Development Banks in Greece and Financial Sector Development . ..... principal-agent problems among firmsâ stakeholders, pooling and channeling savings ..... theoretical tradition yet now in a loanable-funds framework, different from the.
University of Athens Department of Economics, UADPhilEcon
Essays on Financial Regulation and Financial Development
by
KONSTANTINOS I. LOIZOS
August 2010
2
3
Essays on Financial Regulation and Financial Development
PhD Thesis Submitted to the Department of Economics University of Athens
By KONSTANTINOS I. LOIZOS
Supervisors: Prof. M. Psalidopoulos Prof. S. Thomadakis Prof. N. Theocarakis
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5
Table of Contents
Introduction ................................................................................................................ 7 Chapter 1 Financial Regulation and Financial Development: A Transaction Cost Approach . 13 1.1. Introduction ........................................................................................................... 15 1.2. Transaction Cost Economics and Financial Markets ............................................ 19 1.3. Modeling Financial Repression/regulation as Governance Structure ................... 23 1.4. A Formal Model of Financial Repression/Regulation .......................................... 28 1.4.1 A two-Period Framework ................................................................................... 28 1.4.2 The Model for T > 2 Periods ............................................................................. 53 1.5. Implications of the Model ..................................................................................... 65 1.6.Connecting the Model to the Literature ................................................................. 70 1.7. Conclusions ........................................................................................................... 80 Chapter 2 Development Banking and Institutional Transformation ........................................ 83 The Case of Greece 1963-2002................................................................................ 83 2.1. Introduction ........................................................................................................... 85 2.2. The Historical and Theoretical Context ................................................................ 87 2.3. Development Banking and Financial System Development: In the Quest of their Relationship ............................................................................................................... 100 2.4. Real Economy and Financial Sector Development in the post-War Greek Economy: A Process of Transformation .................................................................... 111 2.5. Development Banks in Greece and Financial Sector Development ................... 131 2.5.1. ETEBA ............................................................................................................. 136 2.5.1.1 The years of Economic Growth 1963 - 1973 ................................................ 136 2.5.1.2. The Period of Crisis and Stagnation 1974 – 1987........................................ 140 2.5.1.3. The Transformation into a Merchant Bank 1987 – 2001 ............................. 142 2.5.2 Investment Bank ............................................................................................... 145 2.5.2.1. The Period of Expectations: 1962 – 1975..................................................... 145 2.5.2.2. Investment Bank 1975 – 1985: Crisis and Reorganization .......................... 149 2.5.2.3. The Merchant Banking Transformation that never realized: 1986 – 1997 .. 151 2.5.3. ETBA ............................................................................................................... 153
6 2.5.3.1. The Period of High Growth: 1964 – 1975 .................................................... 153 2.5.3.2. ETBA: The Crisis Years 1976 – 1986 ........................................................... 155 2.5.3.3. The Transformation of a Public Developmental Agency to a Private Universal Bank: 1987 – 2002 ..................................................................................................... 159 2.6. ETBA, ETEBA and Investment Bank: Serial Trend Analysis ........................... 164 2.6.1. Income, Expenses and Net Profits ................................................................... 165 2.6.2. Earning Assets: Loans and Placements in Securities ...................................... 181 2.6.3. The Liability Side: Own and Borrowed Funds ................................................ 192 2.7. ETBA, ETEBA and Investment Bank: Financial Indices ................................... 200 2.7.1. Profitability Ratios ........................................................................................... 201 2.7.2 Solvency Ratios ................................................................................................. 211 2.8. Economic Development and the Changing Nature of the Banks ....................... 217 2.9. Conclusions: Development Banks and Institutional Change .............................. 228 Chapter 3 Is There an Optimal Degree of Financial Regulation? .......................................... 237 3.1. Introduction ........................................................................................................ 239 3.2. How Financial Regulation Emerges in History? ................................................ 247 3.3. Regulation and The Minsky-Kindleberger Model of Financial Cycles .............. 256 3.4. In Search of the Optimum Degree of Regulation ............................................... 262 3.4.1 A Model of the Interbank Market Based on Banks’ Liquidity Preference Function ..................................................................................................................... 263 3.4.2 A Model of the Banking Firm............................................................................ 271 3.4.3 Changing Market Shares and the Financial Cycle ........................................... 281 3.4.4 Explaining Regulation in a Minsky-Kindleberger Framework ........................ 297 3.5. The 2007 – 2010 Crisis ...................................................................................... 301 3.6. Conclusion .......................................................................................................... 305 Concluding Remarks .............................................................................................. 310 APPENDIX ............................................................................................................ 313 Financial Data and Indices ..................................................................................... 313 References .............................................................................................................. 344
7
Introduction
The relation between financial regulation and financial development is one of the themes that are ranked at the top of the research agenda in financial economics during the last three decades. What spurred this debate was the deregulation wave of the 1980s and 1990s that compelled economists to reconsider the efficiency of different financial systems and regimes concerning their effect on economic development and growth. The definition of financial regulation that we meet in the literature relates it to government intervention in the financial system in order to overcome market failures. Such market disfunctioning might relate to the way the financial system operates given the existence of information asymmetries in the market and the adverse externalities of bank failures spreading in the whole economic system. Regulation instruments to address these problems include deposit interest rate ceilings, entry and merger restrictions, portfolio restrictions and reserve requirements, deposit insurance and capital requirements (Freixas & Rochet (1997:257-259). On the other hand, market failures might also relate to the deficiency of the financial system to serve economic development. According to Fitzgerald & Vos (1989:18) there was a strong theoretical underpinning of this strand of thinking emerging from the ideas of J. M. Keynes (1936) that cast doubt on the ability of the market mechanism to achieve optimal allocation of resources from the point of view of long term economic growth. The financial aspects of this policy recommendation were administered low interest rates and government ridden credit allocation to priority sectors. Either to preserve financial stability or to promote economic development or both, financial regulation is ultimately related to another notion: that of financial development
or
financial
deepening
usually
implying
increased
financial
8 intermediation and innovation1. The issue repeats itself in the literature during the post-War period but especially from 1970s onwards as the direction of causality between finance and growth. The “liberal” view relates financial development to the benefits of enhanced financial intermediation per se. In this context, Levine (1997) identifies the functionality of the financial system with its ability to decrease risk by enhancing liquidity and diversifying idiosyncratic risk, allocate capital efficiently to investment uses by lowering the costs of acquiring information and coping with principal-agent problems among firms‟ stakeholders, pooling and channeling savings between surplus and deficit units and facilitate the exchange through contracts that lower transaction costs. In short, the underlying unifying principle of this kind of definition of financial development is what Fry (1995:293-316) indicates as the minimization of transaction and information costs. On the other hand, for post Keynesians, financial development is rather understandable as “active” intermediation as far as banks assume an active role in lending activity. In the finance-investmentsavings circuit, banks channel newly created money to finance investment and promote economic development, while financial markets promote the stability of the system (Studart (1995): 64-65) through funding mechanisms that enhance liquidity and diminish financial fragility. As Joan Robinson (1952:86) put it: “where enterprise leads finance follows”. Whatever view one might adhere to, financial development is usually closely related to institutional development concerning the legal and regulatory framework of an economy (Rajan & Zingales (1998a)) and issues such as accounting systems for information disclosure, contract enforcement and definition and enforcement of property rights to the degree that these institutional developments reduce the risks that lenders assume (World Bank (1989:3)). On the other hand, according to Minsky (1957), financial development and innovation that yield cash substitutes decrease the liquidity of the economy increasing equivalently its leverage, risk and fragility. Furthermore, Minsky (1957) indicates that the regulatory defense of the system looks like the Maginot line. It is a response to the 1
To obtain an empirical grasp of this notion note that measures of financial development in the literature include ratios such as liquid liabilities of the financial system over GDP, credit to private firms over total credit, credit to private firms over GDP (Levine (1997)), the ratios of M1, M3 and currency over GDP in comparison to each other (World Bank (1989:31)). In addition, measures of the size of the stock market such as stock market capitalization over GDP (Rajan & Zingales (1998a), Demirgüç-Kunt & Maksimovic (1996)), the total value of shares traded over stock market capitalization (Demirgüç-Kunt & Maksimovic (1996), Levine(1997)) and even institutional measures such as accounting standards as indicator of the level of financial data disclosure (Rajan & Zingales (1998a) or quality of investor protection laws (Demirgüç-Kunt & Maksimovic (1996).
