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| Title: |
Avoiding Financial Crisis: The Role of Banks, Bailouts, and Economic Diversification |
| Discipline: |
Finance |
| Date: |
11/2007 |
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Executive Summary:
Banks, Bailouts, and Emerging Economies: The Key of Economic Diversification
What is a root cause of financial crisis in emerging economies? Experts have posed numerous macroeconomic explanations such as financial market liberalization, too much foreign currency debt or too much foreign direct investment, and too much short-term debt. Research by Finance Professor Amar Gande of SMU Cox and co-authors attributes a missing link that is fundamental to financial crisis: economic specialization. In "Bank Incentives, Economic Specialization, and Financial Crises in Emerging Economies," forthcoming in the Journal of International Money and Finance, an alternate view of the origins of financial crises and banks' incentives offers policymakers the trappings of a fine-tuned economy, whether emerging or developed.
DNA of an Economy
The role of economic specialization has not really been brought into the academic literature in relation to financial crises. Gande says, "From a financial portfolio perspective, people understand what it means to be diversified. Much of the focus in the literature on financial crisis has been on the macro-level issues. In our research, we see economic specialization as very fundamental." This idea reveals itself in the example of Asian countries exporting certain types of goods prior to the 1997 Asian financial crisis. "When a country specializes, you get the upside of your expertise in the given product market, but this leaves the economy much more vulnerable to a financial crisis," Gande relays.
The authors illustrate the role of specialization or a lack of diversification of economic activities to prove the point. "India is sufficiently diversified at this point. If they specialized exclusively in high tech or agriculture (consider the spice trade in the 14th and 15th centuries) that would be a driving force for vulnerability," Gande describes. "That specialization would be a root cause for financial crisis in the underlying system. Everything else-debt ratios, foreign currency debt, or foreign direct investment-plays out over and above." If a country has a narrow set of products or specialties, and say borrows from overseas investors, the likelihood or probability is higher for financial crisis as shown in the paper, purely from a debt-driven state. In the United States, for example, this is not such a problem because of economic diversification. Thus large inflows of foreign capital or borrowings are not such a big deal.
Gande likens the concept of economic specialization as the "DNA of a country." Conversely, if an economy is largely diversified, whether there is considerable debt or foreign currency debt holdings, they are second order effects. The United States has the ability to take on shocks because of economic diversification. Looking at empirical data (which the authors are currently exploring in a sequel paper), if one looks at economic output across sectors and if diversification is present, the likelihood of financial crisis is lower. Gande states, "If we look at those economies with past crisis, many of those Asian countries were very specialized in narrow sectors, even some Latin American countries are afflicted. Countries like Malaysia, Korea, and Thailand were more specialized prior to the 1997 crisis. They have become a little bit more diversified since then, but we see that the world has become more connected economically as well."
What is central to a country is what activities they are involved in and whether those activities are broad-based. "With the advantage of economic diversification, whether there is a lot of debt or foreign currency debt, the effects will be of second-order," Gande says. In other words, if you have a lot of flexibility, you can better take the shocks that invariably happen.
Bank Financing Equations & Bailouts
When the role of bank financing is layered into the economic specialization equation, a different picture emerges. While having access to bank finance, the entrepreneur can expand the menu of projects taken on, the positive side of bank finance. This financing helps reduce economic specialization in the economy as it expands the menu of projects, which in turn helps reduce the potential for financial crisis. But, bank debt financing may "incentivize" the entrepreneur to take on more risk, possibly too much. This tendency or potential for equity holders to become risk-loving (i.e., less risk-averse) in the face of more funds for investment is a classic outcome in the financial economics textbooks. So there is a positive and negative to the role of bank finance in this regard.
