Banking for Development

Mar 01, 2013 Editorial

Today we conclude our survey of why China may be recording record growth for the last two decades: like other high flyers in the last century, it has imbibed the lessons of the historic American experience in the early nineteenth century. These were infant industry tariffs, internal infrastructural improvements, and a sound system of national finance. Today we consider: a sound and appropriate financial system.
It is hard to determine what the characteristics of a “good” financial system are, but we should not assume that this only has to do with stability. In fact, it is hard to describe our prototypical American financial system in the 19th Century as “stable” and as well-functioning. In fact the American banking system was chaotic, prone to crises, mismanaged, and often fraudulent, and yet the US grew very rapidly during that time.
One commentator claimed that “reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada.” Canada was blessed (or cursed, according the commentator) in the 19th Century with being part of Britain, and so inheriting England’s much better managed financial system.
The American financial system then (and now) has been very good at providing money to risky new ventures. It provides capital on the basis not only of asset value but, more importantly, on future growth expectations – and risk-taking has been actively rewarded.
It also tended to self-correct very quickly – in the form of a crisis – and bad loans were written down and liquidated almost immediately. This was certainly painful in the short term – especially if you were a depositor in the affected bank – but by writing down loans and liquidating assets three important objectives were achieved. Financial distress costs were quickly eliminated, capital allocation was driven by profitability, not by implicit guarantees, and assets were returned to economic usefulness quickly.
The bottom-line for countries like Guyana, trying to achieve double-digit growth rates, is that while a ‘good’ financial system must allocate capital efficiently, it must also reward the correct level of risk-taking. In Guyana, the banking system has been much too conservative in its lending practices and has actually stymied the growth of our economy. This conservatism is not only found in its unwillingness to take its own risks in imitating, for instance, the shadow banking system introduced by the western financial system.
China is demonstrating that this type of financial system, which uses wealth management products or WMPs – deposit-like instruments that offer higher yields and are mostly held off-balance sheet – can be critical for intermediating its high savings. Just this week, the government has mandated they have to be registered with the local regulator. In Guyana, the Bank of Guyana offers the banks, awash with deposits, a safe haven in treasury bills. The government has been forced to pick up the investment slack, for which it inevitably misallocates finance, which then becomes a drain on the public treasury.
Unlike private businesses, the government’s investments are not loans which can be written down and eventually liquidated. In fact the IFIs that provide the loans always insist in receiving their pound of flesh, which comes from the taxpayers.
For a good financial system at our stage of development, it is vital that banks become much more adventurous (if they do not want to be ‘reckless’) in their lending policy. The Chinese shadow banking system has quadrupled since 2008 to about $3.2 trillion or 40 per cent of economic output. There is no evidence that countries with sound and conservative financial systems grow faster than countries with looser and riskier financial systems (although they do seem to have fewer financial crises.)
So, while the capital allocation process is obviously vitally important, we would also suggest that higher risk taking by banks and the liquidation of bad loans is just as important. Guyana has to move away from providing a vehicle for just allowing banks to only literally mint profits.