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    Published in The Role of Government in East Asian Economic Development

    Comparative Institutional Analysis, M. Aoki, H-K. Kim & M. Okuno-Fujiwara, eds.,

    Clarendon Press: Oxford, 1997, pp. 163--207.

    Financial Restraint:

    Towards a New Paradigm

    Thomas Hellmann

    Graduate School of Business

    Stanford University

    Kevin MurdockDepartment of Economics

    Stanford University

    Joseph Stiglitz

    Washington, D.C.

    Abstract:

    This paper examines a set of financial policies, calledfinancial restraint, that address

    financial market stability and growth in an initial environment of low financial deepening.

    Unlike with financial repression, where the government extracts rents from the private sector,

    financial restraint calls for the government to create rent opportunities in the private sector.

    These rent opportunities induce outcomes that are more efficient than either financial

    repression or laissez-faire policies. It is argued that deposit rate controls and restrictions on

    competition create franchise value in financial markets that curtails moral hazard behavior

    among financial intermediaries. Lending rate controls may also increase the efficiency of

    intermediation by reducing agency cost in loan markets.

    We would like to thank Masahiko Aoki, Gerard Caprio, Shahe Emran, Maxwell Fry,

    Masahiro Okuno-Fujiwara, Mushtaq Khan, Hyung-Ki Kim, Ronald McKinnon, Juro

    Teranishi, participants at the World Bank conferences in Kyoto and Stanford, and

    participants at seminars in the Stanford Department of Economics and the Stanford Graduate

    School of Business for their many helpful comments. This paper represents the views of the

    authors and does not necessarily represent that of any organization with which they are or

    have been affiliated.

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    Introduction

    This paper responds to the question of what governments can do assist the development of

    the financial sector. While the neo-classical "laissez-faire" prescriptions have been

    challenged -- in theory by the development of information economics, and in practice by themostly disappointing results from financial liberalization -- there is no consensus yet of what

    constitutes a good set of financial policies. The only point on which a consensus seems to

    exist is that financial policies matter. King and Levine (1993) identify financial depth as the

    most important explanatory variable in a large set of cross-country regressions.

    In this paper we propose some elements of financial policy that we believe form the core of a

    government strategy to promote financial deepening. These ideas are influenced by a stylized

    analysis of the policies pursued by a number of high-performing East Asian economies, and

    in particular by the Japanese post-war experience (cf. Aoki, Patrick and Sheard, 1994). The

    concepts are not, however, culture specific. Rather, we believe they represent a normative

    analysis of more general validity.

    The set of financial policies that we will call "financial restraint" are aimed at the creation of

    rents in the financial and the production sectors. For the purpose of this paper, by rents we

    do not mean the income that accrues to an inelastically supplied factor of production, rather

    we mean the returns in excess of those generated by a competitive market. The essence of

    financial restraintis that the government creates rent opportunities in the private sectorthrough a set of financial policies. The government sets the deposit rate below the

    competitive equilibrium level. In order to preserve rents in the financial sector, it must

    regulate entry and sometimes direct competition. The control of deposit rates may be

    complemented by a set of controls on lending rates to different sectors. Such controls serve

    to affect the distribution of rents between the financial and production sectors. We argue in

    this paper that rents in the financial and production sector can play at positive role in

    reducing information-related problems that hamper perfectly competitive markets. In

    particular, these rents induce private sector agents to increase the supply of goods and

    services that might be underprovided in a purely competitive market, such as monitoring of

    investments or the provision of deposit collection. A number of preconditions must be met,

    in order forfinancial restraintto operate effectively. The economy needs to have a stable

    macroeconomic environment, where inflation rates are low and predictable. Heavy taxation

    (whether direct or indirect) of the financial sector is incompatible with financial restraint,

    and importantly, real interest rates must be positive.

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    We think of two broad categories of rent effects. First, giving rents to financial

    intermediaries and production firms will increase their own equity stakes and make these

    institutions behave in a more proprietary way. Second, we often think of rents not so much

    as the transfer of wealth, but as opportunities to create wealth. Rent opportunities thus link

    actions of agents to the receipt of the resources. We will focus on instances where the

    government creates rent opportunities that induce economically efficient actions that private

    markets would not undertake because of a divergence between private and social returns.

    Financial restraintshould be clearly differentiated from financial repression. Under a regime

    of financial repression, the government extracts rents from the private sector, whereas under

    financial restraint, the government acts to create rents within the private sector. See Figure

    1. We can highlight the flow of rents under financial repression using a two-sector model of

    the economy -- the private sector and the government, as shown in Figure 2a. Thegovernment extracts rents by holding nominal interest rates well below the rate of inflation.

    A model offinancial restraintrequires a four sector model of the economy -- households,

    financial intermediaries, production firms, and the government, as shown in Figure 2b.

    Underfinancial restraint, no rents are extracted by the government. Rather, deposit rate

    controls create rents that are captured by financial intermediaries and by firms (if additional

    lending rate controls are applied as well).

    Our paper clearly relates to the large literature on financial development. While our analysis

    addresses the same fundamental issues raised by McKinnon (1973) and Shaw (1973), we

    reach somewhat different conclusions. We agree with McKinnon in warning against the

    government depriving the private sector of a positive real return on financial assets. We also

    share Shaws view that improving the quality of financial intermediation is critical to

    increasing the efficiency of investment. Our analysis differs, however, from theirs in arguing

    that selective intervention --financial restraint-- may help rather than hinder financial

    deepening.

    Our analysis identifies a number of ways howfinancial restraintcan foster financialdeepening. We argue that rents create "franchise value" for banks that induces them to

    become more stable institutions with better incentives to monitor the firms they finance and

    manage the risk of the loan portfolio. Rents create incentives for banks to expand their

    deposit base, and increase the extent of formal intermediation. In addition, the government

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    Financial

    Repression

    Financial

    Restraint

    Southern Cone

    experiment*

    Free Markets

    High

    Low

    Extraction Zero Creation

    Direct Rent Flow

    Inflation

    * The government did extract rents from the financial

    sector indirectly through the inflation tax

    Fig. 1 Rent Effects

    can sometimes target rents for specific bank activities to compensate for market deficiencies,

    such as the lack of long-term lending. Whenfinancial restraintpasses on some rents to the

    production sector through lending rate controls, there can be further beneficial effects. Lower

    lending rate reduce the agency problems in lending markets. Also, as firms accumulate more

    equity, lending risks and associated informational problems become less prevalent. since

    equity provides a tool for firms to signal private information to financial intermediaries that

    the banks would not otherwise be able to incorporate into funding decisions. Finally, if

    financial restraintis accompanied by a policy of directed credits, as some East Asian

    countries did, there may be "contest" effects among firms. If well structured, "contests" can

    provide even stronger incentives than competitive markets.

    It is important to note thatfinancial restraintis not a static policy instrument. Rather, the setof policies envisioned herein should be adjusted as the economy matures. Initially, when the

    economy is in a low state of financial development, the full set of policies described in this

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    Government

    Private Sector

    Government

    Flow of

    Rents

    Private Sector

    Productive Firms

    Financial Intermediaries

    Households

    Indicates flow of rents within private sector

    Fig. 2 The Flow of Rents under (a) Financial Repression and (b) Financial Restraint

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