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German Working Papers in Lawand Economics
Volume Paper
Law and the Poverty of Nations - GivingCredit to Credit
Robert D. Cooter Hans-Bernd SchaferLaw School, UC Berkeley University of Hamburg, Germany
Abstract
Copyright c©2007 by the authors.http://www.bepress.com/gwp
All rights reserved.
Law and the Poverty of Nations
Robert D. Cooter∗
and
Hans-Bernd Schäfer∗∗
Chapter 5: Giving Credit to Credit – Banking and Securities
1st draft
∗ Simon Hall School of Law, Boalt Hall, University of California, Berkeley, CA 94720, USA. [email protected],edu ∗∗ Institute of Law and Economics, University of Hamburg, Rothenbaumchaussee 36, 20148 Hamburg, Germany. [email protected]
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In Afghanistan the wives of Pashtu herdsmen traditionally wear heavy silver
bracelets to show off their beauty and to store the family’s savings. Robbing a
woman provokes clan revenge feared by thieves, so women are good protectors of
wealth. In India, in contrast, poor people developed another way to store wealth. A
small group of friends, say twelve of them, meet in January, each one contributes
$10 into a pool and gets a chit, one chit is drawn at random, and the winner gets
$120. The winner uses the money for a relatively large purchase – a bicycle for
commuting, seed for planting, a refrigerator, a television, or a wedding. In February
the twelve people repeat this process: each pays $10 into the monthly pool and a
person chosen at random wins $120. January’s winner, however, is ineligible for the
draw in February or any subsequent month. The process repeats itself each month
until December, so everyone wins $120 exactly once.
How do silver bracelets and chits differ? The silver bracelet does not produce
anything. The Pashtu herdsman resembles an Indonesian merchant who buries gold
under the floor or a South American subsistence farmer who stores crops in his
house until he eats them. By contrast, the chit fund creates something, namely
“credit,” just like a commercial bank, mutual fund, investment bank, dealer in stocks
and bonds, or other financial intermediary. With the chit fund, eleven lucky people
get $120 in less than a year and one unlucky person gets $120 at the year’s end. In
contrast, if each individual saved $10 each month for twelve months, then each of
them would have $120 at the year’s end. By advancing access to $120, the chit fund
makes eleven people better off and one person no worse off (a “Pareto improvement”
in economic jargon). Capital in bracelets is economically dead whereas capital in the
chit fund is economically alive.
Why do Pashtu herdsmen store wealth rather than investing in something
productive like a chit fund or a financial instrument? The chit fund involves the risk
that someone in the group who wins the pot will stop paying the monthly fee of $10.
The Pashtu herdsman apparently does not want to risk loaning to someone else.
Credit always involves a promise of future payments and the risk of non-payment.
When property protection is uncertain and promises are not enforced, savings flow to
the best protector and much capital remains as dead as a silver bracelet. Conversely,
when property protection is certain and promises are enforced, savings flow to
borrowers who can good use of the money as in a chit fund.
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The twelve friends who form the chit fund can pressure each other to make
their monthly payments. By personal relationships and group responsibility, the chit
fund overcomes the problem of “deadbeats” - people who do not repay debts. In
terms of Chapter 1, the chit fund is a form of “relational finance” based mostly on
informal social norms. Like chit funds, commercial banks, investment banks, and
other financial intermediaries create credit and channel savings to good uses. These
organizations, however, are forms of “private finance” and “public finance” based on
formal state law as well as social norms. This chapter concerns the informal and
formal legal foundations for financial intermediaries from chit funds to global banks.
Chapter 1 explained that economic innovation must overcome a double-trust
problem in order to unite ideas and capital. This chapter explains how financial
intermediaries confront and solve it. The property principle for growth and the
contracts principle, which the two preceding chapters explained, have their most
important application in finance. Finance does not just move paper money around in
obscure ways that ordinary people resent. Rather, finance is the foundation of
innovation and sustained economic growth. In this chapter we give credit to credit.
I. Lending to the Poor: Relational Banking
More than 20% of the people in poor countries live from less than a $1 per day
and more than 50% live from less than $2 dollars per day.1 If these people had
capital, some of them would invest in agriculture, small business, or education, where
the rate of return is high.2 For example, the private rate of return for investment in
schooling is higher in poorer countries than in richer countries or the stock market.3
People with little capital can ideally finance profitable investments by borrowing. The
1 World Bank, World Development Indicators, 1005, Table 2.5. 2 Empirical evidence on the rate of return for credits given to the poor is still scanty, but shows high average rates. A field survey based on 133 credits to small peasants in the Philippines found an average rate of return of 117 percent. Financing of mobile phones yields a very high return. See Hossain, M. and C.P. Diaz (1999). Reaching the Poor with Effective Microcredit: Evaluation of a Grameen Bank Replication in the Phillipines, International workshop on Assessing the Impact of Agricultural Research on Poverty Alleviation. International Center for Tropical Agriculture, CIAT, Cali, Columbia. 3 Note that the social rate of return on investment in education is somewhat lower than the private rate of return. Apart from education, intelligence increases productivity and commands a wage premium. A school certificate allows the graduate to “signal” that he is intelligent. Even if education does not increase productivity (no social return), schooling that signals intelligence commands a wage premium (private return).
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poorest people, however, cannot borrow from a bank because they have no regular
income and they own nothing to pledge as security.4 Between 65 and 85 percent of
Latin America’s people are outside the banking sector and have no access to credit.
Like chit funds in India, organizations in many poor countries solve the
problem of loaning to the poor by personal relationships and group responsibility.6
Personal relationships improve credit evaluations, so deadbeats never get loans.
Group responsibility improves debt collection by relying on social pressures rather
than on state courts. As a result, chit funds, cooperative banks, and similar
organizations that rely on group responsibility create credit for the poor more
efficiently than banks in some circumstances. These organizations played an
important historical role in rich countries and they continue to play that role in poor
countries, as we will explain.
A. Chit Funds Evolve In the preceding example of a chit fund, the monthly winner is chosen at
random. As chit funds developed, some of them changed the way to pick the winner.
Instead of a random draw, some chit funds auction the pot. To illustrate, if the pot is
$120 in January, members can bid to for it by offering to take less than $120. The
member who offers to take the least from the pot wins it. The winner in January
might offer to take $108, in which case $12 remains. The $12 can be divided among
the members with each receiving $1, like interest on a loan. With chit fund winners
chosen by auction, some members join primarily to become borrowers and bid for the
pot, while other members join primarily to become lenders and receive interest.7
Chit funds have increasingly stretched beyond close friends to encompass
more people, which creates more credit. If 24 people paid $10 per month to
participate in a 24 month chit fund, then 23 people would each get $240 in less than
2 years and 1 person would get $240 at the end of 2 years. Thus 23 out of 24 people
could buy something substantial sooner rather than each one saving for 2 years. 4 “Money, says the proverb, makes money. When you have got a little, it is often easy to get more. The problem is to get that little” Smith, A. (1776). The Wealth of Nations, reprinted 1983, p.195 6 A general name for these organizations is “rotating savings and credit associations” or “roscas.” 7 India’s Chit Fund Act of 1982 set a limit of 30% on the amount that could be bid for the pot. This is the equivalent of a maximum amount of interest on a loan (“prohibition of usury”). See Eeckhout, J. and K. Munshi (2002). Institutional Change in the Non-Market Economy: Endogenous Matching in Chennai's Chit Fund Auctions, Working Paper, University Pennsylvania, Department of Economics.
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Many people, however, do not have 24 relatives and close friends willing to
participate in a chit fund. To reach this scale, they must deal with acquaintances, so
the danger increases that someone will refuse to make his monthly payments. To
solve this problem, people form something resembling a club whose members screen
applicants for trustworthiness before allowing them to join. The club may hire a
professional to organize and operate the chit fund in exchange for a commission. In
this way, the chit fund reaches beyond relatives and close friends.
