Development failure, corruption, and the financial system - CiteSeerX

EUROPEAN PUBLIC CHOICE SOCIETY CONFERENCE April 15-18, 2004

Development failure, corruption, and the financial system Arye L. Hillmana,b,c and Miriam Krausza a

Department of Economics, Bar-Ilan University, Ramat Gan 52900, Israel b

CEPR, London

c

CES-ifo, Munich

Abstract Development failure in low-income countries is associated with poor governance reflected in pervasive corruption and also with fragile and ineffective domestic financial systems.

We show the relation between the two attributes of low-

income countries, with corruption providing the source of the fragility and ineffectiveness of the financial system by creating adverse selection in project financing and reducing the volume of financial intermediation. Development failure arises because of restricted growth opportunities through domestic investment but also, because of adverse selection, the projects that are financed are more likely to fail. Keywords: Development failure; Financial intermediation; Corruption; Adverse selection; Roving bandit; Stationary bandit JEL classification:

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Introduction Substantial evidence ties development failure to poor governance manifested as corruption (for example Easterly 2001; Abed and Gupta, 20021). At the same time, low-income countries are in general characterized by poorly developed financial systems (King and Levine, 1993, Calderon and Liu, 2003). The simultaneous presence of corruption and poorly developed financial systems in low-income countries raises the question whether it is corruption or the inadequacy of the financial system that is the impediment to development. Or, perhaps the consequences for development failure of corruption and Nietzschean behavior (where the strong simply appropriate from the weak; see Hillman, 2004a) are overemphasized, with other features of low-income economies independently compromising the functioning of the financial system in impeding growth and development, as for example deficient collateral or lack of trust. Rather than providing alternative explanations for development failure, corruption and inadequate financial systems may not be independent and a relation might be sought whereby the corruption that is pervasive in low-income countries is the basis for the inadequacies of the functioning of the financial system. In this paper we set out a model showing how corruption is indeed the foundation for the contribution of the financial system to development failure. Corruption is the cause of adverse selection in project financing selection by domestic financial intermediaries, with the consequence that a bias is imparted to financing of risky projects while also the volume of financial intermediation is reduced so denying individuals returns on savings. The ultimate cause of development failure through the financial system therefore remains corruption.

The effects of corruption on financial

intermediation differ, however, according to whether corrupt officials behave as stationary or roving bandits. As is well known, stationary-bandit behavior results in more efficient outcomes than roving-bandit behavior. In the circumstances we shall describe, roving-bandit behavior is the source of the adverse selection that undermines the functioning of the financial system, since the roving bandit

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For summaries and reviews of the observations and arguments by Easterly and in Abed and Gupta (2002), see Hillman (2002, 2004b).

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demands bribes before the uncertainties associated with the realization of a project’s returns are realized while the stationary bandit awaits the realized outcome of the risky investment project. We derive a condition establishing whether an official will choose to behave as a roving or stationary bandit, which in turn affects the efficiency of financial intermediation. We thus explain the risk and fragility inherent in financial intermediation in low-income countries, and also the phenomenon of low volumes of financial intermediation in these countries, as the consequence of the effect of corruption through adverse selection of investment projects.

The low volumes of

intermediation reduce welfare for individuals who wish to save as well as for entrepreneurs who cannot proceed with productive projects. Growth opportunities are consequently diminished. This paper is related to two strands of economic development literature; corruption and growth, and finance and growth. There is a large body of literature that addresses the issue of corruption and growth. A comprehensive review of the earlier literature can be found in Bardhan (1997). Corruption is attributed two opposite effects on growth, one positive and the other negative. The positive effect points to the ability of corruption to speed up processes and to motivate officials to act more efficiently. The negative effect of corruption is in slowing down investment. One of the most important aspects of this negative effect is that corruption results in poor protection of property rights and in the expropriation of income and wealth. When investors cannot be sure of their ability to realize investments and to protect their property, they will be reluctant to carry out projects. Moreover, an important source of corruption is red-tape. An increase in red tape creates more opportunities to extract bribes (Mauro 1995). Red tape slows down the process of investment as well as imposing the additional cost of the bribes. Parallel to the corruption literature, research has been carried out on how financial development is related to economic development. In the case of financial development there is a question of causality. Does financial development create growth2 or, does economic development foster the development of financial systems? Empirical evidence suggests that the direction of causality depends on

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Rajan and Zingales (1998), Beck et al. (2000), Calderon and Liu (2003).

