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Banking Systems in a Financially Integrated World

Author(s):
International Monetary Fund. Research Dept.
Published Date:
March 2003
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Over the last two decades, banks’ activities, which in many countries had been traditionally heavily regulated and protected from competition, have been progressively liberalized. Financial sector reforms, mutually reinforced by innovations in information technology and the relaxation of capital controls, have fostered international financial integration and consequently have given banking sector issues an increasingly important role in the activities of the IMF. Prompted by these developments, IMF researchers have examined a variety of issues related to banking sector liberalization, market structure, and financial reforms.

Financial reforms have eased legal barriers to entry, liberalized deposit and loan rates, relaxed restrictions on bank portfolios and ownership, and reduced reserve requirements. This process has also often involved the redesigning of prudential regulation and supervision, and a reduced public presence in the banking sector. Moreover, substantial theoretical work in the last 20 years has emphasized the role played by information in credit markets.1 A number of studies at the IMF have, therefore, focused on the interaction between information, bank market structure, and liquidity allocation.2 These studies show that the superior knowledge about borrower creditworthiness, which incumbent banks possess relative to new entrants, represents a barrier to entry in the banking industry. When faced with increased competition from foreign institutions, domestic banks reallocate their portfolio toward those market segments where their informational advantage is greater (for example, loans to small enterprises) and where returns, but also risks, are higher.

Exchange Rate Regimes: Choices and Consequences

Atish R. Ghosh (IMF), Anne-Marie Guide (IMF), and Holger C. Wolf (Georgetown University)

Over the 30 years since the breakdown of the Bretton Woods system, countries have adopted a wide variety of exchange rate regimes, ranging from dollarization and currency boards to simple pegs and crawling pegs, target zones, and clean and dirty floats. This proliferation of exchange rate regimes suggests that they must matter for something—but quite what remains an open question in the profession. While a vast theoretical literature explores the implications of various regimes, the abundance of possible effects makes it difficult to establish clear relationships between the exchange rate regimes and common macroeconomic policy targets such as inflation and growth. Exchange Rate Regimes: Choices and Consequences (MIT Press) takes a systematic look at the evidence on macroeconomic performance under alternative exchange rate regimes, drawing on the experiences of some 150 member countries of the IMF over the past 30 years. It asks whether pegging the exchange rate leads to lower inflation, whether floating exchange rates are associated with faster output growth, and whether pegged regimes are particularly prone to currency and other crises. The book draws on history and theory to delineate the debate, and on case studies and statistical methods to assess the empirical evidence.

The traditional industrial organization framework predicts that competition should reduce the costs and prices of banking services and lead to an efficient allocation of aggregate liquidity. More recent theories focusing on the special role played by information in banking have argued, instead, that standard models of competition are inappropriate for the banking sector. These studies have emphasized that competition may lead banks to take greater risks thereby making the financial system more fragile, and that, in the presence of informational asymmetries, greater bank competition may reduce, rather than increase, the aggregate supply of bank credit to the economy. IMF researchers have examined this issue from both a theoretical and an empirical point of view. Sarr (2000) presents a model where profit-maximizing banks are willing to reduce account fees when they have market power that allows them to reduce deposit rates. The overall effect is a reduction of the cost of deposits and, hence, increased financial deepening.3 Several empirical papers focus on the effects of bank competition and entry on intermediation spreads and credit availability. A number of these studies examine single-country cases. For example, Barajas, Steiner, and Salazar (1999) find that financial liberalization and foreign entry had a beneficial impact on bank behavior in Colombia by enhancing operative efficiency and increasing competition.4 Other studies analyze panels of countries. Martinez-Peria and Mody (2002) use panel data from five Latin American countries and find that foreign bank entry tends to promote competition by reducing administrative costs, and that foreign banks charge lower intermediation spreads than do their domestic competitors. Grigorian and Manole (2002) examine commercial bank performance in a panel of 17 transition economies. They find that bank consolidation and foreign ownership and control are likely to improve the efficiency of banking operations. Bonaccorsi di Patti and Dell’Ariccia (forthcoming) find a nonlinear relationship between bank competition and the creation of new firms, suggesting that some competition is “good,” but too much competition is “bad.”5 Furthermore, consistent with the prediction of recent theories of financial intermediation, they find that bank competition is more favorable to firms operating in sectors characterized by less severe information problems. Bossone and Lee (2002) approach the issue of the efficiency of entire banking systems rather than that of individual banks. They focus on “systemic scale economies” in banking, that is, efficiency gains associated with the size of the system in which banks carry out their operations. The authors use a wide cross-country panel to show that banks operating in systems with large markets and infrastructures have relatively lower costs of production and risk absorption.6