9 shortcomings exhibited in previous crises with the definition of money and financial instruments prevailing then. However, financial innovation described above brings in new opportunities and new risks to the system that are not faced by the existing institutional/regulation structure. Hence, financial development/innovation might be the development of institutions, instruments and attitudes of agents or techniques used by them that decrease the market cost of capital. Either as an accommodating factor of economic growth or as an independent contributor to it, financial development relates to financial regulation in a rather ambiguous manner. For “liberals” government intervention in the financial system is detrimental for both financial and economic development. For post-Keynesians the opposite idea holds both for economic development and financial stability reasons as financial regulation tries to overcome market failures. The papers we present here aim at contributing to this debate by exploring the relationship of financial regulation and financial development/innovation from three different angles. At first we would like to reconsider the degree of tension in the relationship between financially regulated regimes and the process of financial development at a theoretical level. In this context, our first paper explores the following question that emerges from the literature: Although it is desirable to lower the cost of capital and boost investment and financial stability through financial regulation/repression policies, the price that should be paid is high to the degree that these policies impede financial development according to the literature initiated by the seminal work of McKinnon (1973) and Shaw (1973). Hence, the question arises: Is there a way to think of financial regulation as a policy that would accommodate rather than prevent financial development without abandoning the goal of economic development? The novelty of this study emerges both from the use of a governance framework in the study of financial regimes and the results of this endeavour that justify, under certain conditions, a positive relationship between financial regulation and financial development. The argument developed there is the following: If lowering transaction costs related to the definition of contract rights, bargaining costs, information costs and enforcement costs, contributes to financial development then hierarchies ( including government agencies such as development banks) serving this purpose are positively rather than negatively related to financial development.
10 The second way in which we seek to contribute to the literature is by investigating the relationship between financial regimes and institutional development in the longer term. It is common in the economics profession to forget history and consider present economic conditions and perceptions as universal both in time and place. This attitude had the effect of drawing a “veil of ignorance” over the situations that allowed the establishment of regulated financial regimes before the 1980s. However, if we consider past policy perceptions and prescriptions as misleading mistakes then we cannot comprehend the underlying process of institutional development that spans not only from 1980s onwards but even from the end of the World War II. Hence, the aim of the second paper is to shed a light on the institutional change that characterizes the evolution of a financial regime from regulation to deregulation. The analysis developed there combines the framework of modern institutional analysis with the examination of historical data in order to address the question of institutional transformation in an economy. To the degree that this process concerns the financial sector, the paper uses development banks as the privileged object of research that brings together the episodes of regulation and deregulation and highlights the relevant transformation. What makes this study a novel contribution is the perception of development banks as dynamic entities that reflect the evolution of financial systems rather than as remnants of the past as it is common in the literature that relates them to specific financial structures as in Fry (1995:362-365) or Chang and Grabel (2005). Development banks, as hybrid institutions with both profit maximization (or financial viability) and “social maximization” (or remuneration of economic returns) aims, were both the means and the objects of institutional development. In this sense, the transformation of a country‟s economy towards industrialization and modernization should have been reflected in development banks‟ transformation from traditional cheap credit channels to modern market-supporting merchant and investment banks. Hence, the main thesis of the paper is that understanding the dynamic nature of development banks and its constraints is the key for understanding institutional development and change in the financial sector. The argument is supported by the examination of the historical data available in the Annual Reports of the three development Banks in Greece, ETEBA, ETBA and Investment Bank in the context of the economic and financial history of Greece during the period 1963 – 2002. Main questions examined relate to the constraints that development banks had to face in their operation, the role of the government
11 concerning their viability and the relation between the evolution of the financial system and the internal transformation of the banks. In short, this study tries to shed a new light on the understanding of how financial development comes about at the real world micro-level. The final way by which we explore the issue of financial regulation and financial development/innovation is the question of the optimal degree of the former given the course of the latter in financial history. This leads us to the question of how does regulation emerge in history and how should it change as economic conditions change? The literature as represented by opposing views such as Benston & Kaufman (1996) and Dow (1996) revolves around the choice between market self-regulation and government regulation without the ability to form a comprehensive view of financial regulation that would acknowledge both the significance of market failures within a fundamentally uncertain environment and the risk of government discretion and short-sightness that could stifle financial innovation. Our last paper attempts to give an answer to this problem by building a model of regulatory change based on the “Minsky-Kindleberger” theory of financial cycles. The microeconomic basis of the model allows us to represent a new view on how the interaction between agents‟ perceptions of economic conditions and their expectations and behavior shape and contributes to the formation of the existing regulatory framework. The argument presented there is that a regulatory framework is in fact a structure of incentives offered to agents in order for them to act in a specific way conducive to financial stability and this structure depends or it should depend on the phase of the MinskyKindleberger cycle that the economy places itself. This thesis is supported by a mathematical model of the banking sector where prevailing economic conditions are reflected in the liquidity preference functions of banks and these affect their lending behavior. Then the government or a monetary authority can act as an agent of different degrees of regulation depending on the phase of the cycle. The three papers presented below differ in the use of techniques as the first and the third make extensive use of mathematical modeling while the second one is based on historical reconstitution of our perception of the past with the use of empirical data. They also differ in the emphasis given on different aspects of the relationship between financial regulation and financial development/innovation. However, there is a unifying line of thinking that penetrates all three and this is the importance of institutions as means for coping with fundamental uncertainty and
12 reducing the costs related to it. In this sense, our study is an endeavour at a theoretical level to give a microeconomic basis to macroeconomic financial issues where the latter are understood within the Knight (1921)/Keynes (1936) perception of uncertainty and the former is built upon cost minimizing or profit maximizing principles under constraints. In this context, the first paper uses Williamson‟s (1985) transaction costs analysis to address the issue of financial regulation as a trade-off between return reductions in exchange for safeguards provided by government agencies. Furthermore, the second paper builds on North‟s (1990) analysis of institutional transformation in order to conceive development banks as both the purposeful outcome of government policies to overcome path dependency and promote economic and institutional development and the subjects of that change as dynamic transforming entities themselves. Finally, the third paper uses the Minsky (1982) -Kindleberger (1978) financial cycles framework and its microeconomic behavioral implications in order to build a model of financial regulation as the institutionalization of incentive structures for economic behavior conducive to financial stability.
13
Chapter 1
Financial Regulation and Financial Development: A Transaction Cost Approach
14
Abstract
Financial repression/regulation has been heavily criticized after the 70s for being detrimental to financial development which is deemed necessary for the efficiency of investment decisions. This paper takes a different stance by arguing that financial regulation policies, under specific conditions, can contribute to the institutional transformation of an economy. The basic argument is based on the transaction costs economizing function of hierarchies versus markets under adverse economic conditions. The reasoning of the paper is founded on a model of micro-behaviour of households and firms and the cost minimizing problem of the government that implements such a policy. Then, useful implications can be drawn from the analysis for both the success or failure of these regimes and their link to financial development.