The evolution of chit funds did not stop at this point. Companies that organize
chit funds have become so large that they resemble commercial banks. Chit funds
are used to buy cars and houses. A large company offers different chit funds with
different terms, determines credit-worthiness of applicants, charges a commission,
and assumes responsibility for non-paying members.
According to our theory in Chapter 1, the three stages of finance in Silicon
Valley are relational, private, and public. The movement from friends to clubs
represents the transition in chit funds from relational to private finance. The
movement from club to competitive market represents the transition from private to
public finance. As in Silicon Valley, all three types of chit funds depicted in Figure 5.3
co-exist as living parts of India’s credit system.
Chit funds developed spontaneously without state approval, encouragement,
or subsidies. Social norms originally controlled them, without state law. This
Figure 5.3. Evolution of Chit Funds
Friends
Club
Market
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evolution illustrates a process that we call “market modernization”: The legal system
modernizes itself by following business practice, not by leading it.8 Specifically, chit
funds developed first and then laws regulated them. The laws ideally improve chit
funds by increasing the trust that consumers have in them. The polar opposite of
market modernization is legal centrism: Laws are made from the top down, in the
same way that central planning controls production.
Legal centrists sought to modernize India’s commercial banks by
nationalization and heavily regulation, which drove users out of banks and caused a
surge in the activities of non-bank financial institutions like chit funds. In recent years,
however, the reversal of these policies has shifted activity back from non-banks to
banks. But India’s banks continue to suffer from bureaucratic sclerosis and political
intrusion, which increases the space for chit funds. Chit funds lend to people who
cannot borrow from banks, charge lower interest to borrowers, and pay higher
interest to depositors than state banks.9 In 2005 non-banking financial institutions
counted for 6.5 percent of total assets in the financial sector, which is a lot of
activity.10 And this number only counts registered chit funds. India has created a
registration process and imposed minimal regulations on the activities of chit funds,
allegedly to curb abuse and fraud. But chit funds in the informal economy, which
especially serve the poorest people, are unregistered, unknown in numbers, and
uncontrolled by state law.
Much like chit funds, small cooperative banks developed in 19th century
Europe to pool funds, finance development, and share responsibility. On of the most
successful was the Raiffeisen Bank in Germany in the late 19th century and early 20th
century. Friedrich Wilhelm Raiffeisen was a conservative catholic who gave up his
military career for health reasons and eventually became the mayor of several
villages in Prussia. In the winter of 1846-47 a famine struck the village of
Weyerbusch where he was in charge. Raiffeisen founded a bread cooperative
8 See Cooter, R. (1996), The Theory of Market Modernization of Law, International Review of Law and Economics. 16: 141-172; a version of this paper was reprinted as Market Modernization of Law: Economic Development Through Decentralized Law with a comment by W. Kovacic (1997), in: Jagdeep S. Bhandari, Alan O. Sykes and (eds.), Economic Dimensions in International Law. Cambridge: Cambridge University Press: 275-317; 317-323. 9 Other advantages over banks are that people enjoy the element of gambling, and chit funds in the informal sector have more ability to avoid taxes. 10 Reserve Bank of India (2005) Non Banking Financial Institutions, Part 1, www.rbi.org.in/scripts/PublicationsView
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funded with money from a charity. The members of the cooperative built a bakery
and received credit from the cooperative to buy bread.
Later he transformed this organization into a cooperative bank, which became
a runaway success in rural Germany. It grew into a network of affiliated banks, many
of which still exist today. Here is how it worked. Each Raiffeisen bank was organized
as a cooperative in which old members nominated and screened new members. The
members bought shares in the bank, made a deposit, and then they were entitled to
borrow. Friends and relatives co-signed loans for individual borrowers. All of the co-
signers were responsible to the cooperative for repaying the loan (“sureties”).
Collective responsibility for debts and shared profits made every member interested
in admitting only reliable members, and the members monitored loan-making and
debt-collection.11 The central Raiffeisen bank pooled funds of the member banks,
served as lender of last resort, and supplied an outside professional to supervise and
audit the member banks.
The Raiffeisen banks needed legal innovations to succeed. The system
began as charitable relief of the poor by the rich. The first innovation allowed these
charities to accept deposits and lend money against interest to poor people. This
innovation shifted activity from charity to commercial lending. Originally each of the
members was liable for the debts of the whole cooperative. In technical terms,
cooperative banks were joint stock companies with unlimited joint and several liability
of the members. The second innovation replaced group liability for everything with a
new rule limiting each member’s liability to a multiple of his share value. Thus a
member’s liability depended on how much he invested in the bank, not on the total
amount of his wealth. Limited liability triggered explosive growth of Raiffeisen banks
in Germany. Numbering several hundred in 1885, they grew to 14,500 in 1910.
They helped to finance many agricultural improvements, and they replaced village
moneylenders.
In Germany, Raiffeisen banks succeeded in villages and rural areas where
enduring relationships made collective responsibility feasible, and they mostly failed
in larger towns where people have more anonymity and mobility. Raiffeisen banks
were transplanted to Holland, the Austrian-Hungarian Empire, Switzerland, and Italy,
11 Hollis, A. and A. Sweetman (1989). Microcredit, What Can We Learn from the Past, World Development. 26 (10): 1875-91
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but they failed in Ireland and India in the early 1900s.12 In the 1960s and 1970s,
development agencies tried to transplant cooperative banking to developing
countries, but they mostly failed. Cooperative banks failed due to corruption (big
loans to the families of their managers) and political interference (big loans to
politicians as demanded by regulators). The cooperative banks found in developing
countries today are mostly conduits for charitable and subsidized lending, not self-
sustaining commercial organizations. Many countries have forms of group finance
that we cannot discuss, such as the mutual insurance organizations in Islamic
countries called a "takaful." These organizations originally pooled funds to aid a
member of the group who suffered a calamity.13 Much like mutual insurance
companies that developed from the cooperative movement in the west in the late
19th and early 20th century, takaful currently operate increasingly like for-profit
insurance companies.
As an alternative to cooperative banking, many developing countries have set
up rural development banks run by the state. Commercial banks in India are legally
obliged to channel some of their liquid assets into rural development banks. These
banks give credits to small farmers. Unfortunately, the borrowers often regard the
loans as gifts exchanged for political loyalty. If the borrower defaults, the bank does
not enforce repayment.14 Unlike chit funds or Raiffeisen banks, rural development
banks in most of the world are not commercially viable and their lending is politically
motivated.
Many development experts who favor rural development banks regard
cooperative banking as an outdated model.15 The foundation of cooperation
banking, however, is the same principle that succeeded dramatically in chit funds --
12 Ghatak, M. and T.W. Guinnane (1999). The Economics of Lending with Joint liability: Theory and Practice, Journal of Development Economics. 60 (1):195-2
13 We wish to thank Haider Ala Hamoudi for explaining the takaful to us. He says that the rhetoric of mutual aid continues unabated, although many of these organizations actually function as profit-making institutions. 14 These problems have been extensively discussed in the Narashimham report. This report shows how gradual improvement is possible. It proposes to restrict obligatory lending to rural development banks to a fixed and moderate quota of total saving accounts of commercial banks and to end the political influence to finance sick corporations. 15 We owe this information to Klaus Glaubitt, Director for micro-finance at the Kreditanstalt fuer Wiederaufbau, the German development agency for capital transfers.
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collective responsibility. Next we turn to another variation on cooperative banking that
has multiplied faster than the rabbit in Australia.
B. The Grameen Bank In 1976 Muhammad Yunus, an economics professor in Bangladesh, went out
of his office into the street and tried to help someone. He began a project that grew
into the Grameen Bank of Bangladesh, which reported in 2006 that it has 6.23 million
borrowers in 2121 branches serving 67,670 villages covering 99.51 percent of the
total villages in Bangladesh.16 His efforts won him the Nobel Peace Prize in 2006.
The Grameen Bank continues to expand geographically (e.g. projects in Bosnia-
Herzegovina) and functionally (e.g. a new program of loans to beggars).
The Grameen (“gram” + the word for “village”) Bank works roughly as follows.