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the level of development of the economy (Arestis et al., 2001). Thus, in poor countries financial development is crucial for creating economic growth (Levine and Zervos, 1998). The role played by financial institutions is to provide liquidity services to depositors3 and to channel funds from savings to productive projects by reducing transaction costs and diversifying risk (Diamond 1984). We argue that the existence of financial intermediaries does not in itself ensure economic development. This is because corruption and financial intermediation are related in several ways. First, a stable financial system can exist and function properly only if laws and regulations concerning their activities exist and only if these laws are enforced. Regulators themselves are, however, a source of corruption. Second, financial intermediaries may themselves be party to corruption through ownership of firms and through their ties with corrupt government officials. In fact, they may be owned by corrupt individuals and used by them as a tool for corruption. Third, financial intermediaries rely heavily on the judicial system to uphold the contracts signed with borrowers and to protect their rights in the case of bankruptcy. In the absence of these institutions, financial intermediaries are unable to function properly. We suggest that the ability of financial intermediaries to operate efficiently is determined by the level and the type of corruption that prevails in the economy. More precisely, we consider two types of corruption. One type of corruption involves officials who collect bribes immediately when they identify an opportunity to do so. These types of officials are known as roving bandits. The second type of corruption is characterized by patient officials who wait until they are able to identify the most lucrative sources of bribes. These types of officials are known as stationary bandits. Within this framework we show that corruption determines the level of risk in the financial system and hence its stability. This is due to the unique nature of financial intermediation, which operates in an environment of asymmetric information. The paper is planned as follows. Section 2 describes the framework of the model. Sections 3 and 4 describe the results of the model in the case of a roving bandit and a stationary bandit, respectively. Section 5 discusses the implications of the model with respect to the existence of different types of corrupt officials.

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Diamond and Dybvig (1983), Jacklin (1987), Levine (1991).

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Section 6 describes the effect of entrepreneurs' characteristics on the type of corrupt behavior and Section 7 concludes. 2.

The model In this model we consider a low-income economy that consists of several types of individuals and one monopolist financial intermediary. The individuals in this economy are divided into savers who have surplus income, entrepreneurs who have projects but do not have the income to implement their projects, and a corrupt official who controls either the implementation of projects or the realization of project returns through bribes. The model is a one period framework with two points in time such that t=0,1. 2.1 Savers and entrepreneurs Savers have one unit of savings they would like to invest in order to obtain a positive return on their money. Some savers are able to deposit their savings at the intermediary receiving a return equal to the deposit rate. The remaining savers either consume immediately and eventually do not save, or store their savings independently within their homes with zero return. Entrepreneurs are have risky projects but do not have the funds to carry out their projects. Each entrepreneur is endowed with one project, requiring one unit of investment. Entrepreneurs are risk averse, with identical exponential utility functions, such that U (W ) = −e − ρW , where W is wealth and ρ is the measure of risk aversion. Thus, each project must have a gross expected return that is increasing in the risk level of the project, otherwise the project is abandoned. The gross expected return on the project and the risk level of the project are known only to the entrepreneur. The asymmetry in information as well as transaction costs rule out the possibility of a direct flow of funds from savers to entrepreneurs. The entrepreneur is thus able to carry out his project only by taking a loan from a financial intermediary.

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2.2 The Financial intermediary The financial intermediary (FI) is assumed to be a risk neutral, profit maximizing institution. Only the FI is able to channel funds between surplus units and entrepreneurs. This is because the FI enjoys economies of scale that reduce transaction costs and allow risk diversification. Without the financial intermediary, projects cannot be carried out and individuals are not able to save. Thus, the amount of intermediation carried out indicates the growth opportunities in the economy. Since small underdeveloped economies are characterized by a small number of FI-s, we assume that there is just one monopolistic FI in the economy. We also assume that the FI accepts deposits only in the amount required to fund loans and that the risk-free rate of return, r>1, is paid on deposits. Since the entrepreneur is unable to communicate credibly the risk level of his project to the FI, the monopolistic FI, which faces asymmetric information, sets a uniform borrowing rate, rL , rL > r , for all entrepreneurs. 2.3

Corrupt officials In the economy there are corrupt government officials. We consider two types of corrupt officials. One type is a roving bandit, in the sense that the official takes a bribe from the entrepreneur at the outset of the project. A project cannot be carried out without bribing this type of corrupt official so as to obtain his permission for the project to proceed. Since, the official faces the same asymmetric information as the other participants in the economy, he takes a flat rate, C, from every entrepreneur in order to provide the necessary documents and approvals to carry out the project. The second type of corrupt official is a stationary bandit, who waits until project returns are known in order to collect his bribe. This type of official will provide the necessary documents and approvals for the entrepreneur to realize the returns on his project. The stationary bandit is patient in the sense that he forsakes the flat rate taken by the roving bandit and waits until returns are revealed. He then takes a bribe, which gives him a proportion, C p of the excess return on the project. Thus, the stationary bandit faces the risk of the project as well as the cost

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of deferring his income to a later date but gains the ability to take a higher bribe from projects with higher returns.

