Since the global financial crisis, “banking” haspractically become a swear word. But, while banks undoubtedly have the capacityto inflict serious damage on economies and livelihoods, a well-run financialsystem can offer significant benefits. A growing body of evidence, highlightedin the World Bank Group’s recent GlobalFinancial Development Report,shows that financial institutionsand markets have a profound influence on economic development, povertyalleviation, and the stability of economies worldwide, and that a pragmaticassessment of the state’s role in finance is warranted.
On the surface, the most unusual feature of the ongoingfinancial crisis is that developed economies have been affected much morestrongly and directly than developing economies, many of which have learnedfrom previous crises, put their fiscal houses in order, made progress onstructural reforms, and improved supervision and regulation.
But this distinction misses the larger point: the qualityof policy matters much more than the level of economic development. Somefinancial systems in developed economies – for example, in Australia, Canada,and Singapore – have shown remarkable resilience, while others have gotten intotrouble.
At the same time, the focus on financial reform indeveloped economies, while warranted, has contributed to complacency indeveloping economies. For example, many are facing their own version of the“too big to fail” problem – which the crisis reinforced – but have done littleto address it.
Moreover, measures taken during the crisis may have helpedto mitigate financial contagion, but some do not support robust long-termdevelopment of the sector. Many developing economies weatheredthe crisis at the cost of massive direct state intervention, while their financialsectors lack breadth and access.
The financial crisis has had a particularly profound impacton the supply of finance at longer maturities.To some extent, this is understandable, given the focus on short-term liquidityand capital flows. But the sharply decreased availability of longer-termfunding is heightening financial-sector vulnerabilities.
While developing economies’ share of the global economy hasrisen from roughly one-third to one-half over the last decade, developedeconomies continue to dominate the supply of long-term funding. The mismatchbetween the time horizon of available funding and that of investors andentrepreneurs, particularly those in developing economies, is a source ofvulnerability that acts as an impediment togrowth.
Several factors have diminished investors’ willingness toextend long-term credit. The financial crisis reduced private financiers’ risk appetite, making long-term exposures unappealing. Net private capital flows, particularlyto developing economies, have become more volatile.
Private capital, which accounts for more than 90% ofcapital flows to developing economies, will remain the dominant source oflong-term financing. But the availability of long-term capital appears to havebeen impaired, as traditional providers of equity to infrastructure projects,for example, have become less able or willing to invest. Financing from bankshas also been constrained owing to deleveraging, particularly by Europeanbanks.
The new Basel III package of global banking reforms may increasefunding costs further for some borrowers, while reducing the availability of finance, especially for longer-termdebt. Institutional investors, such as pension funds and life-insurancecompanies, with more than $70 trillion in assets, are a major additional sourceof long-term capital. While such investment in long-term productive assets likeinfrastructure is essential to generating the income that these investorsdemand, less than 1% of pension-fund assets are allocated directly toinfrastructure projects.
Meanwhile, net savings in developing economies areincreasing, and low yields in developed economies are providing an incentivefor investors to channel more resources to productive investment in thesecountries. Recently, several banks have been able to issue long-term bonds ataffordable rates.
Another promising development is the growth oflocal-currency bond markets. These markets can become a strong source of financingfor longer-term domestic investment, including in infrastructure, therebyreducing currency risk for borrowers and investors. But strong and sustainabledevelopment of these markets cannot occur without institutional and regulatoryreforms that ensure an attractive environment, as well as capacity-building inboth the public and private sectors to facilitate further market development.
Investors’ willingness to make capital available over thelonger term for infrastructure development, job creation, and economic growthdepends on their perceptions of various kinds of risk. Policymakers can managethese perceptions by improving public-sector governance, ensuring soundmacroeconomic management, promoting a transparent and supportive legalframework for private-sector activity, building debt-management capacity, andprotecting investors from expropriation.
Moving away from a one-size-fits-all approach to financialreform means committing the time and effort needed to understand the politicaleconomy, as well as establishing partnerships with representatives fromgovernment, civil society, and the private sector. Such tailored solutions areessential to bolstering economic performance indeveloped and developing economies alike.