A bank employee, who believes in the Bank’s philosophy, attracts members from
poor people, each of whom buys a share for approximately $2 and receives a loan.
A typical loan might equal $75 and extend for 1 year at 20% interest, with repayment
in weekly installments. The loan might go for fertilizer on a farm or handcraft
materials for a small business. Early in its history, the Grameen Bank found that
women repay debts more reliably than men, so it mostly recruits women as members.
In 2006 the Grameen Bank proclaimed that 97 percent of its borrowers are women.
The members are organized into groups of 5. The bank employee works
intensively with the group to assure prudent use of loans and timely repayment. If
someone in the group fails to repay, the bank will not loan to anyone in the group in
the future. Individuals, however, are not liable for the debts of others. Thus the
Grameen Bank principle is group responsibility and individual liability. The Raiffeisen
bank’s original principle was group responsibility and group liability for everything
(later modified to a multiple of individual liability).
What about commercial versus charitable lending? Chit funds never received
subsidies, so they had to be commercially viable from the beginning. The Raiffeisen
banks began as charities and became commercially viable within 25 years of their
founding. Is the Grameen Bank a charity or commercially viable? A study
16 Grameen Bank of Bangladesh (2006). Report. http://www.grameen-info.org/bank/index.html.
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commissioned by the Grameen Bank in the late 1980s calculated that its subsidy on
operations was between 39% and 51%.17 A more recent study calculated that, for
the period 1983-1997, the subsidy per dollar-year borrowed was $ 0.22. In recent
years its annual reports claim a modest profit (but not in 1996 when it went bankrupt).
This claim is probably misleading because organizations like the International Fund
for Agricultural Development give it credits at below market rates. Grameen Bank
loans are mostly commercial and partly charitable, or so it appears.
Private commercial banks seldom voluntarily lend to the poor, who cannot
offer collateral, so the state often requires or pressures private banks into making
charitable loans, or the state extends loans directly through state banks. State banks
in India, the rural development banks, are required to make social loans to farmers.
The lucky recipients, who are often selected for their political connections, usually
have no real obligation to repay, so these loans are actually subsidies. Rural
development banks in many countries are plagued with high proportions of overdue
debts, which they roll over. They avoid bankruptcy only because they do not have to
meet commercial accounting standards. A political loan by a state bank is a form of
corruption. Forcing private banks to make charitable loans distracts them from their
core function of commercial banking.
Subsidized lending through organizations like the Grameen Bank is probably a
better way to combat poverty, so long as they continue to benefit poor people at
modest cost.18 However, its philosophy deserves critical scrutiny. According to the
philosophy of micro-finance, the solution to poverty is to turn the poor into micro-
capitalists. The poor in Bangladesh, according to this view, have investment
opportunities and will take advantage of them if they have credit. The poor will borrow
and then buy-and-sell their way out of poverty. No country in history has become rich
nor has any country removed its poor people from poverty by this path. If this
philosophy is correct, then poor people in countries like Bangladesh will follow a very
different path out of poverty compared to Europe, North America, Japan, or recent
17 Hossain, M. (1988). Credit for Alleviation of Rural Poverty: The Grameen Bank in Bangladesh. Research Report 65, Washington D.C.: International Food Policy Research Institute and the Bangladesh Institute of Development Studies. 18 A recent study concluded dryly that, for Grameen Bank lending, “...the consumer surplus probably exceeds the subsidy... [so Grameen Bank subsidies are] probably a worthwhile social investment”. Schreiner, M. (2003). A Cost-Effectiveness Analysis of the Grameen Bank of Bangladesh, Development Policy Review. 21(3): 357-382.
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progress in China. In Europe and North America, rising wages lifted most people out
of poverty in the 19th and 20th centuries, and the same is true more recently in East
Asia. Workers in these countries mostly use credit to buy cars or houses, not to
invest in production and raise their incomes. Investment by workers is marginal like
repairing a house, growing vegetables in the backyard, or contributing to a pension
fund.
Instead of using micro-finance to help most poor people become micro-
capitalists, another approach seeks out the small fraction of poor people who have
the ability to develop tiny businesses into larger ones, and lends money to them.
Lending money to the entrepreneurial poor may spur new businesses that will employ
other poor people and raise their productivity and wages. Instead of creating a not-
for-profit organization like the Grameen Bank or Pro Mujer in Bolivia, the alternative
approach creates for-profit organizations to supply microfinance to the poor. The
discipline of having to make a profit focuses these organizations on making loans to
poor people whose businesses will flourish and grow. The for-profit approach has
attracted some organizations in developing countries such as Acción International,
some high tech billionaires in California including Google.org and Omidyar Network
(Pierre Omidyar helped to found eBay), and Citigroup which is the world’s largest
banking network.19 A recent magazine article contrasted the two approaches as “not-
for-profit-do-gooders” and “for-profit-do-gooders.” The world needs more contests in
which the winner is the one who does the most good.
C. How to tell a banker from a moneylender
For-profit lenders hustle to find new opportunities to make money. In contrast,
subsidized lending necessarily creates more demand than supply, so charitable
lenders do not need to hustle. If some poor individuals have investment opportunities
and entrepreneurial ability, why don’t for-profit businesses hustle to find them and
loan them money? This question brings us to the oldest, most pervasive lender on
earth - the village moneylender. In rural villages or poor urban districts, these lenders
live among their borrowers and know who is thrifty and who is profligate, who works
19 Bruck, C. (2006). Millions for Millions, New Yorker Magazine. October 30, 2006: 62-73.
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regularly and who works episodically, who keeps his word and who breaks his
promises. With this information they can make loans to people who lack collateral or
steady income, and extend loans in response to misfortunate, thus acting as insurers
as well as lenders. Moneylenders generally make relational loans and insure based
on local knowledge.
Moneylenders profit most when reliable people stay forever in debt. Instead of
helping customers to pay off their loans, they prefer for people to pay only the interest
on their loans, and to pay it forever. Some borrowers fall farther and farther into debt,
so more and more of their income goes to interest payments, until they eventually
lose everything.20 Whether in Bangladesh or Baltimore, collecting debts from poor
people who cannot make their loan payments is a heartless business. When the legal
system is weak, gangster lenders who profit from distress assault or maim
recalcitrant debtors as a lesson to others.
Modern social critics describe moneylenders in scathing terms, like Christians
described Jewish bankers in medieval times. The scathing rhetoric is one-sided. For
each defaulting debtor in Bangladesh who is thrown into the street by a moneylender,
how many others who suffer a temporary setback escape being thrown into the street
by a loan from a moneylender? For every debtor whose interest payments grow and
grow, how many successful businesses began by borrowing from a moneylender?
The scathing critics have no information on this point.
Alas, neither do we, but development economists increasingly propose that
modern finance should encompass moneylenders.21 Compared to other lenders,
moneylenders have superior information on their debtors. Moneylenders are more
flexible than micro-credit organizations that insist on fixed repayment installments to
boost discipline. Moneylenders provide flexible terms of repayment in cases of
financial shocks. They can use social networks to enforce debt servicing. Traditional
moneylenders outsmart others when lending to the poor and the vulnerable.
20 For a model of emiserations by moneylenders, see Ligon, E. (2005). Formal Markets and Informal Insurance, International Review of Law and Economics. 25 (1): 75-88. 21 For a survey of the literature see Garg, A.K. and N. Pandey (2006). Making money work for the poor in India: Inclusive finance through bank-moneylender linkages, Agricultural Financing Corporation (working paper), available at http://dlc.dlib.indiana.edu/archive/00002110; See also Hoff, K. and J. E. Stiglitz (1998). Moneylenders and bankers: price-increasing subsidies in a monopolistically competitive market, Journal of Development Economics. 55 (2): 485-518.