2.4 Risky projects We denote by σ 2 the risk level of the return on the entrepreneur's project,

[

]

such that σ 2 is distributed over the interval, σ 2 , σ 2 . The probability distribution

( )

( )

function f σ 2 and the cumulative distribution function F σ 2 are both known to the financial intermediary. The expected return on a project, θ , is increasing in the risk level of the returns such that it is equal to

θ = r + δσ 2

,

(1)

where δ is the risk premium4.

2.5 The sequence of events At t=0 an entrepreneur must receive the necessary approvals from the roving bandit, if such an official exists, and incur the cost, C, of obtaining approval from this official. Once the approval is obtained, the entrepreneur applies for a loan at the FI. The FI collects deposits from savers in the amount necessary to finance the loan. The project is then carried out. At t=1 the entrepreneur must receive the necessary approvals from the stationary bandit, if he exists, to realize the projects returns. At this point he or she incurs the cost, δσ 2 C p , of paying the official for these approvals. After paying the official, the loan is repaid and the entrepreneur obtains and consumes the residual return from the project. At the same time the financial intermediary reimburses savers who then consume the value of their savings. The FI closes. 3.

The Roving Bandit In the case of a roving bandit the entrepreneur will carry out his project only if his expected utility from the project is greater than zero, namely, 4

The CAPM states that in equilibrium the excess return on a financial asset compensates only for systematic risk measured by beta. Our version of a risk premium can be reconciled with the CAPM by assuming that all projects have the same correlation coefficient with the market portfolio. This could be the case when there is specialization in a particular sector.

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r + δσ 2 − rL − C − 0.5 ρσ 2 > 0

(2)

This condition provides a critical level of risk, σˆ 2 , below which projects

will not be carried out, producing adverse selection.

σˆ 2 =

C + rL − r δ − 0.5 ρ

(3)

The FI sets the loan rate so as to maximize expected profits σ2

Π FI =

∫ (r

L

σˆ

( )

− r ) f σ 2 dσ 2 .

(4)

2

3.1 The optimal loan rate From (4), the optimal loan rate as determined by the FI is rL = r +

(1 − F )(δ − 0.5ρ ) . f (σˆ ) σˆ 2

(5)

2

where 1- Fσˆ 2 is the probability of the risk of a project being above σˆ 2 . Note that

(δ − 0.5ρ )

is the net compensation to the entrepreneur per unit of risk. Thus, the

optimal loan rate is determined such that the net return on loans, rL − r , is equal to the expected net compensation on risk. Solving for Fσˆ 2 gives the following expression for the loan rate: σ rL = r + 0.5 

2

(δ − 0.5ρ ) f (σ 2 ) − C 

( )

 

f σˆ 2

(6)

From (6) it can be seen that the loan rate is higher when the upper limit of risk is higher, when the risk premium δ is higher and when entrepreneurs are less risk averse. Furthermore, the higher the bribe set by the corrupt official, the lower the loan rate. 3.2 The critical risk level

Given the loan rate, the critical risk level is now

σˆ 2 =

(1 − Fσˆ 2 ) C + . δ − 0.5ρ f (σˆ 2 )

(7)

Solving for Fσˆ 2 gives the following expression for the critical risk level:

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σ 2 f (σ 2 ) C σˆ = + 2(δ − 0.5ρ ) 2 f (σˆ 2 ) 2

If C=0, σˆ 2 =

(8)

σ 2 f (σ 2 ) . Thus, the higher the bribe paid to the official, the higher 2 f (σˆ 2 )

the critical level of risk below which projects are not carried out and the more severe the problem of adverse selection. A higher upper limit of risk, a lower risk premium and a higher level of risk aversion all increase the critical level of risk, producing greater adverse selection in the economy. 3.3 The level of corruption

Given the loan rate set by the bank and the critical level of risk, the corrupt official sets the level of corruption so as to maximize his expected return, which is: σ2