15
1.1. Introduction
Financial regulation, as part of public regulation in general, emerges from government intervention in the financial system to correct market failures. The later may be the outcome of adverse external effects of bank failures spreading in the whole economic system and related to the existence of information asymmetries in the market. Regulation instruments might include deposit interest rate ceilings – such as “regulation Q” in the United States until April 1986 – entry and merger restrictions, portfolio restrictions and reserve requirements, deposit insurance and capital requirements (Freixas & Rochet (1997:61, 257-259). Although financial regulation may be characterized by any of the previous institutional restrictions, deposit interest rate ceilings seem the most striking ones to the economist as far as price determination out of the market is concerned. This “anomaly” was given a name in the early 1970s, namely “financial repression”. Hence, financial repression is the policy of administered below market interest rates in order to lower the cost of capital and boost investment demand. This policy was followed by many countries after the World War II in an economic environment where aggregate risk was very high and investment returns uncertain. The recipe was based on a specific understanding of Keynesian economics that stressed the desirability of government intervention to supplement and even substitute markets towards the aim of economic development. In this sense, market failures were also related to the deficiency of the financial system to serve economic development. However, it is compelling to indicate that Keynes‟ doubts on the effectiveness of monetary policy would probably lead him to disagree with such policies aiming exclusively at the level of the interest rate (Keynes (1936:164, 378)). Indeed, Keynes believed that the solution to the problem of decreased investment demand rested predominantly on entrepreneurs‟ glooming long term expectations and less on the cost of capital as such, given that the basic determinant of the level of the interest rate is the liquidity premium of money which becomes very high in turbulent times (Keynes (1936:236)).
16 Financial repression policies were heavily criticized by the McKinnon-Shaw theoretical tradition yet now in a loanable-funds framework, different from the liquidity preference model of Keynes. In this context, decreased interest rates meant decreased return on savings and hence, a lower demand for them which meant a decrease in the supply of capital to finance investment (McKinnon (1973:59-61,69), Shaw (1973:9-10)). The other point of criticism was the lower efficiency of investment projects as that was reflected at the lower discount rate by which their present values were calculated. Hence, projects with negative net present values were now becoming artificially profitable (Fry (1995:25-26)). The answer offered to these distortions is financial market liberalization that restores prices at their market levels. Financial liberalization in the sense of “financial deepening” of Shaw (1973:3-12) is identified by this school of thought as a prerequisite for financial development that would boost both the efficiency and the volume of investment. The critique to this theoretical strand of thinking was carried out by the Neostructuralist school of Taylor (1983:91-103), Van Wijnbergen (1982, 1983, 1985) who indicated the inefficiency of financial liberalization policies in economies with flourishing curb markets. In effect, these markets cover the gap left by the official markets in the satisfaction of investment demand in such countries. Financial liberalization policies raise the deposit rate at the official sector and therefore, move funds from curb markets to the banking system where reserve requirements exist. This results in a fall of the supply of loanable funds and a rise in the demand for curb loans and thus, the curb rate that enters the aggregate supply function of the economy rises which contributes to a rise in the inflation rate in a cost-push inflation environment along with a fall in income. To the degree that unofficial markets persist, financial development as the outcome of financial liberalization seems questionable if lower savings, because of lower income, more than outweigh higher savings because of higher deposit rates (Van Wijnbergen (1983)). However, in all these approaches, there is a missing link between financial repression – or more generally financial regulation – and financial development or underdevelopment. The missing point stressed by Post-Keynesians such as Arestis (1999), Arestis & Glickman (2002) and Arestis & Stein (2005) is the specific institutional environment in which financial repression or liberalization policies are implemented. Arestis (1999) stresses the importance of the legal infrastructure of LDCs concerning contract enforcement, bankruptcy procedures and banking
17 regulation and supervision. Arestis and Stein (2005) even propose a theoretical framework for institutional transformation that would take into account the existing institutional matrix of each country concerning norms, rules, incentives and existing capacities of financial organizations to assume the burden of transformation towards a more
liberalized
regime.
The
upshot
of
the
mix
between
institutional
underdevelopment and financial liberalization in an environment characterized by general retreat of state regulation and control of the financial system is given in Arestis & Glickman (2002) where it is asserted that financial liberalization in countries with weak regulatory framework precipitated and made financial crises more severe. What these approaches stress is the inefficiency of financial liberalization policies in economies institutionally unprotected to abrupt international short-term capital flows. The institutional perspective is also followed by another strand of literature expressed by Rajan, R. G. and L. Zingales (1998, 2003a,b) who identify the “great reversal” from developed capital markets to financially repressed regimes during the period of the Great Depression. Financial repression regimes are characterized at the institutional level by a relationship-based system among incumbent large firms, banking oligopolies and the government. Important ingredient of this system is the regulation of capital flows that insulates the financial system from external competition and market discipline . Investor protection takes on non-price forms such as specific monopoly power of the bank over the firm it finances – for example, the particular bank is the main lender of the firm while it uses connections with managers, politicians etc. as a means of contract enforcement. In a sense, hierarchical control is substituted for market control and makes the efficiency of the legal system and contract enforcement less important. Furthermore, dissemination of information is rather discouraged than encouraged, since this would endanger the whole system of relationship finance. All these make financial repression an impediment for financial development. The issue of legal systems and institutions that purport to establish a system of investor protection from management and/or shareholder opportunism is the theme of Modigliani & Perotti (1997) and La Porta, R., F. Lopez-de-Silanes, A. Shleifer & R. W. Vishny (1997, 1998). Modigliani & Perotti (1997) indicate that financial liberalization, not followed by the appropriate institutional development concerning legal rules for investor protection and their enforcement, might lead to banking crises
18 and instability. This is because poor enforcement of legal rules renders market transactions unreliable. The result is a shift of institutionally underdeveloped economies to systems characterized by long-term relations. On the other hand, La Porta, R., F. Lopez-de-Silanes, A. Shleifer & R. W. Vishny (1997, 1998) focus on the specific kind of the prevailing legal system – common or civil law – and its effect on investor protection and financial development. It is assumed that law enforcement and investor protection is poorer in civil law compared to common law countries. Then, swings in financial development are meant to be explained by differences in institutional environments between countries. Finally a new political economy perspective on financial regulation and development is followed by Pagano & Volpin (2001). In a “corporatist” sense, the state, and hence, its interventional policy, reflects the balance of power between conflicting interests that affect the formation of the legal framework which determines the dispersion of control rights between different stakeholders within the firm. Coalition governments, which are correlated with corporatism, permit an institutional environment with low investor protection as opposed to high employee protection. This is the case in Continental Europe, while countries with Anglo-Saxon tradition are characterized by high investor and low employee protection. Hence, Investor protection is determined by the degree of diffusion of shares (with respect to controlling shareholders) and the power of management. Again the cost of “corporatism” which is now the basis for explaining a specific form of financial regulation, is low degree of financial development because of low degree of investor protection. This short review of the literature indicates a major issue: Although it is desirable to lower the cost of capital and boost investment and financial stability through financial regulation/repression policies, the price that should be paid is high to the degree that these policies impede financial development. Hence, the question arises: Is there a way to think of financial regulation as a policy that would accommodate rather than prevent financial development without abandoning the goal of economic development? Our paper attempts to answer this question by studying financial repression/regulation policies from another perspective; that of a governance structure. The literature on governance mechanisms after the pioneering work of Williamson (1985), is directly pertinent to the case of financial repression/regulation versus financial liberalization as far as it examines the conditions under which a
19 choice between markets and hierarchies should be made on the basis of the related transaction costs. This approach of financial repression/regulation is even more fruitful if financial development connected to decreased transaction costs is to be considered. The paper builds, in this context, a model of financial repression/regulation based on the microfoundations of households‟ and firms‟ behaviour. The context used is the one of loanable funds so as to place the model directly in comparison with the orthodox line of thinking. The implication of the analysis is that institutional considerations are directly pertinent to the judgment of the success or failure of financial repression/regulation policies. In this sense, the optimum trade-off between fiat policies of setting below-market rates for encouraging investment and their support through safeguards provisions is crucial. More importantly, the latter makes the difference for financial development as far as they indicate the determination of the state for institutional transformation that would justify a lower risk premium. Then both goals of economic and institutional development could ideally be attained. Reservations relate to political economy issues such as the credibility of the state and its willingness to adhere to long-term institutional change. The remaining of this paper is divided in six parts. Section 2 gives the necessary translation of Transaction Cost Economics jargon in the study of financial markets. Then, Section 3 gives a verbal modeling of financial repression/regulation as governance structure while Section 4 develops the mathematical model. Section 5 gives the implications of the model and Section 6 connects it to the literature on financial repression, financial systems and the role of the state. Finally, Section 7 concludes.
