Financial Institutions and Economic Growth Essays

Financial Institutions and Economic Growth Essays Financial Institutions and Economic Growth Essay Financial Institutions and Economic Growth Essay 2000). Other things being equal, better-off and more dynamic societies have not only a larger amount of available resources out of which to save but also a higher propensity to do so. Throughout these years, the Scandinavian countries would appear to have been at an advantage in both respects relative to southern Europe. Before we analyse this relationship, however, we must deal with two potential distortions. The first concerns the probability that not all the financial resources considered in the preceding sections originated domestically. At a time of great international factor mobility, a poorer economy might well have a weaker domestic supply of savings to fuel its financial development, but be able to compensate this by attracting foreign-owned capital. On the other hand, more developed financial systems might reinforce their advantage by drawing in, additionally, large amounts of funds from abroad. Table 7 shows that at the end of our perio such net inflows were indeed contributing significantly to the growth of all financial systems but far more in the Scandinavian case. The latter’s superiority in attracting domestic resources was thus matched by a similar strength in the international sphere, a fact that has been noted before (Rousseau and Sylla, 2001). On the other hand, this did not alter much our previous ranking of these countries and still leaves to be explained the considerable gap between the two groups of countries in terms of financial liabilities per capita. table 7 about here] A second potential source of distortion was the effect of hoarding on financial activity. Given the alleged inclination of southern Europeans towards this form of storing wealth, as might befit traditional peasant societies, it seems fair to ask how much of the region’s weaker institutional savings performance was due to this. For the sake of argument, we suppose that Scandinav ian countries were too advanced, socially and culturally, to engage in such practices. We further assume that in southern Europe this concealed wealth would have taken the form mainly of gold coin silver would have been too bulky – and therefore the stock of this type of specie would have been its upper limit. In the late 19th century, this varied between ? 1. 4 and ? 2. 4 per capita, for Italy and Portugal respectively, with Spain somewhere in between (Zamagni, 1993; Reis, 1992; Tortella, 1974). Even if we admit that as much as half of this was hoarded, this would have entailed only a small correction of the figures in table 7, of about ? per capita, thus leaving its essential findings untouched. [15] Recent evidence based on more than seventy developed and less developed economies, between 1960 and 1995, have established a strong correlation between indicators of private savings and financial development. More importantly, they also provide us with regression estimates that quantify the positive influence of per capita GDP on the savings rate (Beck et al. , 2 000). The lack of any comparable evidence for earlier times prevents us from replicating this exercise here but we can follow another, less exact approach. This rests on the assumption of linearity in the relationship between the two variables, which is suggested by the behaviour of the underdeveloped economies that comprise this sample. Using the data in Prados (2000), we find that average differences, between Scandinavia and southern Europe, of income per capita were respectively 12 % in 1880 and 25% in 1913, and we shall presume that the gap between gross savings must have been similar. The differential in domestic per capita savings absorbed by the financial systems was, however, much greater, respectively of the order of 30 and 100%. This strongly suggests that besides the effect on financial development of levels of income and savings, other factors, mainly of an exogenous nature, must have played an important part too by causing economic agents to channel different shares of their spare resources to the financial systems of their respective countries. Three features of any financial system are bound to affect the inclination of savers to enter into lasting relationships with its institutions and markets and, in particular, to entrust them with funds. One is accessibility to users, another is suitability to their specific needs, a third is trust. In what follows we shall concentrate exclusively on the corporate financial sector because, in contrast, differences among countries in the development of their respective stock markets appear relatively minor. In the Scandinavian countries, the volume of private securities was considerably greater than that of state bonds, whereas in Spain, Portugal and Italy the opposite prevailed. Yet when we put all of these financial instruments together, the aggregate volume per capita is relatively uniform throughout the sample. Moreover, the information regarding national stock markets suggests that inter-country regulatory divergences were not substantial at this time and where they existed, this would not have made much difference to global outcomes (Fohlin, 2002). [16] Recent research on the post 1960 period has argued that cross country differences in legal and accounting systems help account for differences