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Instead of suppressing moneylenders, a better policy is to compete with them
through cooperative banks, micro lending, and chit funds. Competition among
lenders is sure to benefit borrowers. Another important approach uses law to coax
moneylenders to become bankers. First, the state must suppress strong-arm debt
collection and separate the moneylenders from gangsters. Second, the law must
allow consumers to escape their creditors through effective bankruptcy proceedings,
so that a defaulting consumer suffers no more loss than destruction of the ability to
borrow in the future. Third, he state should protect consumers from manipulation and
fraud in lending, which is no easy task.22
II. Bankers and Brokers
Having discussed relational loans to the poor, we turn to conventional banks.
Relational lenders and conventional banks finance investment in capital. To
understand the role of banks in economic growth, we first consider the connection
between capital and productivity. In construction sites in Germany, machines
resembling dental drills for dinosaurs bore the foundations of buildings, and other
machines carry away the dirt without human hands touching it. Germans substitute
capital for expensive labor on construction sites. In India laborers with picks and
shovels dig the foundations of some buildings and women remove the dirt in baskets
balanced on their heads. Indians substitute cheap labor for capital on construction
sites. Rich countries like Germany have more capital per person than poor countries
like India. If Indians accumulated as much capital per worker as Germans, would
Indians be as rich as Germans?
To answer this question, we define terms more precisely. If a country needs
$4 in capital to produce $1 in wealth on average, its capital-output ratio is 4/1. The
capital-output ratio measures efficiency in using capital. If the country becomes more
efficient, it might need only $3 in capital to produce $1 in wealth, and its capital-
output ratio would fall to 3/1. Excavation on a construction site uses more capital in
Germany than India, and the speed of excavation is much higher. If we form the ratio
of capital to output measured in dollars, does the German construction site use
capital more or less efficiently?
22 In the United States, the Truth in Lending Act protects consumers from exploitation by lenders, but it is a cause of massive litigation against banks that many observers call nuisance suits.
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Two important reasons point to opposite answers. A well-run construction
company first acquires machines that boost productivity the most, and later acquires
machines that boost productivity less. Getting more machines without any
improvements in them is called “capital deepening.” It is subject to the “law of
diminishing returns,” which implies that the German construction site should have a
higher capital-output ratio than the Indian construction site. Conversely, innovation
improves machines or their use, so the construction company’s newer machines
should be more productive than its older machines, or the old machines are better
used. When machines improve, buying newer machines or better using old ones can
increase productivity, rather than decreasing it as predicted by the law of diminishing
returns. Innovation implies that the capital-output ratio can remain equal or even
decrease in spite of capital accumulation.
We have explained that capital deepening causes the capital-labor ratio to
rise, and innovation causes the capital-output ratio to fall. Which effect dominates in
fact? Britain was much richer than Algeria or Tunisia in 1960. The ratio of capital to
output, however, was about the same in all three countries. So Britain was using
capital more efficiently than Algeria and Tunisia. Over the next 30 years, Britain and
Tunisia grew steadily richer, and the ratio of capital to output changed little. Thus
Britain and Tunisia sustained its efficient use of capital while it accumulated more of
it. Savings in these countries apparently flowed to innovative businesses. In
contrast, income stagnated in Algeria during this period, and the ratio of capital to
labor grew significantly. Thus Algeria used capital less efficiently as it accumulated
more of it. Instead of financing innovations, savings in Algeria deepened capital and
the returns to investment decreased. These observations of three countries suggest
what an analysis of many countries confirms: There is no general tendency for
countries to have a higher capital output ratio as they acquire more of it per worker.23
Savings can finance innovation and produce sustained growth, or savings can
deepen capital and yield diminishing returns. An important historical case of the
latter concerns communist Russia in the 1940s and 1950s. Stalin and Khrushchev,
who were successive chairmen of the Soviet Communist Party, forced the savings
and investment rate of the economy to unprecedented levels, and forced the women 23 King and Levine find no strong positive correlation between the capital-output ratio and capital per capita for 129 countries in the 1980s.
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into the workforce. Growth rates were spectacular until the 1950ies but less so from
the 1960ies to 198724. The weakness of the Soviet economy contributed to the
downfall of communism in 1991. Russian communism’s downfall is apparently a
story of diminishing returns from capital deepening in an economy with little
innovation. Even during the Stalin era the main motivation behind economic policy
was not growth or efficiency but the establishment of a command and control
economy. To gain loyalty from the party establishment, the budget constraint for
socialist firms and their managers was softened. This punished efforts to reduce
costs and work efficiently and it rewarded shirking, stealing and lying, thus increasing
the capital-output ratio.
A conventional wisdom about financing development in poor countries is the
idea of a “savings gap”. A low income level does not allow people to save much. To
reach high growth, the overall investment rate must be increased well above the
overall savings rate, especially by development assistance. But this idea is not
supported by facts. Since 1970 the savings rate in poor countries was not lower than
in rich OECD countries. Savings in poor countries are adequate to finance growth. In
recent years, people in low-income countries have even saved a larger fraction of
their income than people in high-income countries.26 The main problem is not saving,
but to channel the savings into productive use.
Banks attract savings and invest them creatively. Good finance causes growth in
poor countries. Bank development and stock market liquidity are good predictors of
future economic growth in a developing country. To unite new ideas and capital,
banks have to overcome the double trust problem described in Chapter 1. To explain
how banks accomplish this, we will first describe their most relevant activities.28
24 M. Harrison and K.B.-Ye (2006). Plans, Prices, and Corruption: The Soviet Firm under Partial Centralization, 1930 to 1990, The Journal of Economic History 66 (1): 1-40. 26 See World Development Indicators (2007). 28Beside banking and brokerage, financial services also includes insurance and payments instruments (credit cards, checks, electronic funds transfers, notes). In recent years, the financial services industry has found lucrative new ways to package risk, such as derivatives, swaps, letters of credit, and mortgage-backed securities.
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A. Portrait of Banking The traditional core of the financial services industry includes commercial
banking, investment banking, and brokering. Figure 5.1 characterizes these activities
according to the sources and uses of funds. First, banks take deposits from savers
and make loans to borrowers, which is called “commercial banking.” Commercial
bankers mostly require collateral from the borrower to secure the loan, such as land
and buildings (mortgages), movables such as machines, inventories, or financial
claims (pledges of movables), If the borrower defaults, the lender seizes the collateral
and sells it to satisfy the debt. Banks also make loans unsecured by collateral
(personal loans). To obtain an unsecured loan, most borrowers need wealth or a
steady cash flow or income like a government job.
Second, banks sell their own stocks and bonds, and then use the money to
buy the stocks and bonds of other companies. This is called “investment banking,”
as depicted in Figure 5.1. Banks invest in various funds such as the “technology
stock fund”, the “emerging markets fund,” the “municipal bond fund,” the “venture
capital fund”, or the “hedge fund.” The profits from these funds are divided between
the bank that manages them and the bank’s customers who invest in them. Different
funds carry different risks, but lending to an investment bank is generally more risky
than depositing funds in a commercial bank.
Figure 5.1. Three Core Banking Activities
Source of funds Use of funds Commercial banking deposits loans Investment banking bank’s stocks and bonds corporate stocks and bonds Brokering client’s orders execute orders
Third, brokers get money from their clients for executing orders to buy and sell
stocks and bonds in public markets. The clients pay commissions to their brokers,
who act as intermediaries in a market for shares and bonds, in which the lenders are
private persons.
Chapter 1 explained that innovation creates a double trust problem: The
innovator is afraid that the investor will steal his idea, and the investor is afraid that
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the innovator will steal his capital. Each of the three banking activities solves the
problem differently, and thus contributes to economic growth in a different way.
Instead of a business plan, some innovators give the financier collateral for a
loan. When collateral secures a loan, the lender does not need to know the details of
the borrower’s business. Secured creditors let borrowers keep most of their
innovative ideas and trade secrets. Commercial banking with fully secured credits
thus reduces the double-trust problem to a single-trust problem. When a borrower
defaults, the bank will seize the collateral. To seize collateral legally, commercial
banking requires laws and institutions for debt collection. The first line Figure 5.2
depicts these facts.