( )

Π C = ∫ Cf σ 2 dσ 2

(9)

σˆ 2

The resulting corruption level is C=

(1 − F )(δ − 0.5ρ ) . f (σˆ ) σˆ 2

(10)

2

This is identical to the expression obtained for rL − r in equation (5). Thus, the roving bandit emulates the FI's behavior, and consequently compounds adverse selection. This happens because both the FI and the official disregard risk and both impose a fixed cost on entrepreneurs. The FI disregards risk because it can diversify risk and thus can be assumed to be risk neutral, while the roving bandit does not face any risk. Solving for Fσˆ 2 gives the following expression for the corruption level: C=

σ 2 f (σ 2 )(δ − 0.5 ρ ) 2 f (σˆ 2 )

(11)

From (11) it can be seen that the corruption level is higher when the upper level of risk is higher, when the risk premium is higher and when risk aversion of the entrepreneur is lower. The loan rate can now be computed and is equal to: rL = r +

σ 2 f (σ 2 )(δ − 0.5ρ ) 4 f (σˆ 2 )

(12)

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The results in equations (11) and (12) lead to the following proposition: Proposition 1: In the presence of a roving bandit, corruption and loan rates are high when (a)

The economy has a riskier pool of investment opportunities (a high upper limit of project risk),

(b)

Entrepreneurs have a low level of risk aversion, and

(c)

The risk premium is high.

The critical risk level can now be computed,

σˆ 2 = 2

(1 − F ) . f (σˆ ) σˆ 2

(13)

2

This turns into the following expression after substitution of the solution to Fσˆ 2 into (15):

σˆ 2 = 0.75

σ 2 f (σ 2 ) f (σˆ 2 )

(14)

If the distribution function is such that there is higher probability of being at the upper level of risk, namely, f (σ 2 ) > f (σ 2 ) , this increases the corruption level as well as increasing the effect of adverse selection by resulting in a higher loan rate. Proposition 2: Adverse selection, which is compounded in the presence of a roving bandit, is high when (a)

The investment pool in the economy is risky (a high upper limit

of project risk), and (b)

A high proportion of projects are located in the upper regions

of risk.

The existence of a critical level of project risk implies that the FI finances only the riskiest projects in the economy. The corrupt official has an important part in this outcome, since, in the absence of a corrupt official, the critical value of risk is lower. The consequences for the economy are that the FI is riskier in the presence of a roving bandit and the volume of intermediation is reduced.

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Since projects are not carried out, this also implies that funds are not needed by the FI. Thus, surplus units cannot obtain positive returns on their savings. They will either consume immediately or store their savings obtaining zero returns. 4.

The stationary bandit

The stationary bandit waits until project returns are revealed and holds up the realization of these returns by the entrepreneur. C p is the percent of the excess return appropriated by the corrupt official before allowing the entrepreneur to realize the return on his project. The entrepreneur will carry out his project only if his expected utility from the project is positive, requiring the following: r + δσ 2 (1 − C p ) − rL − 0.5ρσ 2 (1 − C p ) > 0 2

(15)

This creates a critical value of risk below which projects will not be carried out:

σˆˆ 2 =

(rL − r )

(1 − C )(δ − 0.5ρ (1 − C )) p

(16)

p

4.1. The loan rate

Taking into consideration the critical level of risk, which defines the pool of projects that require a loan, the FI sets a loan rate so as maximize expected profits The FI's expected profit is: σ2

Π FI =

∫ (r

L

− r ) f (σ 2 )dσ 2

(17)

σˆˆ

Maximum expected returns are obtained when the loan rate is set as: rL = r +

σ 2 f (σ 2 )(1 − C p )(δ − 0.5ρ (1 − C p ))

( )

2 f σˆˆ 2

(18)

This loan rate increases when the upper limit of risk is higher, when the risk premium is higher and when risk aversion is lower. 4.2 The critical level of risk Substituting the loan rate into the critical value of risk in (16), below which projects are not carried out gives :

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σˆˆ 2 =

σ 2 f (σ 2 ) 2 f σˆˆ 2

( )

(19)

The result in (19) leads to the following proposition: Proposition 3: In the case of a stationary bandit, adverse selection is not affected by corruption. It stems only from adverse selection created by the asymmetric information faced by the FI. Thus, in the case of a stationary bandit, adverse selection is less severe than in the roving bandit case and in fact stems only from the FI. This is due to the stationary bandit not facing asymmetric information and therefore not contributing to adverse selection.