in financial development (Levine et al, 2000: 31) and similar claims have been made in a far broader historical perspective (Sandberg, 1978; Sylla, Tilly and Tortella, 1999). An overview of the legislation governing corporate financial activity does not suggest, however, that this was a major cause of the divergence we have been examining here. This is not to say that there was absolute regulatory uniformity within the sample or that the legal framework had no impact on other aspects of the financial history of these countries. Rather, there could and was an influence but the effect was not necessarily important in the present context. The Norwegian-Swedish comparison illustrates this. Regulation restricted the lending policies of savings banks in the latter country while it was quite liberal in the former. As a result, the Norwegian savings sector flourished and even took on the functions of commercial banks. In Sweden, on the other hand, it did only half as well and was overshadowed by the commercial sector, which in Norway was comparatively weak (Egge, 1983; Nordvik, 1993). Globally, however, the two countries achieved very similar results in terms of the assets gathered by the financial corporate sector as a whole, only through different structures. There are three ways in which the time-path of regulation could have influenced the evolution of commercial banking, yet in all of them a surprising degree of international uniformity is encountered. Barriers to entry is one of them. After a highly restrictive first half of the nineteenth century, which was dominated by specially chartered national privileged banks of issue created to deal with pressing monetary and fiscal problems, in the 1850s and 1860s it became relatively easy to found joint stock commercial banks with limited liability. This new ease of incorporation opened the system to competition, vastly increased the number of institutions and allowed them the freedom to open branches, which in some countries proliferated and in others not. The second area is that of the limits placed on the scope and type of business banks might undertake. Typically, rules defining lending policies were few and on the whole were quite liberal. In some cases, banks were simply governed by the general law on joint stock companies, while in others they were placed under a specific banking code (Grossman, 2001). Towards the end of the 19th century, however, and as a consequence of various crises, regulation was tightened in some countries, but it is unclear whether this entailed much change. The evidence is that the enforcement of bank legislation was on the whole lenient, in the spirit of Liberalism, and the institutions dealt with were often allowed to evade it when this was found expedient (Fritz, 1988). The ease with which Norwegian banks overcame the strictures of usury laws is an eloquent illustration of this (Knutsen, 2003). 17] Finally, a fully centralised note issuing regime does not appear to have produced results that were inferior, in terms of financial development, to those where multiple issue was in place. Despite the contemporary belief that commercial banks that had a right of issue enjoyed a business advantage over deposit banks, one finds instances of both regimes both in Scandinavia and southern Europe with no obvious impact on global financial performance. [18] Mortgage banking based on the issue of bonds, which was for profit in some countries, but not in others, displayed the most significant degree of regulatory variety. In Spain and Portugal, national monopolies were established from the start, while Italy experimented with regional ones and went over to a national one in 1890. They therefore tended all towards large loans and large denomination bonds. In Scandinavia, Sweden and Denmark were very liberal on this score, but Norway had a state mortgage bank. Table 5 reveals that in the long run, however, this mattered less to the respective shares of this sector than might be expected. In Denmark, mortgage bonds were very important but Sweden was on the level of the monopolistic countries, while Spain, with a similar set of rules, did frankly worse than all others, including Portugal,. When it comes to non-commercial, small scale, local and often cooperative banking, it is essential to remember first that this was a era in which two quite different types of saver supplied the resources of financial institutions and arguably constituted quite separate segments of the market (Verdier, 1996)[19]. The well-to-do deposited with or bought the shares of commercial banks, while middle and low income people prefered to entrust their savings to local savings banks, credit co-operatives and the like (Vittas, 1997). This being so, in societies where both kinds of institution had a significant presence, as happened in Scandinavia, the financial system was likely to collect a larger portion of savings. In Spain and Portugal, the weakness of the savings sector was such that it meant that a majority of the population in effect had little access to the system as a whole. Consequently, the volume of savings per capita gathered was smaller. Italy was able to do better than the Iberian peninsula because of a considerable and varied movement of thrift organisations prevalently in the northern half of the country that tapped, the savings of the humble and middle class people, whether rural or urban. It is far from evident, however, that