1.2. Transaction Cost Economics and Financial Markets The term “transaction” might sound vague, non-specific and hence, ultimately non-useful in economic modeling. Besides, every economic activity can be seen as a transaction between two parties. However, as Furubotn & Richter (2005:49-50) indicate, the concept of “transaction” obtains a particular importance for economic analysis if it is conceived in the double sense given by Williamson (1985:1) and Commons (1931). In its first meaning, transaction relates to the act of technologically
20 determined transfer, within a broad sense of division of labour. In the second meaning, transaction relates to property rights transfer and hence it is legally vested. Combining technological necessities arising from the division of labour with explicit or implicit property and contract rights on goods and services disengages transaction from its unique relation to markets and permits its use to describe any form of economic conduct. In this sense, Furubotn & Richter (2005:50) assert that transactions are the social activities that underpin economic institutions. However, the question arises. Even if this is the case, what difference does it make if we include the term “transaction” in our economic models? In what respects do these models change? To answer this question we need to remember that transaction is an economic activity and every economic action has its costs. In this sense, what makes “transaction” important is not itself as a new category among others, but the related costs that accompany it when it enters economic model building. Arrow (1969), as reported also by Williamson (1991a), gives a general definition of transaction costs as the “costs of running the economic system”. This definition implies that an economic structure is a system of institutions within which economic activity takes place at a cost. Furubotn & Richter (2005:51-55,568) analyze and categorize the various forms of costs entailed in creating, maintaining or changing economic institutions. The double sense of transaction explained above, is maintained in the definition of transaction costs. Hence, transaction costs relate to the costs of defining property and contract rights (Williamson (2000)) and measuring the related claims and the underpinning resources. Another kind of transaction costs relates to the enforcement of these rights with the establishment of an appropriate legal environment and legal mechanisms either formal or informal corresponding to explicit or implicit rights. Furthermore, the need for transfer of these rights entails information and bargaining costs that fall also into the category of transaction costs. Finally, a general division of transaction costs between “fixed” and “variable” help us distinguish the initial stage of forming a new institution – where fixed costs come in – from the subsequent stage of developing this institution where transaction costs depend on the volume of transactions. These variable costs can take the form of search and information costs, bargaining and decision costs and finally, supervision and enforcement costs.
21 The basic hypotheses of Transaction Costs Economics, according to Williamson (1979) include: a) bounded rationality that describes the limited ability of economic agents to calculate all possible future contingencies in the course of the implementation of a transaction either because of the extremely high costs of such an operation or because of fundamental ignorance about the future (Furubotn & Richter (2005:4)). Hence, even the more complex contracts are “unavoidably incomplete” (Williamson (2000)). b) Opportunism as a major characteristic of human behaviour which effectively means that agents are “self-interested with guile” (Kreps (1990:744)). Hence, the one party of the contract might break it in the course of its implementation if he had the opportunity. But, in order for this threat to be meaningful another hypothesis is needed. c) That transactions refer to investments with high degree of “asset-specificity”. “Asset-specificity” is synonymous to nonmarketability of the incurred costs of investment so as the two parties to be tied up in a relation necessary to be maintained either for both or at least for one party. These kinds of “idiosyncratic” investments refer to cases such as specialized physical capital investments and human-capital investments which are, however, of a recurring kind (Williamson (1979)). Hence, d) the fourth hypothesis relates to the frequency of the transaction (Williamson (1996:45)). The crucial point of the Transaction Costs Economics analysis is that relatively frequent “asset-specific” transactions between opportunistic bounded rational agents entail “maladaptation costs” (Klein (1999:467)) after the signing of the contract in the context of incomplete contracts under fundamental uncertainty. The solution to this problem is the design of specific “governance structures” that is guidelines
of
appropriate
adaptations
to
changing conditions
during
the
implementation of the contract. Governance structures is a way to mitigate the conflict between the parties of a contract for the mutual benefit of both parties giving the appropriate incentives for its implementation (Williamson (2000)). The problem is to match specific governance structures to specific kinds of transactions under the above criterion of efficiency. Hence, Williamson (2000) indicates a hierarchy of governance structures from simple to complex as follows: spot markets, incomplete long-term contracts, firms, regulation, and public bureaus. According to Williamson (1979), markets relate mainly to non-specific transactions of whatever frequency and of standardized products. Furthermore, the non-specificity of assets means that contracts are mainly of short-term nature (Kreps (1990:751-752)) and hence “classical
22 contracting”, where all contingencies are described by the contract, is the appropriate governance structure here. However, as the level of asset-specificity – idiosyncracy – of the transaction increases and as far as occasional transactions are concerned, “neoclassical or trilateral contacting” is the relevant governance structure. Here, a third party – an arbitrator – substitutes the complete description of contingencies in the contract as a means to alleviate future maladaptation of the contract. However, the more interesting case is the one where frequent, long-term highly-specific investments are concerned. In this case, the establishment of specialized governance structures is efficient because of the recurring nature of the transaction since the cost of such structure can be recovered. (Williamson (1979)). These specialized governance structures are referred to as “relational contracting” and range from bilateral governance to unified governance as the idiosyncracy of the relevant investment increases. An example of a unified governance structure is the internalization of the transaction with the establishment of a firm although now further costs emerge in the face of bureaucratic costs and decreased role of market incentives. However, an interesting observation of Williamson (1979) is that the maturing of an industry that gives rise to lower degree of uncertainty might lead to a reverse move from unified to bilateral governance and consequently to more market-based solutions. Financial markets and financial institutions in general are a special kind of economic institutions where claims on future money streams are traded. As far as financial instruments are contracts between debtors and creditors for the allocation of these income streams conditioned on the uncertainty of future economic conditions, institutional considerations in finance seem indispensable from economic analysis proper. Given the previous analysis, the most important insight of Transaction Cost Economics (TCE) that it is of interest to us is the extension of the notion of transaction to any form of economic organization, not just to that of the market. Williamson (1996:6) indicates that the notion of “transaction” becomes the unit of economic analysis to the degree that the later focuses on how transactions are organized or “governed”. Then it is easy to conceive economic organization of any form as a means to economize on transaction costs and hence compare different forms of economic organization from this point of view. In this sense, transaction costs relate to the formation and functioning of specific financial institutions – of which
23 markets are only one form – as compared to their efficiency in allocating funds between surplus and deficit units. It could be argued that TCE is not an appropriate framework to use when analyzing financial transactions. Besides, the origin and development of TCE literature has to do more with explaining oligopolies or monopolies in product markets by describing the conditions under which a move from market to hierarchical (firm) organization might be efficient in transaction costs economizing respects. Williamson (1979) gives a preliminary answer to this critique. He considers his model of matching governance structures with transactions pertinent to the case of capital markets too. He bases his assertion on the observation that the crucial element in financial transactions is the “ease of verification” of future income streams. Indeed, one can assert that thin capital markets with increased uncertainty and limited calculability of future contingencies and varied degree of frequency and highly assetspecific transactions give rise to relational governance structures. On the other hand, the maturity of the financial system might decrease asset-specificity – although opportunism is always present – and might justify more market-based solutions. Hence, a developed capital market with the adequate institutional infrastructure where information dissemination is continuous and reliable might not need a special governance structure other than the market itself. However, a premature legal infrastructure along with underdeveloped investment culture and weak enforcement of contract rights renders the market an inefficient governance mechanism. Additional governance mechanisms might be needed to ensure that profitable projects would obtain finance in the first place. Our thesis is an endeavour to justify Williamson‟s (1979) claim for the usefulness of TCEs‟ framework in explaining financial phenomena. The rest of this section specializes this attempt to the case of financial repression/regulation by introducing
a
new
microeconomic
perspective
in
the
old
financial
repression/liberalization or regulation/deregulation debate.