4.3 The level of corruption The stationary bandit determines the level of corruption, C p , so as to maximize his expected utility. We assume that the stationary bandit has an exponential utility function with a risk aversion measure denoted by ρ C . The expected utility of the stationary bandit is thus: σ2

( )

σ2

( )

CE C = ∫ C p δσ f σ dσ − 0.5 ρ C ∫ C p σ 2 f σ 2 dσ 2 2

2

2

2

(20)

σˆˆ 2

σˆˆ 2

and the level of corruption chosen by the stationary bandit is thus Cp = δ

ρC .

(21)

In the case of a stationary bandit, the chosen level of corruption does not depend on the distribution of risk but only on the level of risk aversion of the official and on the risk premium. Proposition 4: The stationary bandit appropriates a small (large) percent of returns on projects when he has high (low) risk-aversion and when the risk premium is low (high).

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5. The roving bandit vs. the stationary bandit

We have seen above that a stationary bandit does not create adverse selection. Hence, the critical level of project risk below which projects are not carried out is lower than in the case of a roving bandit. This implies that, in the presence of a stationary bandit, more projects are carried out and the projects are on average less risky than in the case of a roving bandit. Furthermore, the volume of intermediation is also greater, implying that more people obtain positive returns on their savings. It is therefore important to know under what condition the corrupt official will choose to act as a stationary bandit rather than a roving bandit. This will be the case when the expected utility from being patient and waiting to collect bribes is greater than the value of the bribes obtained at the outset, multiplied by the rate of return on deposits, namely, rΠ C < CE C .

(22)

This leads to the following condition for a stationary bandit to exist:

(

) (

)

r 0.5 σ 2 [δ − 0.5ρ ] < δ σ 2 [δ ρ C ]

(23)

The left hand side of inequality (23) is the future value of the bribe taken by the roving bandit from one entrepreneur. It represents the income lost by being patient and by acting as a stationary bandit rather than a roving bandit. The right hand side of inequality (23) is the value of the bribe taken by the stationary bandit from the entrepreneur who is holding the riskiest project. It is therefore the highest possible bribe gained by the stationary bandit. Thus, for a given pool of projects, stationary bandits are more likely to exist in the economy when there are low levels of returns on deposits because this will encourage corrupt officials to be patient. This will have the effect of allowing more people to save and more projects to be carried out. On the other hand, each surplus unit will earn a lower return on his deposit. It is likely, however, that the cost of patience faced by a corrupt official is not the local deposit rate but rather the rate of return on investments abroad or on other high return projects available only to the corrupt official. In this case, the cost of patience is higher and roving bandits are more likely to emerge. Stationary bandits are also more likely to exist when officials are less risk averse. Officials in poor countries may face arbitrary unpredictable loss of their

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position because of threats to the regime. High levels of risk aversion then result in high discounting of the future and behavior of a roving bandit rather than a stationary bandit. This results in greater adverse selection, with a lower volume of intermediation carried out by riskier financial intermediaries. 6. Entrepreneurs’ characteristics and the type of corrupt behavior

The effect of entrepreneurs on the type of corrupt official is such that when entrepreneurs are less risk averse, stationary bandits gain less than roving bandits. The reason is that the problem of adverse selection is less severe when entrepreneurs are less risk averse. In this case, the roving bandit looses a smaller portion of the pool of entrepreneurs than in the case of entrepreneurs who are more risk averse. 7. Conclusions

Corruption and ineffective systems of financial mediation are not independent contributors to develop failure. Corruption is rather the foundation for a fragile and ineffective financial system, through adverse selection in project financing. Hence, for the financial market to effectively contribute to growth and development, governance problems need to be resolved. Corruption of the stationary-bandit type is not the problem here5. Rather the adverse selection stems exclusively from corruption of the roving-bandit type, which stifles financial intermediation. Roving-bandit corruption creates a reality in which less financial intermediation takes place and a bias is imparted towards financing of risky projects. People therefore have fewer opportunities to save and productive low-risk investment projects are foregone. Corruption arises from poor-governance institutions in low-income countries. However, if institutions in low-income countries continue to make poor governance inevitable, the financial system can be made more effective in contributing to growth, and development failure can be averted, if at least incentives can be provided for corruption to be of the stationary-bandit type.

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Stationary bandits are able to appropriate a cut of the returns on projects. Their existence can create a loss of resources in the economy because of the rent seeking activities of those who wish to attain a position of a stationary bandit.

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