Figure 5.2. Solving Double Trust Problem
Device Law Commercial banking collateral debt collection Investment banking insider profit sharing contracts & corporate Brokering outsider profit sharing corporate & securities
Some banks in Silicon Valley specialize in lending to startup firms. The loan
agreement may require the startup to open a checking account with the bank for its
everyday transactions, and to maintain a stipulated balance. The bank stays
informed about the borrower’s financial health by monitoring the transactions in its
checking account. Silicon Valley banks finance innovation directly by lending to
businesses. Other commercial banks contribute indirectly by freeing the borrower’s
savings for use in business. Thus an entrepreneur may borrow money from a
commercial bank to purchase a house, which frees his accumulated savings to invest
in his business. The amount of commercial lending in a country depends partly on the
cost of debt collection. As we will explain, obstacles to debt collection in poor
countries limit the pool of commercial loans.
Unlike commercial banking, investment banks mostly get money by selling
their customers participation rights in its different lines of investment. A bank
organizes its different lines of investment into funds -- “technology stock fund”, the
“emerging markets fund,” the “municipal bond fund,” the “venture capital fund,” or the
“junk bond fund.” These funds buy stocks and bonds from companies whose
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success or failure determines whether the investment fund profits or loses. The
bank’s customers who participate in a fund share its profits or losses. Different
investment banks follow different investment strategies in different funds. Some
strategies rely on mathematical models that respond quickly to public information, so
the investment bank has no relationship with the companies whose stock it buys.
Other strategies rely on working relationships between the investment bank and the
companies whose stock it buys.
In such a relationship, the investor often wants to know the plans of the target
business in order to assess future profits, and the business often wants to keep its
secrets. As explained in Chapter 1, investment banking is a form of private finance
that solves the double trust problem through contracts, so contract law underpins
investment banking. In addition, corporate law protects the interests of different
parties entitled to a share of a company’s profits, so corporate law also underpins
investment banking. As we will explain, ineffective contract and corporate law in poor
countries limit investment banking. However, this limitation can be overcome
because investment banks can protect themselves even when law is ineffective. As
a condition of investing in a company, an investment bank often places its
representatives on the company’s board of directors or similar executive position.
Thus the investment bank is an insider that can use its power to protect its interests.
In contrast, the clients of brokers are usually outsiders who play a passive role
in the company’s management. Outsiders are more easily cheated out of their fair
share in the company’s profits than insiders. Protecting outside investors who buy
stocks requires corporate law and also securities laws with a specialized enforcement
agency. The last row of Figure 5.2 summarizes these facts about brokers. As we will
explain, ineffective contract and corporate law in poor countries restrict the
development of public securities markets and increase the relative importance of
banking.
B. Napoleon’s Problem Napoleon possessed almost absolute power, including the power to cancel his
own debts. As a consequence, his subjects would not buy his bonds. His excessive
power thus deprived him of an ability that he strongly depended on to fight his wars --
the ability to borrow money. The British king, in contrast, had less power – he shared
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it with Parliament – and he had to repay his debts. His subjects would buy his bonds,
and he sold them in London to finance his wars. The British king thus outspent
Napoleon in the wars between Britain and France, and England’s debt grew to more
than two times the British GDP by the end of the Napoleonic wars.29
State law in developing countries does not force some people to repay their
debts, so, like Napoleon, they cannot borrow much money. In Brazil the law forbids a
creditor to seize the debtor’s collateral without first obtaining a valid court order,
which makes debt collection expensive and time consuming. Peru has more than 20
different registries for different types of loans (one registry for collateral of farmers,
another registry for collateral of industrialists, etc.), and the registries in one part of
the country are unconnected to those in another part of the country.30 The World
Bank identified 40 countries where legal devices allow debtors to drag out the
process of seizing collateral.31 In Germany, however, the creditor can repossess the
debtor’s collateral within weeks or months of default without a court proceeding, so
many people in Germany can borrow money that could not do so otherwise.
Another legal problem for secured loans, which adds to the Napoleon problem is, that
substantive property law often imposes overly formalistic conditions for pledging
movables. Especially poor countries with a civil law system often suffer from the
“fallacy of concreteness” in movable collateral. Suppose that a bank wants to lend
against a herd of 100 cattle worth $100,000. In Kansas, the rancher would pledge
cattle worth $100,000 in a specific herd. In Uruguay the individual cows must be
enumerated in a closed list and the list must be continuously updated in order for the
court to accept the pledge as collateral. Similarly, in Kansas a dealer in wool can
pledge wool worth $100,000 in a warehouse, and the pledge remains good as the
particular wool in the warehouse turns over through sales. In Uruguay a dealer in
wool can only pledge the particular wool in the warehouse, so the collateral will
29 Ferguson, N. (1999). Wars, Revolutions and The International Bond Market from the Napoleonic Wars to the First World War. http://icf.som.yale.edu/pdf/NF.pdf. p. 13. And F. Mc Donald (2004). Is Public Indebtedness Essential to Democracy and Freedom? GMU History News Network. 1-19-04 30Salaverry, F. C. (2004). Accesso al credito mediante la reforma de la legislacion sobre garantias reales. Latin American and Carribean Law and Economics Association (ALACDE), Lima, Peru. 31 World Bank, Doing Business around the World (2005), p. 44. India has revised its law to accept credit agreements on the repossession of movable collateral without court involvement.
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dissipate as the wool in the warehouse turns over through sales. Uruguay’s civil law
system suffers from the fallacy of concreteness.32
A silver candlestick, barrels of beer in a warehouse, or bonds in a drawer are
easier to hide than land and buildings. And it gets easier the more time the creditor
needs to repossess the collateral. Creditors in poor countries consequently prefer
real estate as collateral, provided that they can repossess it.33 In many developing
countries, the creditor can evict a business and seize its real estate to satisfy a debt.
A recent study of secured loans in 60 developing countries found that corporations
secure 70% with mortgages and only 30% with movable capital.34
We have discussed some legal obstacles to debt collection. (There are
others.35) Higher obstacles yield greater rewards for overcoming them. One of
Mexico’s richest businessmen, Ricardo Salinas, first built his fortune by finding an
effective way to collect consumer debts. His “Elektra” stores, which now number over
600, sell televisions, refrigerators, washers, etc. Many of the buyers are poor people
who purchase on credit. When deciding whether or not to make a loan, the account
manager in the store obtains the names of the borrower’s relatives. If the borrower
subsequently falls behind in his monthly payments, the account manager will enlist
the help of relatives to collect the debt. This approach to debt collection relies on
reputation and group responsibility, similar to a Raiffeisen bank or Grameen bank.36
Inefficient debt collection raises the bank’s cost of loaning money, so it will
charge higher interest rates to borrowers. The bank, however, need not pay a higher
interest rate to its depositors. Inefficient debt collection thus causes the difference
between the interest rate that a bank charges to borrowers and the interest rate that it
32 See Fleisig, H. (1996). Secured Transactions, The Power of Collateral, Finance and Development. 33(2): 44-46. 33 The creditor wants the collateral’s value to stay as high as the remaining debt. "... Basically, the bank wants to ensure a rough balance between the value of the debt outstanding and the value remaining in the project, including the value of the collateral, at all times." Hart, O. (1995). Firms, contracts, and financial structure. Oxford and New York: Clarendon Press and Oxford University Press: 8-9.
34 This is true even though the study found that land accounts for only 22% of the value of corporate assets. Safavian, M., H. Fleisig and J. Steinbucks (2006). Unlocking Dead Capital, How Reforming Collateral Laws Improves Access to Finance, Public Policy Journal. 307 35 Another obstacle to collateral in the civil law tradition is that the pledge of a movable requires the creditor to take possession of it. If a shop in Germany sells a television on credit and lets the buyer take it home with him, the shop cannot have the television as collateral for the loan. To circumvent this problem, the shop in Germany retains title of the television until the debt is paid. 36 Ricardo Salinas explained these facts to Cooter.
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pays to depositors to increase. The difference between borrowing and lending rates
by banks is roughly three times higher in developing countries than developed
countries.
