policy response so far

As part of the policy response to the global financial crisis, the Financial Stability Board (2009) has developed an agenda of reform, and the Basel Committee has prepared new capital and liquidity requirements (as part of the so-called Basel III). New legislation has been passed or is being prepared also at the national level. For example, the Dodd-Frank Act is being implemented in the United States. (4)

While the reform initiatives go some way towards addressing the incentive breakdowns highlighted in the run-up to the crisis, there are significant implementation challenges. The prevalent regulatory approaches rely too much on 'symptomatic treatment' and, as a result, fail to address perverse incentives faced by financial institutions, market participants, regulators, supervisors and politicians.

Underlying these initiatives is the belief that the crisis would not have occurred if only the regulatory standards had been more comprehensive and sufficiently extensive, and if only the supervisors had had more extensive discretionary authority and resources. So, the deficiencies that caused the crisis are supposedly eliminated by ever-more complex sets of rules and regulations. However, in the United States, where the global financial crisis started, the regulations were already quite complicated and supervisory discretion and resources were extensive during the pre-crisis period. Internationally, the complexity of the banking rules had already increased significantly before the crisis with the introduction of Basel II. Nevertheless, private risk-taking at public expense reached unprecedented levels.

No matter how well intentioned and executed the Basel III redesign, Basel is an inherently static framework. As with its predecessors (Basel I and Basel II), Basel III is likely to be overtaken by events. Risk weights need to be able to change with the evolution of risks. For example, capital requirements should take into account the co-dependence of financial institutions, which can change substantively as the financial system evolves. This type of regulatory arbitrage and re-regulation is an inevitable part of regulatory reform that does not take into account incentive issues in a dynamic, forwardlooking fashion.

How to address incentive issues in an evolving financial system?

Ever more complicated rules, or even more supervisory discretion or resources, will not address the fundamental problems, unless there is an appropriate alignment of incentives. On the contrary, introducing simpler rules that take into account the incentives of market participants and regulators are less likely to be circumvented by market participants and easier for supervisors to monitor and enforce. An example would be to replace current risk-weighted capital adequacy rules with a simple leverage ratio complemented by loan interest rates. Such simpler rules, accompanied by increased transparency and appropriate alignment of incentives, could greatly enhance the role of market discipline.

As part of a more fundamental solution, Cihak, Demirguc-Kunt and Johnston (2012) propose regular 'incentive audits' to help identify and address those perverse incentives, before they give rise to systemic risk. The paper outlines an approach to the regulation of financial systems that would place issues of asymmetric information and incentives at its centre rather than as an afterthought. The proposed 'incentive audit' is a new tool to better identify perverse incentives faced by financial institutions, market participants and regulators, before they give rise to systemic risk.

There is a particularly great need for properly monitoring and addressing the underlying incentive weaknesses in market-based systems, as illustrated for example by the incentive breakdowns that contributed to the subprime meltdown in the US. Therefore, carrying out incentive audits, while relevant in any financial system, would be particularly useful in market-based systems.

Conclusion

In this article, we have brought together two distinct but related streams of recent research on the financial sector. One is the literature on financial structures, which finds, amongst other things, that, as economies develop, services provided by financial markets become comparatively more important than those provided by banks. It also suggests that less bank-centric systems are less prone to systemic crises. The second stream is the regulation literature, which emphasises the central role of incentives in the financial sector. It points out that the challenge of financial sector regulation, highlighted by the global financial crisis, is to align private incentives with public interest without taxing or subsidising private risk-taking.

Our core observation is that, as financial systems develop from bank-based to market-based, the traditional regulatory approach that relies on banking ratios becomes less effective. There is therefore a greater need for properly monitoring and addressing the underlying incentive weaknesses in market-based systems--as illustrated for example by the incentive breakdowns that contributed to the subprime meltdown in the US. In other words, tools such as 'incentive audits', while relevant in any financial system, would be especially useful in market-based systems.

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NOTES

(1) The quantile regressions model the relation between log real GDP per capita and financial development at the specific percentiles (or quantiles) of log real GDP per capita.

(2) These calculations use the systemic banking crisis definition of Laeven and Valencia (2010) but the results are qualitatively similar when this is replaced by alternative (broader) crisis definitions from the paper.

(3) Even supervisors that are independent in principle can be overruled for political purposes in practice. For example, US supervisors did raise alarms over the risks of subprime lending, but a significant tightening of the prudential practices did not occur before the crisis, reflecting pressures from the industry and lawmakers (Levine, 2010). Reviews of compliance with the relevant international standards (such as the Basel Core Principles) around the world find that some of the weakest areas relate to operational independence of regulators (Cihak and Tieman, 2011).

(4) Cihak, Demirguc-Kunt, Mohseni and Martinez Peria (2012) provide an update on regulatory developments in countries based on the World Bank's Banking Regulation and Supervision survey.

* World Bank, Washington, D.C. Emails: [email protected] and [email protected]. The views expressed in this paper are those of the authors and do not necessarily represent those of the World Bank or World Bank policy. The authors' thinking on financial structure and incentives has benefited from discussions with Ross Levine and Barry Johnston, respectively, as well as from comments at a World Bank seminar. Any remaining errors are those of the authors.

Table 1. Descriptive statistics

                             Standard
Variable              Mean   deviation   Maximum   Minimum

Log of real GDP per
  capita (constant
  2000 USD)            7.6      1.6        10.9      4.1
Private credit        39.3     35.9       319.7      0.0
Stock value traded    28.8     57.4       632.3      0.0
Stock market
  capitalisation      47.7     58.4       561.4      0.0
Securities market
  capitalisation      59.1     71.2       588.3      0.0

Source: World Bank's Global Financial Development Database.

Note: Calculated from available annual data for 1970-2010.