1.3. Modeling Financial Repression/regulation as Governance Structure In order to reconsider financial repression/regulation as an institutional framework we need to search beyond the macroeconomic treatment of both the liberal
24 school of the McKinnon-Shaw tradition on the one hand and the neostructuralist school on the other hand. This is because their analysis obscures an implicit assumption made by them concerning the functioning of markets at the micro-level. Their argument in favour of or against financial liberalization as opposed to financial repression/regulation revolves around the efficiency of macroeconomic measures, such as the liberalization of interest rates ,or of capital movements on the availability of funds for saving and investment and their allocation. Hence, the discussion focuses on the effectiveness of official organized markets as opposed to curb markets without questioning the issue of market organization as an adequate institutional mechanism within the general encompassing institutional environment in which the economy operates. The Post-Keynesian tradition takes a closer look at the issue of the liberalized markets and their proper functioning, but again the discussion takes on a macroeconomic perspective and confines itself to international financial flows. We think that a more comprehensive approach would be to start from the basic elements of financial transactions and attempt to reformulate them in the light of Williamson (1985: 32-35) “simple contracting schema”. The main idea is that asset specificity (k), safeguards (governance) of contracts (s) and price (p), are determined simultaneously because of the inevitability of their interaction when a financial contract is signed. In fact, as far as we introduce asset specificity and governance considerations, along with price, in the determination of the financial contract, we take a decisive step away from the traditional liberal view. Remember that the level of interest rates is considered by the McKinnon-Shaw school as a major obstacle to financial and economic development. Hence, the importance given to price determination is disproportionately greater than that given to institutional issues, the later being exhausted to the appropriate “sequencing” of the fiscal, monetary and exchange rate policies in the process of liberalization so as to preserve macroeconomic stability. This “sequencing” constitutes the optimum order of economic liberalization so as for fiscal control to precede the liberalization of the financial system whilst international capital flows should be freed after domestic liberalization has been completed with the achievement of domestic price stability (McKinnon (1993:4-10)). Asset specificity refers to transaction-specific investments in the sense of the degree to which “non-marketable” transaction expenses are incurred (Williamson
25 (1979)). A financial contract between a lender and a borrower becomes transactionspecific to the degree that the transaction costs incurred for its completion are asset specific, namely specific to the pertaining asset and hence, not possible to be retrieved through the market. The more difficult it is to verify the future income streams from an asset, the higher these costs will be. In other words, the degree of “ease of verification” of financial returns has the same meaning as “the degree of transactionspecific investment” (Williamson (1979)). However, the degree of asset specificity is closely related to the existence of a proper institutional framework for the functioning of the capital market that includes a range of issues such as investor protection against managerial or shareholder opportunism, reliable information dissemination, safeguards against default of the borrower etc. Furthermore, these governance characteristics of the market also act as a feedback, on prices of the financial instruments both on their level and the degree to which these prices reflect the true profitability of the project. Note that the degree of asset specificity is not the same as the degree of liquidity of an asset. However, these two are related when tradeable financial assets are concerned. Hence, in a capital market with a developed institutional framework, verification costs of asset returns are low and hence, non-marketable (specific to the related asset) transaction costs are low, which contributes to increased liquidity/marketability for the asset. However, decreased asset specificity is also a feature of non-tradeable financial assets such as bank loans to the degree that a developed institutional environment lowers the transaction costs related to the completion and execution of the relevant contract. Hence, asset specificity (k), when translated in financial terms, is predominantly an institutional – rather than a technical – issue closely related to the other two characteristics referred above as contractual safeguards (s) and price (p). Viewing asset specificity as an indicator of non-marketability of the incurred costs, guides us to the core of the institutional infrastructure of an economy and hence to the microeconomic underpinnings of financial repression/regulation or liberalization as a financial structure. For Williamson (1996: 41-42) the crucial or “canonical” governance choice is between buying something in the market or producing it internally at the level of the firm. This entails that his theory implies strict microeconomic decisions on the level of the individual firm where the issue of
26 vertical integration and the optimal size of the firm are questioned. However, the same choice in the case of finance, takes on a macroeconomic perspective as far as the alternatives are between capital markets on the one hand, and hierarchical or hybrid modes of governance at an economy wide level on the other hand. In this sense, financial repression/regulation is the institutional framework that governs contractual relations between firms – borrowers – and investors – suppliers of financial capital – when a high degree of asset specificity and institutional underdevelopment pose safeguard hazards and increase the price of capital to a level prohibitive for investment. Williamson (1991a,b) distinguishes the three main types of governance structures – market, hierarchy and hybrid mode – in terms of their major distinctive characteristics. The latter include differences in the ability to adapt in changing circumstances and in the relative weight between incentive intensity and administrative controls. Changes in asset specificity determine the type of adaptation needed and hence the related mode of governance. Markets are characterized by type A (autonomous) adaptation where prices are the sufficient means that reflect changes in demand and supply. As asset specificity increases and we move away from markets towards hybrids or hierarchies, type C (coordination) adaptation predominates where conscious attempts to overcome coordination failures substitute for market autonomy. Placement of the above logical schema in historical perspective might be interpreted to reflect – in terms of shifts between markets and hierarchies – differences between alternative financial systems depending on their development. The level of economic development is a decisive factor concerning institutional development. Hence, a Less Developed Economy might be characterized by rather primitive financial structures because of its low level of economic development. In such an economy, the elementary or limited level of monetary transactions justifies a situation of institutional underdevelopment. On the other hand, there is no unique relation between the level of economic development and the development of capital markets as Rajan & Zingales (2003b:212) indicate. Indeed, financial markets decreased in importance as a source of finance after 1929 and throughout the whole period up to the deregulation wave of the 1980s. The point to be made here is that financial repression/regulation might be
27 interpreted as emerging from the need for type C adaptation as transaction specific investments increase and liquidity risk increases in a system. Hence, disrupting events in economic history such as the Great Depression in the 1930‟s lead many developed countries with large capital markets in the political decision for the “great reversal” toward financial repression/regulation. Such interpretations of financial development make Williamson (1991a,b) analysis for adaptation needs pertinent to the understanding of financial repression/regulation. Nonetheless, a price has to be paid when deliberate efforts for adaptability of the system increase as we move from markets to hierarchies. This price is the cost of degrading incentives versus the benefits of administrative control. In type A adaptations, prices are adequate guiders of decision, furnishing agents with the necessary incentives to adapt efficiently. Full-information prices in developed markets are not vulnerable – in principle – to opportunistic distortions. Yet, in cases of bilateral dependency where type C adaptations are needed, and where prices are not fully-informative and hence they are prone to distortions, the need for decisions based on fiat leads to the double effect of degrading high-powered incentives – that is incentives guided by prices – and the addition of bureaucratic costs (Williamson (1991a)). The costs of bureaucracy as explained in Williamson (1985:148-152) relate to three major themes: a) the propensity of decision makers in a hierarchy to overstate their ability to solve complex problems or their strategic inclination to use the means provided by the organization to meet their preferred subgoals; b) the fact that internal organizations forgive errors more often than markets; c) the logrolling effect, namely the propensity of hierarchies to renew reciprocal relations among agents within it even if this is not justified on the grounds of efficiency calculations. On the other hand, incentives within hierarchies are rather “flat” (Williamson (1991a)) in the sense that greater effort is not reflected in larger pecuniary or non-pecuniary compensation. The implication for financial repression/regulation regimes is that the decisive role of the state in forming prices of capital and guiding its supply either in a hierarchical or in a hybridical form might lead to the additional burden of bureaucratic costs and diminished private incentives for efficient allocation of resources. Bureaucratic costs in a financially regulated regime might take the form of preferential relationships between government officials and particular agents with distorting effects for investment financing. It might also be the case that the former
28 meet their short-term political goals at the expense of the long-term declared goals of government policy. Then flat non-market incentives might simply add to this result. Although such costs are indispensable in hierarchical organization, they might more than offset by the gains of this form of governance. The competence of the political and administrative personnel of a given government and its agencies are pertinent to this net calculation. Nevertheless, the matter of decision for the financial regime is ultimately determined by the particular historical conditions given the type of adaptation needed by the real economy.