Source: World Bank, World Development Indicators, 2006
This fact suggests a big difference in the efficiency of bank collections,
although other causes are also at work.37 Improving debt collection is easy legally
and hard politically. People who suffer economic hardship struggle to pay their
debts. The public naturally sympathizes with the poor debtor and antipathizes with
the rich lender. The public does not feel the suffering of the poor who will be denied
loans in the future if poor people do not have to repay their debts. Public sentiment
generally puts greater weight on an ‘identified person” like a defaulting debtor than a
“statistical person” like a future borrower.
Beyond burdening debt collection, many poor countries forbid using some
valuable assets as collateral. A change in law that allows the owners to pledge these
assets can cause a spurt in economic growth. To illustrate, much of the country of
Silesia was devastated following wars that ended in 1763. To finance reconstruction, 37 Rochas-Suarez, L. (2001). Rating Banks in Emerging Markets, Working Paper, www.iie.com/publications/wp/01-6.pdf. Note, however, that low spreads do not necessarily reflect low risk and a better institutional environment. They can be found in banks in crisis, in politically influenced banks, and in banks that can count on a bail out from the state. And high spreads can reflect monopoly power of banks rather than undeveloped creditor rights.
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the Prussian King Frederick II changed the law in 1770 to allow the nobles to pledge
their manors as collateral. These loans financed the rapid reconstruction of Silesia.38
In the process, manors were thrust into the real estate market, and many noble
families lost their high economic and social position, which changed the social
structure.
Like Silesian nobles before 1770, current law forbids the clans of Papua New
Guinea to pledge their land as collateral, which slows economic development,
especially around cities. Creating a market in rural land, however, would undermine
the clan system of social organization, just like it undermined the manor system in
Silesia.39 Thus economic growth trades off with social stability in the countryside.
Religion poses another obstacle to commercial banking in some countries.
Christianity and Islam traditionally objected to their members charging interest on a
loan. Among Christians the ban against interest disintegrated over centuries and
disappeared, although its language persists in “usury” laws that impose legal caps on
interest rates.40 In Muslim countries, the ban on interest mostly remains in form but
not in substance. To preserve form and circumvent substance, Arab banks re-
characterize interest as profits.41 This makes modern banking possible at the price
of enraging some devout Muslims.
C. Magically Disappearing Profits In a Las Vegas magic show, slight-of-hand makes a beautiful woman
disappear before your eyes. With ineffective law, the same thing happens to
business profits. After 1988 gangster capitalists in Russia made profits disappear
from the books of state companies and reappear in their own pockets. They used
38 Melchers, T. (2002). Preußische Integrationspolitik im 18. Jahrhundert. Oldenburg: Diss. Oldenburg: 550. 39 See Chapter 3 of this book and Cooter, R. (1991). Inventing Market Property: The Land Courts of Papua New Guinea, Law and Society Review. 25 (4): 759. 40 Noonan, J. T. (1957). The scholastic analysis of usury. Cambridge: Harvard University Press. 41 Here is how to make interest in a two-person transaction disappear by using a third person. A has goods that he is sure not to use until next year. A wants to loan $1 to B with repayment of $1.5 in one year, so the interest is $.5. To make interest disappear, introduce C into the transaction as follows: A sells the goods to C for 1, who resells the goods to B for 1, and A promises to repurchase the goods from B for $1.5 in one year. B leaves the goods in A’s possession. The net result is that A receives $1 immediately from B and A promises to pay $1.5 to B in one year, just as with the loan. This ploy was explained by Hamidi, H. (2007) in a lecture, You Say You Want a Revolution: Deviationist Doctrine, Interpretive Communities and the Origins of Islamic Finance (work in progress), Berkeley Faculty Seminar.
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tactics like this: Seize control of a state company with mineral assets, sell the
minerals to your dummy corporation at low prices, and then resell the minerals on the
world market at high prices.
Worshippers at shrines in East Asia give the gods play money and ask them to
repay in real money. Similarly, in joint with foreigners, Chinese entrepreneurs
sometimes give paper rights to foreign investors who pay with real money. The
assets of the project disappear through connivance between local partners and state
officials.42 In general, outsiders are reluctant to buy stocks in a company unless
corporate insiders can give a credible guarantee that they will not divert the
company’s assets into their own pockets. Statistical analysis shows that when
ineffective laws make outside investors feel insecure, they will not invest, so a greater
proportion of companies must finance themselves internally.43
Members of the public who own a few shares in a company are the most
vulnerable outside investors. After 1989, Russia and the Czech Republic privatized
state companies by distributing shares broadly among the public, but the insiders
quickly appropriated the public shareholders. Instead of equality, the result was
cynicism. In a popular joke, the wife says to her husband, “Play cards if you must,
dear. At least you win sometimes. But don’t buy any more stocks.”
Chapter 1 described three general ways to create trust between investors and
the insiders who manage an enterprise: relationships, private agreements, and
public markets. Most rich and poor countries finance growth by combining relational
finance and private agreements. Thus in India stocks are often sold through informal
networks to people with long-run relationships.44 In Japan and Germany each
manufacturer traditionally had a “main bank” or “house bank” that provided most of its
finance. The main bank might arrange for a manufacturer and one of its suppliers –
say, a car manufacturer and a supplier of specialty steel - to stop trading on the open
market - and deal exclusively with each other. To seal the agreement, the bank
42 A friend of Cooter’s consulted on an aviation deal in which Europeans invested over $40 million, their Chinese partners took all of it, and they wrote off the loss. To protect their interests, foreign investors in China often ally with a strong political or military figure. 43 Demirguc-Kunt, A. and V. Maksimovic (1998). Law, Finance and Firm Growth. Journal of Finance. 53 (6): 2107-2137. 44 Cobham, D. and R. A. J. Subramaniam (1998). Corporate finance in developing countries: new evidence for India.Working Paper, University of St Andrews, St. Andrews, UK Asian Development Bank, Manila, Philippines.
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arranges for them to exchange their stock. ”In Japan the companies choose who will
buy their stock,” observers say, “and in Britain the buyers choose which stock they
will buy.”
The obvious way to protect bankers against a company’s managers is to bring
bankers inside the company to actively participate in managing it. As insiders,
bankers can detect slight-of-hand and protect their interests much better than
outsiders. To participate in management, bankers can hold board seats, designate
officers, or establish performance goals for managers with material rewards and
punishments.
A less obvious way to protect bankers against insiders rests on the distinction
in Chapter 3 between a firm and its assets. The firm’s market value is measured by
how much a buyer would pay for it, including its name, reputation, good will,
contracts, roles, and relationships. In contrast, the market value of its assets equals
the sum of its parts when sold piecemeal, such as machines, buildings, materials,
and accounts receivable. A successful firm is more valuable than its assets.
Consequently, a person who steals the assets of a successful firm gains less than
the firm’s value.
This fact provides a way to deter managers from stealing a firm’s assets. In
Silicon Valley the founders of a startup company expect to gain much more from its
success than they could gain by stealing the funds invested in it by outsiders.
Complicated contracts create these expectations by using financial arrangements
including collateral for loans, stocks, stock preferences, options to buy, and options to
sell. In general, if the managers stand to gain a significant share of the value of a
successful firm, then they may prefer for it to succeed rather than to loot it.
Chapter 1 explained that private finance requires less law than public finance.
This hypothesis implies that banks should dwarf stock markets in countries with weak
legal institutions. When a country goes through a period of rapid industrialization,
bank finance should predominate if the legal system is weak, and public stock
markets should play a more decisive role if the legal system is strong.
Developing countries often have only a few large banks. Regulating a few
large banks is relatively easy, even when few judges and regulators have economic
expertise. In contrast, markets for stocks and bonds cannot flourish without effective
corporate and securities laws that apply to hundreds or thousands of firms and that
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are adjudicated in hundreds or thousands of courts. This is especially true where few
judges and regulators have economic expertise. So bank finance may be relatively
successful in earlier phases of economic development because the required laws are
easier to develop compared to securities markets which collect capital from outside
investors.