Another unintended consequence of bank finance in the economy at large is the incentives for banks to concentrate their loans in certain sectors. Gande states, "Banks are rational maximizers. They know if a problem becomes too big, they can get bailed out." Consider the Long-Term Capital Management crisis. We have several notable "rescuers" in the United States that have done their jobs as of late: the Federal Deposit Insurance Corporation (FDIC) for banks, the Federal Reserve Bank for the financial system, and the Pension Benefit Guaranty Corporation (PBGC) for company pensions. The latter two have exercised their role considerably over the last couple of years, respectively: buffering the sub-prime mortgage mess with its spillover effects and bailing out several airlines' pensions with the post-9/11 downturn for the industry. Even now, several of the largest banks in the United States are working to bail themselves out of a credit crunch.
In a given country, banks will consider loan defaults. They could target their lending in certain sectors and the correlated lending will maximize the chances of being bailed out if the borrowers default. This back-end insurance for the banks (the bailout) can in fact create adverse incentives for banks to concentrate loans and create economic specialization. This narrowing of economic activity can reduce the flexibility of the economy once again, leaving it more vulnerable to economic shocks or financial crisis. Thus bank financing can also work against diversification.
An Ounce of Prevention
The authors have devised a mechanism to deter the excessive exuberance of the entrepreneur and the tendency of banks to concentrate loans in certain sectors. This mechanism can be viewed as a progressive tax that kicks in at very high levels of cash flow to the entrepreneur, but similar to the idea of insurance. "At very high levels of cash flow, the entrepreneur will pay a tax to government. And that money can be used for bailouts. So you are collecting money when times are good. It is easiest to implement as a tax or warrant structure. It kills the incentive to take on too much risk."
For the banks, a similar idea could be adopted. Gande says, "If banks concentrate their loans in certain industries, you get a bailout situation. If the International Monetary Fund or the World Bank could collect such a "tax" from the banks, they could help avert financial crises rather than trying to come into a country after the fact and try to sort out the damage." He mentions that by collecting taxes when cash flows are high (i.e., where the banks receive full promised payment on loans made to borrowers), the risk to the system is automatically reduced with funds that can then be deployed for crises. This can even be thought as new securities having features that minimize risk.
Countries' Discussion
Both China and India carry risks related to this specialization-bank finance dynamic. China, while not so economically specialized, has more risks on the bank side. "There are incentives for banks to concentrate their lending in certain limited sectors," Gande notes. "They might be doing more damage by concentrating." He continues, "If banks have more concentrated, correlated lending practices, they might transform the country in a bad way that leaves the country more vulnerable to financial crisis. You might see that in China, but we cannot be sure." When banks concentrate their lending, entrepreneurs will move away from economic activity where there's no financing available. These are the types of risks for India and China-the potential for correlated defaults by virtue of bank financing tendencies if things go wrong.
Countries most vulnerable are those that are specialized, however. In fact, this dynamic directly applies to Africa. Ethiopian co-author Professor Senbet talks about this a great deal when he goes to Africa. Given that many African countries are focused in narrow sectors, they are then more vulnerable to financial crisis. Bank financing may not be as prevalent there, but many African countries are economically specialized, particularly with oil and mineral resource dependent countries. This applies as well in parts of Latin America. The authors have also created an index of countries showing specialized countries at one end of the spectrum versus those that are diversified.
"The general point we make is that the general basic structure of your economy defines what can happen and what can be averted," Gande surmises. "This will determine how things can progress economically. Even though there are good reasons to be specialized from trade theory and the laws of comparative advantage, there are the costs to being too specialized in terms of a financial crisis."
The concept of a "developing" economy or a "developed" country is based on income levels of the population. This paper would say: Look to the distribution of a country's output as a proxy for development-how the economy is structured. "It presents an alternate way of looking at economies," Gande concludes.
"Bank Incentives, Economic Specialization, and Financial Crises in Emerging Economies" by Amar Gande of SMU Cox, Kose John of New York University, and Lemma Senbet of University of Maryland is forthcoming in Journal of International Money and Finance.
Written by Jennifer Warren. |
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