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Esteban Jadresic

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Market concentration and the degree of competition in the banking industry affects bank profitability and credit allocation. These in turn determine the riskiness of bank portfolios and banks’ ability to withstand macroeconomic shocks. Financial reforms are likely to have an effect on financial fragility since they have the potential to change the structure of the banking sector. Several studies have focused on the causes and consequences of banking sector distress.7 Among these, Demirgüç-Kunt and Detragiache (1998, 1999, 2000), drawing on data from panels of countries, seek to identify common determinants of banking crises. They find that, in the absence of proper regulatory and supervisory institutions, financial liberalization and generous deposit insurance schemes tend to contribute to financial fragility.8 This view is also supported by a number of studies that focus on specific episodes of financial distress.9De Nicolò and Kwast (2002) argue that consolidation may facilitate portfolio diversification and reduce risk at the individual bank level, but it may also raise systemic risk because large consolidated banks are more likely to have similar portfolios. They show that stock return correlations among large U.S. banks seem to have increased during the 1990s, suggesting that the potential for economic shocks capable of becoming systemic risks may have increased.10

Financial reforms have expanded the range of assets available to banks, allowing them to invest in foreign assets and to issue foreign denominated liabilities. This has increased banks’ exposure to exchange rate volatility with the result that systemic banking sector problems have played a major role in most of the recent crises. A few papers have focused on the role played by banks in episodes of international financial contagion. Van Rijckeghem and Weder (2000 and 2001) find that spillovers through bank lending or “common lender effect,” rather than trade linkages, explain financial contagion. They examine the Mexican, Thai, and Russian crises and find that countries borrowing from banks that are heavily exposed to the “original” crisis country are most likely to suffer from contagion.11 In their theoretical contribution, Goodhart and Huang (2000) argue that an international interbank market would improve liquidity sharing among banks, but would also lead to international financial contagion, which would have to be contained by some sort of international lender of last resort.12

Finally, bank market structure and the institutions governing the financial system are likely to have an important impact on the cost and effectiveness of bank restructuring in the aftermath of episodes of financial distress. Dziobek and Pazarbasioglu (1997) survey episodes of bank distress in 24 countries and conclude that successful bank restructuring was generally characterized by prompt corrective action on the part of the authorities and on a comprehensive approach that not only addressed the immediate emergency but also corrected regulatory shortcomings and improved supervision and compliance. Countries that privatized troubled state enterprises and allowed a substantial change in the structure of the banking industry through extensive use of mergers and closures were relatively more successful in their restructuring effort.13Zoli (2001) conducts a cross-country study of the cost and effectiveness of bank restructuring policies in transition economies. The absolute size of bad loans and weaknesses in the restructuring policies were the main determinant of the overall fiscal cost, while no relationship was found between restructuring cost and post-restructuring bank performance.14 Several other studies focus on specific country cases.15Frydl and Quintyn (2000) provide a theoretical framework to assess benefits and costs of official intervention during a banking crisis. They identify the relative size of the banking system and liquidation costs as the dominant factors affecting the net benefits of a public intervention.16

    For a review, seeF.Allen, H.Gersbach, J.P.Krahnen, and A.Santomero,“Competition Among Banks: Introduction and Conference Overview,”European Finance Review, Vol. 5 (2001).

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    G.Dell’Ariccia and R.Marquez,“Adverse Selection as a Barrier to Entry in the Banking Industry,”RAND Journal of Economics, Vol. 30 (1999), pp. 515–34; G.Dell’Ariccia,“Asymmetric Information and the Structure of the Banking Industry,”European Economic Review, Vol. 45 (2001), pp. 1957–80; and G.Dell’Ariccia and R.Marquez,“Flight to Quality or to Captivity? Information and Credit Allocation,”IMF Working Paper 01/20, 2001.