In a 1962 book the economic historian Alexander Gerschenkron compared the
industrialization of Germany, Great Britain, and the United States.46 In the United
States and Great Britain, finance for industrialization in the 19th century was provided
more by stock markets than banks. During Germany’s rapid industrialization from
1895 to 1913, in contrast, the ratio of bank deposits to shares of stock increased in
value from 1.5 to 3.4. Large banks financed large firms through a strong credit
market whereas the stock market remained weak.47
As in Germany, the stock market has played an insignificant role in financing
China’s recent explosive growth.48 China grew rapidly in 1977-2003, but the stock
market was did not contribute much to finance until recently.49
46 Gerschenkron, A. (1962). Economic Backwardness in Historical Perspective. Cambridge, MA: Harvard University Press. He based his proposition on observations of the German industrial take off, which gained momentum after the unification of Germany in 1871. Germany industrialized later than most other rich countries. Bank credits played a pivotal role during the industrialization phase in the 19th and early 20th century. 47 Demirgüc-Kunt, A. and R. Levine (1999). Bank-Based and Market-Based Financial System, Cross Country Comparisons, World Bank Policy Research. Paper No. 2143 48 Hoshi, T. and A. Kashyap (2001). Corporate Financing and Governance in Japan. Cambridge: MIT Press. 49 Lau, L. Remarks to the Chinese Reform Summit, National Development and Reform Commission (NDRC), Beijing Diaoyutai State Guesthouse, July 12th-13th, 2005.
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Source: World Bank Development Indicators 2005
In Japan, the pattern was more complicated. Finance was not bank-based when
industrialization exploded in the early 20th century, but bank finance became
predominant in the 1930s when regulation favored it.50 Statistical evidence indicates
that bank finance has a relative advantage over capital markets in poor countries and
that securities markets surpass the importance of banks when the economy gets
rich.51 The change occurs partly because laws become more effective and outside
investors feel more secure. The statistical evidence is however not quite obvious.
The ratio of the market capitalization of stock listed companies to bank credits given
to private firms in high and low income countries was between 0,3 and 0,5 in both
income groups between 1995 and 2004.52 But this does not tell the whole story. In
poor countries most stocks are held by inside investors, by families and the state.
Inside investors are not dependent on legal protection through company law and
securities regulation. If they hold blocks of for instance more than 50 percent of the
equity capital like in Mexico, or more than 60 per cent like in Kenya or Egypt, this
contributes to the market capitalization but does not say anything about how well the 50 Hoshi, T. and A. Kashyap (2001). Corporate Financing and Governance in Japan. Cambridge: MT Press 51 Demirgüc-Kunt, A. and R. Levine (1999). Bank-Based and Market-Based Financial System, Cross Country Comparisons, World Bank Policy Research. Paper No. 2143 52 Calculated from World Development Indicators (2007)
0 20 40 60 80
100 120 140 160 180
Market capitalization of listed companies (% of GDP) Domestic credit provided by banking sector (% of GDP)
China
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law protects outside investors in the securities market. Blockholders are inside
investors and need no legal protection. Demirguz-Kunt and Levin (1999) have
constructed an index which shows whether finance is more through bank loans or the
capital market. Their analysis shows a tendency for more market-based systems in
richer countries. In the sample of 57 countries in more advanced countries with a
GNP per capita of more than 10.000 Dollars, 7 out of 17 countries are more market-
based than bank-based, and in countries below this level, only 11 of 40 counties are
more market-based than bank-based.
We have explained that weak legal systems tilt finance away from stock and
towards credit. This proposition, however, seems to contradict an important theory in
finance whose discovery won Nobel prizes for Modigliani and Miller. This theory
asserts that changing the proportion of stocks and credits used to finance a firm
cannot change its value. They define the value of the firm as the market value of its
stocks and credits. To understand their theory, assume that a firm issues more stock
and uses all of the money to pay back some of its credits. Since the money raised
from selling the stock pays for the credit, the amount of capital available for the firm
to invest in developing its business remains unchanged. If the firm’s investment
remains unchanged, its stream of future profits is also unchanged. Modigliani and
Miller prove that, under certain assumptions,53 the firm’s stream of future profits
equals its value, defined as the market value of its stocks and bonds. So changing
the firm’s ratio of bonds to stocks did not change its value.
Now we can explain why our arguments about stock and bond financing do
not contradict the Modigliani and Miller theory. Weak legal systems allow insiders to
make profits disappear from the firm and reappear in their pockets. If stocks held by
outside investors finance the firm, insiders have an incentive to make profits
disappear. If credit finances the firm, insiders do not need to share profits with
outsiders, so they do not have this incentive to make profits disappear. Therefore the
composition of finance between stocks and bonds affects the value of a firm, defined
as the market value of its stocks and credits. The Modigliani and Miller theory
53 Two important assumptions are tax neutrality with respect to bonds and stocks, and discounting of future profits at a rate reflecting the risk of this line of business.
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implicitly assumes that a strong legal system stops insiders from making profits
disappear from the firm and reappear in their pockets.
Insiders buy stocks and bonds through private deals, and outsiders buy stocks
and bonds in public markets. We have explained that weak law tilts finance towards
private deals and away from public markets. In private deals and public markets,
weak law tilts finance towards credits and away from stocks. Credits of a “main bank”
are easier to enforce than stockholder rights.
Protecting diffuse stockholders against insiders is such a difficult problem that
few countries have solved it. Recent empirical research shows that the widely held
corporation with dispersed ownership plays almost no role in developing countries,
and even in rich countries it is mostly restricted to the USA and the UK. Figure 5.3
shows decisively that stocks are traded far more in rich countries than in low or
middle-income countries. Econometric analysis concludes that better banking law
leads to more activity on bond and stock markets.55
Figure 5.3: Total Value of Stocks Trade as a Percentage of GDP Source: World Development Indicators, 2005.
55 Demirguc-Kunt, A. and R. Levine (1999). Bank-Based and Market-Based Financial Systems: Cross-Country Comparisons, World Bank Policy Research. Paper No. 2143. Data available for 57 countries.
0 20 40 60 80
100 120 140 160 180 200
High income OECD Low & middle income
Fig. É.Stocks t raded, total value (% of GDP) 1971-2003From World Development Indicators 2005
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. The tilt in finance towards bank credits and away from stocks dampens risk-
taking, slows innovation, and increases business failures. To see why, assume that
an entrepreneur uses his own money to start a company and then obtains additional
funds from bank credit. If revenues do not flow into the business fast enough to
redeem the credits, the business will go bankrupt and the entrepreneur will lose his
entire investment. In contrast, if he were able to sell stocks rather than bonds, he
would not need to make fixed payments, so the company’s revenues could grow
more slowly without precipitating bankruptcy.
This is not the only weakness of a bank-based system. The state can regulate banks
more easily than capital markets, but it can also easier manipulate banks for other
than development purposes as compared with stock markets. A predatory
government can get access to power and resources by controlling banks and
discriminating against the development of decentralized capital markets. It can
influence non-market loan decisions aimed at creating large conglomerates with good
relationships to the government (as in South Korea), channeling credits into sick
industries (as in India) or creating a military industrial complex (as in Germany and
Japan prior to the world wars) or to extract surplus from the economy for the benefit
of the ruling family (as in Soharto’s Indonesia).
D. Soft Budget Constraints
In business, sports, and war, leaders who fail lose their power. Business has
a formal legal procedure prescribed to dispossess a failed leader: Bankruptcy (see
chapter 7). The budget constraint is hard. Bankruptcy quickly transfers resources
from failed managers to new managers with better prospects for profitability
Unlike private businesses, the public sector has a relatively soft budget
constraint. Governments have no procedure like bankruptcy to strip power
automatically from officials who fail to meet quantitative goals.56 When a public
56 To our knowledge, the closest to bankruptcy in the public sector is the procedure that operates in some American school districts that close public schools if they repeatedly fail to meet targets for standardized test score by their students.
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organization runs out of money, it negotiates for more, again and again. The budget
constraint is soft.