1.4. A Formal Model of Financial Repression/Regulation
1.4.1 A two-Period Framework In the above section, we gave a general framework of how one could use the tools provided by the Transaction Cost Economics literature to approach macroeconomic
problems
of
financial
structure
as
that
of
financial
repression/regulation. In this section, we will build a mathematical model based on these thoughts, keeping our reservations on whether mathematics can give a determinate answer to such historical problems. Nevertheless, mathematical modeling might give us an insight into these issues from an analytical perspective, while revealing the gaps that historical analysis must fill in. A formal model of financial repression/regulation as governance structure should take into account the three factors of the “simple contracting schema” of Williamson (1985:32-35), namely, asset specificity, contractual safeguards and price. We assume an economy that lives for two periods and its essential relations are described by: 1) a representative firm
that implements physical investment
projects using capital as its only input, 2) a representative household
that receives
income in the form of profits from firm and it has an initial endowment at period 1 part of which is saved as deposits at the bank accepts deposits from household
, 3) a representative bank
and lends them out to firm
that
to finance its
investment projects, 4) the government that oversees the whole system of production and consumption and intervenes by altering the incentives of action. The economy is
29 comprised of
firms,
households and
banks so as
. Households own
firms but do not know how to manage them. For this reason they employ managers who choose and implement investment projects with the stated aim to maximize firms‟ profits. On the other hand, households do not have the knowledge and the capability to monitor managers and hence, they cannot prevent a possibly opportunistic manager from selecting highly risky projects. If these projects succeed the manager‟s reputation is raised while a possible failure might be ascribed by the manager to adverse economic conditions. In effect, opportunism emerges because households‟ bounded rationality and limited calculability prevents them from distinguishing a good from a bad manager as reflected in a good rather than a bad project. This is a function imperfectly performed by banks where households place their savings. Households pay a price to the banks for this function that equals the financial intermediation spread. Firms and banks are modeled as production units. Firms produce output – income – while banks “produce” loans out of deposits. In effect, this is a model focusing in only one market, the capital or financial market, which is assumed to adequately characterize the relevant economic decisions and reflect the conditions in the product market. However, all variables are expressed in real terms. Firm j maximizes its profits by subtracting from its expected cash flow in
period t 1 f j I j the financial cost of its invested capital2 1 l I j and a fixed payment to the manager
3
. Function f j . is supposed to have the usual concavity
properties, that is f j ' I j > 0 and f j ' ' I j < 0. Then we have max j f j I j 1 l I j m j I
2
(1)
Normally, we should expect the firm to produce using an inherited stock of capital along with newly invested one. However, to justify (1) we could assume that capital is fully depreciated in one period, so as production depends only on the flow of investment for each period. 3 Labour costs and labour income are ignored altogether in this model for simplicity. Besides, labour cost and labour income will cancel out at the economy level without affecting any variable if we assume, as we do, that workers consume all their income and only shareholders/firm owners save.
30
Using the implicit function rule on the FOC we obtain the inverse relation between investment demand of firm j and the interest rate l as follows:
d (I )
d (l )
1 0 E[ui ' ' Ct 1 ]S t 1 d E[ui ' Ct 1 ] > 0 d (d )
(9) The first expression on the LHS is the coefficient of relative risk aversion. On the other hand, the above expression is also the inverse of the intertemporal
35 elasticity of substitution of consumption
(Deaton (1992:6)) between two it holds that5,6:
periods as for every two time periods and
Hence, we can write:
(10) The second term on the LHS is negative or zero if expected income from profits is positive or zero respectively. It is plausible to assume that
, that is agents
expect the firm to cover at least its cost part of which is the return on their savings. Hence, equation (10) is satisfied if
and expected income from profits
is positive or zero. If these conditions are satisfied then the substitution effect will
5
Assuming that the change in the ratio of consumption levels and their marginal utilities reflects a change only in t period for given values at period t+1. Hence, and where
is the marginal utility of consumption
in period t. 6 According to Mas-Colell, Whinston & Green (1995:97) in the case of two goods 1 and 2 the elasticity of substitution between them is given by
instead of
implied by Varian (1992:13,100
and 98). However, the two expressions are equivalent since . Furthermore, Romer (2001:91) uses Mas-Colell et al. (1995:97) expression in the case of the elasticity of substitution between consumption in two periods
and
which is given by
where
are the prices of consumption in
periods 1 and 2 respectively. In this formulation we should have for the prices of consumption and and hence, (marginal rate of substitution between consumption in the two periods). However, to the degree that the price of future consumption cannot be but the term as “subjective” price of the degree of patience of the consumer enters the Euler equation so as to determine along with the interest rate the optimal pattern of consumption.
36 dominate the income effect after a rise in the deposit rate7 and, given other factors that possibly affect the level of savings we should observe a rise in savings. Now, imagine that the market loan rate
and deposit rate
pertain to a
situation of high asset specificity. As we have seen, asset specificity in financial markets relates to the “ease of verification” of asset values – or the incurred transaction costs – which in turn relates to the institutional infrastructure of the economy. Hence, we assume an economy with institutional characteristics such as an underdeveloped legal system concerning investor protection, where the degree of asset specificity of the debt claim (the loan) increases, so that an investor would normally require a higher return than otherwise on its investment as compensation. In the above model, this situation could be translated as a moral hazard problem between the bank and the manager of the firm that rises the marginal verification cost
.
However, this in fact turns to be a moral hazard problem between the householdowner of the firm and the manager for whom the household pays a price. This is because, for given deposit rate, a higher loan rate means lower profits distributed to the household. The comparison could be made with economies with developed financial systems where, other things being equal, interest rates for projects with the same characteristics are lower. Hence, the kind of risk that we want to focus on, is the risk of supplying loanable funds in a specific institutional environment that relates the risk of the project returns to the specific institutional risk of each economy because of demand conditions. Given these observations, the context of our analysis indicates that a higher loan rate (and a higher spread for given deposit rate) entails higher asset specificity and the burden of higher asset specificity is carried out by the saverdepositor and not by the bank which will adjust its loan rate to its marginal cost. Hence, the one who is in fact locked-in in this situation of asset specificity is the saver because of the increased non-marketable transaction-specific costs of its debt claim which is in fact its deposit extended as a loan by the bank. In order to give a time-graph representation of a contractual relation in the above context, assume a two-period case with an interim time interval. At date t = 1 7
A rise in the deposit rate will provoke two effects on intertemporal consumption decision. The substitution effect which entails an increase in saving (future consumption) as current consumption becomes more expensive and an income effect as the rise in the deposit rate indicates now that the same amount of current saving yields a higher amount of income to be consumed in next period. However, for the individual consumer, the income effect is positive only if the agent is a net saver (Romer (2001:363)).