national dissimilarities in legislative framework were responsible for this kind of institution to evolve to such contrasting extents. In all countries considered, thrift institutions were supported by local or national authorities in a variety of ways, with deposit guarantees and, perhaps most important of all, with tax exemptions. Arguably though, on the assumption that there was market segmentation, this would hardly have diverted funds from the commercial joint stock sector, which was the principal alternative. Until the 1880s, the general norm was absence of legislation, complete ease of entry, an enormous multiplicity of statutory arrangements and only slight restriction on the uses to which savings could be applied. Full and proper regulation had to await the 1880s 1875 in Sweden but, in the event, was of a very mild nature. [20] Supervision, accounting rules and some operating limits were introduced, against the solid resistance of the thrift institutions themselves, but by most accounts this barely influenced the sector’s level of activity (Bruck et al. , 1995; Hansen, 2001). One of the principal aims of regulation was to stimulate trust in the system by deterring irregularities and imposing transparency on its operations. As we have just seen, Scandinavias superiority in mobilising resources does not seem to have owed much to a better set of rules and regulations. From the publics point of view, a more reassuring indicator of trustworthiness was how a system performed, not its rules, and here stability of markets and institutions was doubtless the factor that would affect the inflow of savings. Whilst all countries were prone to turbulence and its savers and investors suffered losses as a result, between 1860 and the First World War, the southern European record seems to have been by far theworst. One instructive sign of this is the mortality of commercial banks. Complete data are only available for Spain, Italy and Denmark but are highly revealing. In Spain, aside from the earlier devastation wrought by the crisis of 1864-6, of the 117 banks founded after 1874, only 60 were still open in 1914 (Tortella, 1974). The losses to Italian commercial banking during three critical periods were similarly substantial: 42 out of the 143 in existence, in 1873-9; 21 out of the 161, in 1888-93; and 11 out of the 163, in 1902-4 (Mattia, 1967). In Denmark, of the 160 banks created between 1845 and 1914, only 20 failed. A second measure is the variance around the trend of a global systemic indicator such as total assets. Available information covers only the same three countries but the result, now comprehending all types of banks, fully confirms the earlier finding. [21] The stability of the Danish financial system was significantly greater than that of the Italian one, with the Spanish one a long way behind. If a stable financial environment meant anything to savers, then Scandinavia appears to have enjoyed a considerable from this point of view. Several factors can explain this contrast but two especially should command our attention. One is structure, the other is policy. As regards the first, Scandinavian economies enjoyed the benefit which, in southern Europe, Italy had over Portugal and Spain – of a relatively larger not-for-profit financial sector, which was less crisis prone than commercial banks. 22] This was due to several characteristics inherent in such institutions. They had better and cheaper information on the risks posed by clients, lower costs of administration and greater ease in enforcing repayments. Moreover they were less likely to suffer runs by depositors, who knew them well. In addition, they often enjoyed some form of group deposit-insurance, and normally enjoyed deposit guarantees from governments, local authorities or simply groups of local notables. Lastly, because unlike commercial banks they were not under pressure from shareholders to produce high dividends, they did not have to lend to projects with higher returns but also higher risks. Their image of conservatism more often than not was matched by reality even though they had to contend with the instability that is usually associated with a small scale. [23] Given how frequent and severe national bouts of financial instability could be, one has to ask whether domestic counter cyclical policies might not have influenced the attractiveness of these financial systems. As regards government intervention, the low priority given at the time to such policies rules out a significant role for this factor. On the other hand, national banks of issue were just beginning to play the part, informally, of money market regulators, something that would only be enshrined in their charters after the First World War. The timing of their assumption of lender of last resort status matches poorly the way in which these economies responded to financial shocks. In Denmark and Sweden, two highly stable systems, came to this early, between the 1860s and the 1870s, but so did in Portugal and Italy the Banca Nazionale, the Bank of Italy’s predecessor was already behaving as a bankers’ bank in the 1860s (Hansen, 1991; Lindgren and Sjogren, 2002; Reis, 1999; Polsi, 1996). On the other hand, Norway and Spain were both latecomers to this field, respectively in the late 1890s and just before the War and yet were at opposite ends of the league table for financial stability (Egge, 1983; Tortella, 1974). 