Here is how soft budget constraints work in China. The dinosaurs in the old
industrial core – heavy industries like steel – were re-organized as companies that
issue stocks. The government owns enough shares to retain control over these
enterprises, and the law forbids the sale of these shares. 57 When these enterprises
lose money, as they inevitably do, the government makes state-controlled banks
provide fresh loans to cover the losses. In a summit meeting for China’s top
economic officials in 2005, several speakers identified the soft budget constraints on
state enterprises as China’s biggest economic problem.58
China’s startling economic growth has occurred in export industries outside of
its old industrial core. Many of these new enterprises are privately owned, and others
involve a partnership between private businessmen and local government officials,
especially in China’s many “village enterprises”. In dealing with village enterprises,
the Chinese government shows remarkable toughness: If they do not make money,
they cannot expect subsidies from the central government. The old industrial core,
however, receives the subsidized loans. Ironically, China’s failing enterprises in the
old industrial core pay a lower price for capital than China’s successful new
enterprises.
Earlier we mentioned that India nationalized its banks in the 1970s and they
suffered from bureaucratic sclerosis and political intrusion. Many other developing
countries nationalized banks with the same results. As in China, state banks soften
the budget constraint for state owned enterprises and other politically preferred
borrowers. Instead of losing power, managers in these enterprises go to state banks
for more loans.
57 These companies currently have four classes of stock:
Non-tradable shares held owned by the state. Non-tradable shares with non-state owners (e.g. state officials in their capacity as private persons). Tradable shares on domestic exchanges. (Chinese citizens can own them). Tradable shares on foreign exchanges. (Chinese citizens cannot own them.)
58 This was the theme of a speech by Raghuram Rajan, Economic Counselor and Director of Research of the International Monetary Fund, and also a speech by Charles Goodhart of the London School of Economic. Proceeds of the NDRC Economic Summit, Beijing, China, 11 July 2005.
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If the factories close, these employees will lose their jobs, which is very
painful.59 Besides factories, the large enterprises in China’s industrial core are social
enterprises that supply housing, schooling, recreation, and medical care to their
employees. So plant closing endangers more than jobs. Even so, other citizens may
eventually tire of subsidizing the old industries. To hasten the end of subsidies, the
government could make them overt instead of covert. To make subsidies overt, the
state banks should stop giving soft loans and the subsidies should appear in the state
budget as expenditures.60
In much of the world, the budget constraints on commercial banks are soft.
Banks make risky investments in which they win or else the taxpayer loses. In the
1980s, U.S. regulators in the Reagan Administration allowed government-insured
banks called “Savings and Loans” to try gambling their way out of bankruptcy. If their
highly risky investments succeeded, the bankers would win, and if they failed, the
taxpayers would lose. This gamble delayed the collapse until after President Reagan
left office, when massive failures triggered the government’s liability as insurer of the
depositors in these banks. The federal government apparently lost more money in
reorganizing these banks than in any other bailout or financial scandal in U.S.
history.61 When a bank says to the state, “I’ll wager your money that I am right,” the
state should refuse.
Almost every country regulates banking to control fraud, manipulation, and
recklessness, which can abuse individuals or even destabilize an economy. The
structure of banking regulation, however, differs from one country to another. In the
United States and Japan, the regulations traditionally separate commercial,
59 Econometrics from survey data has proved what people know intuitively: Unemployment makes people very unhappy and damages their self-esteem. Frey, B.S. and A. Stutzer (2000). Happiness, Economy and Institutions, The Economic Journal. 110: 918-938. Frey, B.S. and A. Stutzer (2002). What Can Economists Learn from Happiness Research?, Journal of Economic Literature. 40: 402 – 435. 60 Here are three steps to harden the bankruptcy constraint:
1. Prohibit state banks from making loans to failing enterprises. Put state banks on a commercial basis. 2. If a state bank stops loaning to a state owned enterprise, central or local officials can decide whether to pay the subsidies. 3. Create a reorganization procedure for failing state enterprises similar to bankruptcy under Chapter 11 in the U.S.
Goodhart, C. (2005). Remarks on Chinese Bank Debt. China Reform Summit: Promoting Further Economic Restructuring by Focusing on Administrative Reform, Organized by National Development and Reform Commission, P.R. China, Assisted by USB, July 12-13, Beijing, China. 61 Joe Stiglitz estimated the loss at one to two hundred billion dollars.
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investment, and brokerage activities by law.62 Germany and most developing
countries, however, allow each bank to engage in all three activities (“universal
banking”). The best pattern of bank regulation remains unclear. No country
recommends itself as an ideal model for baking regulation. International agreements
propose standards and protocols for all countries to follow.63 In spite of business
advantages from conforming to international standards, many countries do not
participate in the international agreements.
The central bank in each country implements policies that affect inflation,
interest rates, and unemployment. Macroeconomic mismanagement can wreck an
economy. In Argentina in the 1980s, inflation undermined the economy. Conversely,
in Argentina in the 1990s, a stable but over-valued currency destroyed exports and
caused unemployment. Mishandling of exchange rates in Thailand in 1988 caused an
economic slump that spread throughout East Asia. Abrupt devaluation of the
Mexican peso in 1994 caused an economic downturn that affected most Latin
American countries (“peso crisis”). Russia defaulted on its debts in 1998 and the
ruble plummeted, which increased the country’s economic distress. If the central
bank must finance excessive government deficits, the sale of government bonds can
crowd out private credits, so growth slows in the private sector. We mention these
examples of disruptive macroeconomic policies, but this book does not analyze them
because it focuses on law.
62 We say “traditionally” because the Glass-Steagall Act, which the U.S. Congress passed in response to the stock crash of 1929, has been eroded in small ways by new laws and court decisions. The current situation in the U.S. mixes the three forms of banking (and insurance) in complex ways. 63 The Asian crisis of 1997 led to the Basel core principles of banking and credit regulation proposed by the World Bank and the IMF. These principles emphasize the autonomy, powers, and resources of the bank regulatory agency, as well as bank reporting, minimal capital requirements, and risk assessment of credits. Under the “Basel II agreements,” banks should retain capital equal to 8% of liabilities or else submit to an “internal rating basis” that requires disclosing their credit evaluations of their debtors to bank regulators. See Hertig, G. (2005). Basel II to Facilitate Access to Finance: Fostering the Disclosure of Internal Credit Ratings, Law and economic Workshop, Hamburg University Law and Economics Center. The Basel Committee on Banking Supervision is an arm of the Bank for International Settlements whose rules apply to the banking regulators in each of 13 participating countries. Additional countries may voluntarily sign on. Some countries like the U.S. traditionally reduced these risks by legislation prohibiting commercial banks from engaging in investment banking or brokering -- The Glass-Steagall Act of 1933 has been eroded but not repealed. Banking law in these countries seem to be evolving to resemble countries like Germany with a tradition of “universal banking” – banks may engage in all of these activities.
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III. Conclusion
The economist Joan Robinson said, “Where investment leads, finance
follows.” This phrase suggests that banks will find their way to innovators like ants
find a picnic. Influenced by this thought, most textbooks on development economics
give little emphasis to finance or financial law.64 This omission is a serious mistake.
It does not give credit to credit. Sustained growth comes from solving the double
trust problem, and finance is half of it. Finance does not come to innovative ideas
like ants to a picnic. Instead, finance comes to innovative ideas like a man and a
woman come to marry. In finance and courtship, the stakes are high and so is the
risk.
Solving the problem requires law and institutions. Applied to finance, the
property principle for growth implies that law and institutions should enable lenders
and investors to keep much of what they contribute to a firm’s profitability. Similarly,
the contract principle implies that financing agreements should be enforced as made
by the parties. The elaboration of these principles in finance develops corporate law,
banking laws, and securities law. As financial laws strengthen, finance supplements
group responsibility with individual responsibility, relational lending with private
lending, private banks with public markets, and bonds with stocks.
64 R. Levine (1997). Financial Development and Economic Growth, Journal of Economic Literature. 35 (2): 688-726.
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