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    A.Sarr,“Financial Liberalization, Bank Market Structure, and Financial Deepening: An Interest Margin Analysis,”IMF Working Paper 00/38, 2000.

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    A.Barajas, R.Steiner, and N.Salazar,“Interest Rate Spreads in Banking: Costs, Financial Taxation, Market Power, and Loan Quality in the Colombian Case, 1974-96,”IMF Working Paper 98/110, 1998; idem, “Foreign Investment in Colombia’s Financial Sector,”IMF Working Paper 99/150, 1999; M.Mlachila and E.Chirwa,“Financial Reforms and Interest Rate Spreads in the Commercial Banking System in Malawi,”IMF Working Paper 02/6, 2002; D.Hardy and E.Bonaccorsi di Patti,“Bank Reform and Bank Efficiency in Pakistan,”IMF Working Paper 01/38, 2001; H.Juan-Ramon, RubyRandall, and O.Williams,“A Statistical Analysis of Banking Performance in the Eastern Caribbean Currency Union in the 1990s,”IMF Working Paper 01/105, 2001; and A.Kireyev,“Financial Reforms in Sudan: Streamlining Bank Intermediation,”IMF Working Paper 01/53, 2001.

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    S.Martinez-Peria and A.Mody,“How Foreign Participation and Market Concentration Impact Bank Spreads: Evidence from Latin America” (unpublished; Washington: IMF, 2002); E.Bonaccorsi di Patti and G.Dell’Ariccia,“Bank Competition and Firm Creation,”Journal of Money, Credit, and Banking (forthcoming); and D.Grigorian and V.Manole,“Determinants of Commercial Bank Performance in Transition: An Application of Data Envelopment Analysis,”IMF Working Paper 02/146, 2002.

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    B.Bossone and J.K.Lee,“In Finance, Size Matters,”IMF Working Paper 02/113, 2002.

    See the research summary by Enrica Detragiache in the March 2001 issue of theIMF Research Bulletin.

    A.Demirgüç-Kunt and E.Detragiache,“The Determinants of Banking Crises in Developing and Developed Countries,”IMF Staff Papers, March1998; idem, “Financial Liberalization and Financial Fragility,” in Annual World Bank Conference on Development Economics (Washington: World Bank, 1999); idem, “Does Deposit Insurance Increase Banking Sector Stability? An Empirical Investigation,”IMF Working Paper 00/3, 2000.

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    B.Drees and C.Pazarbasioglu,The Nordic Banking Crises: Pitfalls in Financial Liberalization? IMF Occasional Paper No. 161 (Washington: IMF, 1998); T.Balino and A.Ubide,“The Korean Financial Crisis of 1997: A Strategy of Financial Sector Reform,”IMF Working Paper 99/28, 1999; and A.Kanaya and D.Woo,“The Japanese Banking Crisis: Sources and Lessons,”IMF Working Paper 00/7, 2000.

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    G.De Nicolo and M.Kwast,“Systemic Risk and Financial Consolidation: Are They Related?”IMF Working Paper 02/55, 2002.

    C.Van Rijckeghem and B.Weder,“Spillovers Through Banking Centers: A Panel Data Analysis,”IMF Working Paper 00/88, 2000; idem, “Sources of Contagion: Finance or Trade?”Journal of International Economics, Vol. 54 (2001), pp. 293–308.

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    C.Goodhart and H.Huang,“A Simple Model of an International Lender of Last Resort,”IMF Working Paper 00/75, 2000.

    C.Dziobek and C.Pazarbasioglu,“Lessons from Systemic Bank Restructuring: A Survey of 24 Countries,”IMF Working Paper 97/161, 1997.

    E.Zoli,“Cost and Effectiveness of Banking Sector Restructuring in Transition Economies,”IMF Working Paper 01/157, 2001.

    C.Enoch, A.M.Gulde, and D.Hardy,“Banking Crises and Bank Resolution: Experience in Some Transition Economies,”IMF Working Paper 02/56, 2002; M.Pangestu and M.Habir,“The Boom, Bust, and Restructuring of Indonesian Banks,”IMF Working Paper 02/66, 2002.

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    E.Frydl and M.Quintyn,“The Benefits and Costs of Intervening in Banking Crises,”IMF Working Paper 00/147, 2000.

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