37 the debt contract is signed between the saver and the manager of the firm through the intermediation of the bank. This contract could take the form of a time deposit for one period (until date t=2) of an amount
where
is the amount of loan
demanded by the manager. At this date we do not know neither which state of nature will eventually prevail nor the competence or honesty of the manager, and hence, profits are random although expected to be positive. Then, at the interim interval
Figure 1: Time representation of the contract
t=1 (contract signed)
Interim Period
t=2
(nature reveals itself but recontracting not possible)
(project yields received)
“nature” reveals itself or the manager gives signs of its character8 but recontracting is not possible9. Hence, the initial “large numbers bidding condition” has been “fundamentally” transformed to a “bilateral supply” (Williamson (1985:61). Finally at date t = 2 the project yields its income streams10. 8
Note that in our model risk is related either to the unknown true character of the manager or to some unexpected demand or natural shock. 9 Recontracting in this case, might mean premature withdrawal of deposits in the fear of interest or capital loss or renegotiation of the deposit rate. We assume that the transaction costs charged on the depositor for such negotiations are so high, because of the underdeveloped financial system, that exclude them as an option. For example, a zero or negative deposit rate for premature withdrawal would just materialize the feared/expected (and hence, not yet realized) interest or capital loss. 10 Note that, for our argument, it is not important that the interim time interval is assumed here to be of only one period. What is important is that saving decision of households and investment decision of firms have equal time horizons, namely, banks cannot perform a maturity transformation function because of the underdevelopment of the financial system. They cannot offer deposits with shorter maturity than their loans. So the saving decision is a locked-in decision. The time horizon of investment projects determines the decision horizon for consumption and saving of households. Decisions made at the beginning of the period, cannot be altered during the period since there are not deposits with maturity shorter than one period. In fact, we can assume a time interval of any length say, that characterizes the investment and saving horizon. Then the problem becomes: s.t.
and
. Namely, the
decision taken at time determines the allocation of consumption among the first periods according to the subjective rate of time preference factor on the one hand, and on the other hand, the allocation of consumption between these first periods and the last period according to the ratio of the interest rate factor and the rate of time preference factor for this last period. This can be seen by the F.O.C. which yield
. The inability of the financial
system to perform its maturity transformation function makes it impossible for the household to
38 One could figure out the problem of financing investment for economic development in developing countries in the 50‟s and 60‟s, exactly in this way, that is as a problem of high cost of capital because of increased overall risk both institutional and intrinsic. A major factor of this risk might assumed to be the institutional underdevelopment of these countries that called for government intervention in the structure of the financial system. In this context, financial regulation took the form of administered low interest rates for industries that would boost economic development in an international environment with capital controls. To bring this situation in our model now assume that there is the possibility that interest rates are not set by the free market – or freely by the bank in our case – but by a “monetary authority” in an administrative way. Then, it is theoretically possible for this authority to decrease the risk adjusted market rate so as to have
by a proportion
< l . Let us see how our model responds to such a
possibility. The maximization problem for each firm is now stated as: max j f j I j 1 l I j m j I
(11)
f ' I j 1 l 0
And the relation between investment demand of firm j and the interest rate factor
is a negative one: d (I ) l 0 d ( ) Hence, (16) leads to the same relationship (9) which is true if income from profits a rise in
(16)
and expected
is positive or zero. This is what one would expect as far as
is equivalent to a rise in
and so the effect that they should have on
savings should be in the same direction. Hence, a high value of has a positive effect on saving or alternatively, a low value of that decreases interest rates affects saving negatively.
40 Taking into account the overall effects, a government policy that lowers interest rates administratively may lead to a gap between investment demand and supply of loan capital. This happens because decreased savings are translated to decreased deposits at banks. Then, by the equality
loans also decrease
given that the maximization condition for banks
is to be
satisfied. The question is what the government can do to alleviate this gap and hence, sustain the increased level of investment that is deemed necessary for economic development. Williamson‟s (1985:33) contracting schema predicts that lowering of the market price in the face of high asset specificity is possible if the new hierarchical governance structure is able to provide safeguards. To the degree that institutional risk is an economy wide risk that also affects intrinsic risk of each project, the government could intervene in the financial market by providing a more efficient legal system, the establishment of bankruptcy laws, increase the efficiency of law enforcement, provide guidelines concerning disclosure and dissemination of information. In addition, it could implement programmes sponsored by itself for the training of business managers and bank employees on more transparent accounting techniques, more efficient monitoring and supervision of investment projects and the acquaintance of new attitudes of business ethics. All these mean that the state or the monetary authority are able to build a new modern institutional infrastructure that would provide the investor with the additional safeguards needed for its protection against opportunism of the borrower. Hence, the monetary authority aims at substituting the functions that a developed financial market would undertake given the present state of institutional underdevelopment of the economy probably through its own institutions such as governmental agencies or development banks that act as guiding and training institutions. But how can these safeguards be incorporated in our model? Saving, in this model of household behaviour is a by-product of the preference between current and future consumption given their relative prices. Till now we were preoccupied only with the price, or opportunity cost, of current consumption which is the financial variable
assuming that the price of future consumption 1
is given11. The later price is determined by the subjective time preference factor 11
In fact the subjective rate of time preference represents the loss incurred by the individual because of its waiting to consume namely; it is the cost of its patience (Branson (1989:250)). Hence, the higher , the lower the value attached to future consumption (the lower the utility derived by future consumption) with respect to current consumption (as the rate of time preference discounts utility from
41 which is an argument of the intertemporal additive expected utility function and is assumed common to all households. A low increases the value that households attach to future consumption as it increases the factor
1 and hence, increases 1
savings ceteris paribus. If the government could affect in some way this subjective discount factor in the desired direction, it could make a step towards bridging the gap between saving and investment. We propose, that a way to do this is by providing the adequate safeguards mentioned above to the investor-saver, symbolized by the variable . Safeguards given by the state cannot alleviate intrinsic risk due to economic underdevelopment and hence, cannot be a substitute for the variable established by fiat. As far as economic underdevelopment persists, risk evaluation remains high. What safeguards can do is to alter the time preference for future consumption by providing state guarantees –which depend on the reliability of each sovereign state – for the protection of households‟ savings. The price that the state must pay to provide these guarantees is determined by the discounting factor of subjective time preference
1 . Then applied to this discount factor raises the present value of the utility 1 obtained by future consumption and hence, it raises savings. Applying safeguards in our model changes fundamentally the structure of the problem described so far. At first,
affects the loan rate charged by banks to the
degree that the marginal verification cost is decreased because of the institutional safeguards concerning investor protection that are provided by the government. If this is the case, then by the bank maximization problem we obtain the relationship with
. Hence, since the marginal cost of the
bank has been decreased due to government safeguards, the bank can provide a lower loan rate to firms without cutting the deposit rate as its spread has also been reduced12. On the other hand, the safeguard variable also affects the decision of households between current and future consumption, as we have already seen, given the effect of future consumption to the present) and hence, the higher the cost of abstaining from consumption today in return for consumption in the future. This cost is a kind of “price” of future consumption derived from the form of the utility function and hence, it is related to the preferences of the agent. 12 Note that this kind of government interventionism is not a short-lived income transfer from lenders/savers to borrowers. On the contrary, it is long-term looking policy to the degree that lower lending rates are granted to firms because the marginal verification cost of banks is decreased as the latter are aided by the institutional infrastructure that the government builds.