24] While proto-central banking may not have been a major determinant of the closeness between savers and financial institutions, accessibility clearly was. The ease with which economic agents could approach the system mattered a great deal in establishing a relationship with it. One dimension was physical location, distance, ease of travel – and this was an important reason for the success of the Danish ‘parish savings ban ks’ (Guinnane and Henriksen, 1998). Another was the suitability for those involved of the institutions available to them. Savers would more readily supply an institution with funds if, other things being equal, they felt welcome, understood the procedures, knew the people they had to deal with and could easily satisfy burocratic requirements, e. g. minimum size of deposit. In other words, not all institutions and markets served equally well for everyone and this must have had an impact on the propensity to accept the liabilities offered by the system. As Table 8 shows, a considerable disparity existed during these years in the supply of outlets that each system offered. This is one more spect of the enormous distance that separated our two groups of countries, in this case the number of inhabitants per financial outlet, and also brings to light a ranking that matches exactly the ranking presented in table 1. In particular, Italy, which had a density five to eight times that of Portugal and Spain but was five times below the levels of Denmark, Norway or Sweden, had the financial system that managed to at tract the greatest volume of savings of southern Europe. Besides the number, the spatial distribution of these outlets also seems relevant. In Spain and Portugal, financial institutions were an urban phenomenon and were concentrated in the major centres. In Scandinavia, the opposite was the case. A large proportion of financial outlets was in small towns and hamlets. They were therefore close to country people, who were the majority of the country’s population. Thrift institutions were ‘local organizations, formed and run by local people to further what they saw as local goals’ (Guinnane and Henriksen, 1998: 52). . [table 8 about here] Altogether then, perhaps the most important factor in explaining differences in financial development lay in each society’s propensity to accept non-commercial banking in its midst. Scandinavia’s greater overall capacity to mobilise funds mainly derived from the strength of its thrift sector in all its forms, and this arose because so many people there were prepared to join these movements. Since this cannot be ascribed to major income dissimilarities, nor to diversity in regulation, nor even to the rise of central banking, only two explanations seem to remain available. Verdier’s (1996) standpoint is that it was political struggles that lay at the heart of the matter. In Denmark, Sweden and Norway, centrifugal political forces were important and prevented the state’s wish to centralize banking, thereby absorbing the resources of the periphery in order to finance central public expenditure. As a result decentralized thrift banking flourished. In the south of Europe, the opposite happened and consequently non-profit banking was suffocated by the pressure from a centralizing state intent on draining the financial resources of the periphery. There are two objections to this. The first is that what the state wanted these resources for was to finance the public debt, not central public expenditure, and here the contrast between the two regions could not have been greater. As we saw earlier, southern European countries were indeed voracious consumers in this respect. Secondly, we must also not ignore that in these countries finance for the public debt typically does not seem to have come from their peripheries, nor from provincial banks. Rather, it tended to be held personally and was accumulated at the centre, where saving propensities were apparently higher. This would explain why provincial commercial banking was able to expand in Portugal, Spain and Italy during this period, in spite of their huge public debt commitments (Reis, 2003). Perhaps a more fruitful enquiry should ask why, in the latter countries, except for a small group of wealthy and educated citizens, most of the provincial population appeared remote from institutional saving. For this we have to try and understand the roots of the stronger impulses in Denmark, Norway and Sweden to create small thrift organisations in terms of the stronger presence of certain social and cultural conditions in these countries (Guinnane, 1994; Galassi, 2000). A basic ingredient was trust, a form of social capital that involved a readiness to accept peer control and to enter into common ventures with other economic agents beyond one’s immediate social circle, which required that direct monitoring and control was left to others. Societies, like in Scandinavia, founded on a prosperous middle sized peasantry, that experienced successful agrarian reform at the end of the Ancien Regime, and where a more even distribution of income was present, seem to have provided an environment in which such attitudes could flourish. In contrast, apparently this was not the situation in Portugal and Spain, or Italy s south. In Italy, where in some regions only limited liability credit cooperatives (banche popolare) were common, by the 1880s clearly those in the south had much greater difficulty in attracting members’ and their deposits. As a result, they relied much more on share capital and rediscounts at large banks, and tended therefore to have to hide defaults in their accounts. This in turn exacerbated the problem of trust between members and management, the latter usually from a higher social stratum, and fostered a low-trust equilibrium (Ahearn, 2000). A second element in this approach emerges from the analysis of the early development of modern financial intermediaries, which appeared in Scandinavia already in the first half of the nineteenth century and which very much depended on the degree of human capital endowment present. Nilsson, Pettersen and Svensson (1999) have shown how literacy in the Swedish countryside before 1850 was associated with the rise in the use of sophisticated credit instruments and probably created a fertile seed-bed for the activity of localised credit institutions. Again, southern Europe was woefully behind in this field, with rates of illiteracy that were still 50 per cent or more in 1900 compared to negligible figures in their northern counterparts. A greater readiness on the part of Danes, Norwegians and Swedes to accept contract money, particularly in small denominations, may be another expression of this cultural dimension. 25] Finally, one should not neglect the influence of the strength of local sentiment in this matter. Its importance has been remarked upon a propos of Denmark (Hansen, 1982), as it has in the case of Italy, the only southern economy where local thrift organizations developed to a significant degree (Polsi, 1996). 5. Why Scandinavian systems recycled liabil ities better In comparing national differences in financial intermediation, the second major question of this paper has to do with the efficiency with which the funds gathered by each system were transformed into credits to the private sector. From this point of view, three circumstances help us understand the efficiency loss of about one half the measures the distance in this respect between the two groups of countries. Possibly the most important one was the more or less chronic difficulty associated with public finance in southern Europe, in contrast to its generally healthy condition in Scandinavia. For the former, this meant a crushing weight of Public Debt holdings and a scant application of these resources to growth inducing purposes. For the second group, not only was this burden far lighter but the resources thus absorbed were also used more effectively for investment. A further implication, of a more structural nature, was that the problem of an oversized public debt stimulated the emergence in Italy, Spain and Portugal of oversized national banks of issue, which dominated their respective commercial banking sectors, as we saw in section 3, and were the least efficient of all corporate institutions at recycling funds into credits. Why Italy, Spain and Portugal should have been consistently unable to break the grip of budget deficits and of a pyramiding Public Debt is an issue which plunges its roots deeply into the 19th century political, social and military histories of these countries. Unfortunately, it is impossible to do justice here to such a complex problem. One should note, however, that unstable political institutions, a weak public administration and an excessively powerful military were present in the region throughout the period, unlike what happened in the Scandinavian periphery. As a result, southern European governments found it hard to discipline expenditure, whilst the revenue-to-GDP elasticity tended to be very low as a result of the public administration’s incapacity to increase revenue sufficiently and diversify its sources. A strong military tended to embroil the country in occasional internal or external costly conflicts that had to be paid for mostly by means of fiscal and monetary unorthodoxy, and was an ever present factor of political instability. Public borrowing in itself was not the difficulty, since the Scandinavians engaged in it without harm. What was dammaging about it to the southern Europeans was its scale, which dwarfed other efforts at mobilising resources, and its use largely to pay off earlier borrowing and maintain a costly ineffective machinery of government. Negative structural effects on southern Europe were not confined to the politically motivated â€Å"excessive† development of their national banks of issue. The socio-cultural reasons that explained the greater prevalence in Scandinavian financial systems of thrift institutions can also be invoked here in explaining their higher global transformation ratios encountered in table 6 above. Less clear, on the other hand, is whether these factors also help explain the fact that, in every type of institution, this region unmistakably led southern Europe in terms of capacity to recycle its liabilities into credit. Two features of the financial environment appear more helpful in this respect. The first is the difference in the degree of risk that financial institutions had to face. This made it possible for the Scnadinavian ones to immobilise smaller proportions of total assets as reserves, or to avoid tying up resources in safe state bonds. The goals and the quality of management is the second circumstnace to account for differences in the proportion of idle assets in the portfolios of corporate financial institutions. Possibly, southern European managers were simply reacting reasonably to a riskier investment climate by allocating funds with greater prudence and conservatism than Scandinavian ones needed to. On the other hand, it has been hypothesized (Berthelemy and Varoudakis, 1996: 301) that ‘the technical efficiency of the financial sector is an increasing function of the collected volume of savings [and] that learning-by-doing effects also exist in intermediation activities’. Poor management has been claimed for both Portugal and Spain (Reis, n. d. ; Sudria, 1994) though comparisons with Scandinavia have yet to be carried out and the case therefore remains open. As regards Portugal in particular, it has been shown, following Hinderlitter and Rockoff (19.. ), that, after taking risk differences into account, the share of unused funds in the balance sheet of commercial banks was greater than could be justified by reference to practices in contemporary major financial centres. Finally, the high returns on government issued liabilities in southern European caused resources to be diverted away from private credit operations in contrast to Scandinavia where the yield of such holdings was comparatively less attractive and better alternative investment opportunities seem to have been more numerous. 6. Conclusion During the course of the long second half of the 19th century, the southern and the northern peripheries of Europe followed contrasting paths of financial development. This led to quite disparate results in the supply of credit to the non-state non-bank part of their economies and justifies perhaps speaking of a â€Å"Scandinavian†, as opposed to a â€Å"southern European† type of financial system. Having quantified these differences, this paper argues that the gap is large enough to justify the view that finance contributed to the divergence in economic growth between the two regions. To address the reasons for the substantial efficiency differential between southern European and Scandinavian financial systems, it was necessary to break this down into the two basic functions that financial systems carry out. One concerned the mobilization of savings as financial liabilities of these systems. The second revolved around the conversion of these liabilities into credits to the non-financial private sector. Southern European countries were losers in both instances. The analysis of the first of these brought to light that Scandinavian institutions were capable of mobilizing comparatively more resources than their southern counterparts, the exception being in state bonds, where the latter led by a clear margin. The second dimension of this study revealed that Scandinavian institutions were also capable, type by type but equally in toto, of extracting a larger quantity of credit from their laibilities in order to make them available to the productive sectors of the economy. To some extent these contrasts were caused by endogenous conditions. The simple fact is that Italy, Portugal and Spain were consistently poorer and were becoming increasingly so. This affected their volume of savings but also probably lessened the demand for the financial outlets that enabled savers to recycle these funds as institutional financial liabilities. On the other hand, exogenous factors probably also played an important part in helping to understand fully the process of financial development in these two regions. Essentially, three aspects are involved here. Regulatory conditions have loomed large in many analyses of this type but do not appear to have had a significant impact on the global outcomes picked up here, although they probably shaped some of the structural differences observed. A much stronger case can be made instead for the part of political, social and cultural factors in driving a wedge between the financial development paths that we have observed above. The last two were instrumental in leading to a greater development in Scandinavia of the non-commercial bank sector. This was responsible for diversifying the supply of financial outlets, attracting an much greater volume of savings per capita and then ensuring that a larger proportion of such funds became available for investment purposes. In all their complexity, political factors probably mattered most of all because they translated savings into a huge mass of state issued liabilities that stifled the expansion of the other parts of the system in the southern countries. At the same time, having helped to mobilize these funds, politics then became responsible for their sterilisation as financial instruments. When all is taken into account, it is this which perhaps explains the best part of the great financial divide between our two sets of countries. Of politics it can always be said that it might have been otherwise and this may seem a trivial conclusion. To claim this, however, would be to ignore the fact politics and institutions have long histories too and that path dependency is not solely the preserve of economic phenomena. References A’Hearn, B. (2000). Could southern Italians cooperate? Banche Popolari in the Mezzogiorno. Journal of Economic History 60, pp. 67-93. Aleotti, A. (1990). Borsa e Industria. 1869-1989: Cento Anni di Rapporti Difficili. : Edizioni di Comunita. Beck, T. , Levine, R. and Loayza, N. (2000). Finance and the sources of growth. Journal of Financial Economics 58, pp. 261-300. Berthelemy, J. C. and Varoudakis, A. (1996). 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