42 deposit rate. But what is
in this case? If the deposit rate collected by households
after government intervention is difference
, although banks pay , then we can consider the
as an explicit tax levied on deposit interest income
with the tax rate being
. This tax is meant to finance the interventional policy
of the government through the safeguard variable . But why should the government prefer this kind of tax rather than another one? Note that a tax on personal income would not do the job since it would decrease aggregate demand acting on disposable income without any direct counterbalancing effect by the provided safeguards on expenditure. This would act contrary to the ultimate goal of government for economic development. On the other hand, a tax on firms‟ profits would just decrease the incentive for investment that the policy of lower loan rates is meant to boost. Finally, a direct tax on banks‟ loan rate that would entail an indirect tax on the deposit rate to the degree that the marginal cost of banks is unaltered, would meant only a transfer of resources from lenders to borrowers (to the firm as a direct subsidy to it without any resources left to finance government safeguards to depositors. What makes the tax on deposit rate the only solution is that: 1) it entails a direct trade-off between pecuniary loss and non-pecuniary gain by safeguards to whom it interests most, the depositor, 2) the cut on the loan rate is not the outcome of any subsidy to the firm financed somehow but the outcome of government safeguard policy lowering directly the marginal cost of banks, 3) and hence, this tax needs to finance only government expenditures and no other agent in the economy, 4) it does not function counterproductively on the goal of economic development. Taking into account the above meanings of government‟s interventional instruments
and , safeguards included in the household‟s maximization problem13
entail:
13
Note that in the case of a formulation of the problem as in footnote 7, we should have s.t.
F.O.C. yield
and
. Then the . As can be seen from this
expression, the safeguard variable acts on all periods, not only on the last one which the interest rate variable affects. In fact, the longer the interim time interval , and hence, the greater the asset specificity effect, the greater the effect of the safeguard variable on saving decision. In fact, the formulation of the problem in the text ignores these added effects of the safeguard variable and hence,
43
max u i Cti S
1
E[u i Cti1 ]
(17)
Cti S ti1 Wt i
s.t.
which yields the Euler equation: (18) If the object of policy is to alleviate the distorting effects of an < 1 on the allocation between future and current consumption then the safeguards variable must assume values in the range 1 < ≤
Furthermore,
d (S t ) E[u i ' Ct 1 ]1 d >0 2 d ( ) E[u i ' ' Ct 1 ] 1 d u i ' ' Ct 1
(19)
Which is positive since the numerator is positive, the denominator is negative but the whole fraction becomes positive because of the minus sign. Hence, a rise in the provided safeguards raises savings. Now the derivative in is:
d (S t ) E[u i ' ' Ct 1 ]dS t 1 d E[u i ' Ct 1 ]d 2 d ( ) E[u i ' ' Ct 1 ] 1 d ui ' ' Ct 1
(20)
Since now savings are a function of and for given , that is S , , , then if they are dS
to
remain
at
the
same
level
we
must
have
S S S d d d 0 . Substituting the previous expressions we S d
have:
E[u i ' ' Ct 1 ]dS t 1 d E[ui ' Ct 1 ]d ] d ( ) d ( ) E[ui ' Ct 1 ]1 d
(21)
Given the minus sign and the positive denominator, for this fraction to be negative suffices the numerator to be positive which yields the same condition as before:
(22) underestimates its effectiveness. For problem as that in the text.
and
for
we come to the same
44 On the other hand, by implicit differentiation, from the Euler equation (15) we obtain:
E[u ' 'i Ct 1 ]dS t 1 d E[u 'i Ct 1 ]d d ( ) d ( ) E[u 'i Ct 1 ]1 d Hence,
setting
as
objective
to
keep
the
ratio
of
marginal
(23) utilities
Eu 'i Ct 1 1 d 1 constant when the variables and assume values at u 'i Ct inverse directions, is the same as keeping the level of savings constant. But is this the same level of savings as that implied by the Euler equation without government intervention? Note the decompositions:
u ' C 1 d u 'i Ct 1 u 'i Ct 1 E i t 1 , 1 d E E1 d cov u 'i Ct u 'i Ct u 'i Ct u ' C 1 d u 'i Ct 1 u 'i Ct 1 E i t 1 , 1 d E E 1 d cov u 'i Ct u 'i Ct u 'i Ct
(24)
(25)
If the ratios of marginal utilities remain the same, the above expressions differ in the second terms of the products of expectations,
E1 d 1 d and E 1 d 1 d
(26)
and in the term in the covariances
u ' C u ' C u ' C ~ cov i t 1 , 1 d cov i t 1 , d cov i t 1 , d u 'i Ct u 'i Ct u 'i Ct
(27)
Although, till now we have assumed a non-random deposit rate, we will examine the general case with non-zero covariances so as to take account of the case of a banking system in crisis. In this case, with less than 100% deposit insurance, the deposit rate that enters the decision problem of households has also a probability distribution and hence a mean expected value . Then, the certainty case of 100% deposit insurance or diversified sound banking system is a subset of the previous one. Then keeping the ratios implied by the two Euler equations constant at the level before government intervention, namely ~ ~ E u 'i Ct 1 1 d E u 'i Ct 1 1 d 1 u 'i Ct u 'i Ct
(28)
1 is equivalent as setting 1 d 1 d 1 d 1 d 0 and which
jointly yield a value of 1 which indicates no government intervention. However,
45 this analysis does not take into account the compound effect of and on the ratio of the marginal utilities from consumption. This can be seen by the different path of 1
changes in as changes as it is derived by the expressions
1 d 1 d since, the first implies
and
d 1 2 , while the second yields d
d d 1 . The only value of these variables at which both equalities, d 1 d and 1 d 1 d , hold is 1 . However, as falls below 1 and rises 1 above 1, a change in given by the relation 1 d 1 d implies that < .
Indeed:
< 1 d < 1 d 1 d <
1 2 d >
(47)
which is plausible in economic terms since it means an increasing path of consumption through time and hence, a positive level of savings. Then substituting (46) in (44) we have: * 1 2 1 d 1
So, the value of 1 by (44), (46) and (48) is:
1 *
1 *
1
2
(48)
52
1
1 *
1 2 1 d
1
1
>0
(49)
2
Furthermore, substituting (46), (48) and (49) into the first order conditions (38) and (39) under the assumption that 2 3 4 0 , these equations are also satisfied.
d *1 * d d
1 2 1 d
1
1 1 *1 1 * d 1 1
1 1
1 1 2 1 d 1
1
1
1
2
1
1
2
2
1 d
1
2
d d d 0
(50)
1
1
1
2
1 d
1
2
1 2 1 d 1 12 d 1 1 12 d
1 2 1 12 1 d 1 12 1 12
1 1 0 1 1
(51)
The last conditions to be satisfied are * < 1, * > 1 and *
1 Finally, for the last inequality we have:
1
2
> 1 (52)
53 1 2 1 d 1 1 d ** 1 1 2 d 1
1 d
1
1
2
1 d
d
1
1
2
2
1
(53)
Hence, all conditions are satisfied and the above solution
*, *
yields a
constrained minimum. However, since the KKT conditions are only necessary, there may be other solutions for this problem too. Another one, for example, is to assume
j > 0j and the solution in this case is * * 1 . So, the problem has at least two optimal solutions with one of them justifying government intervention with values of and below and above unity. However, note that the second solution is, from an economic point of view, a tautology, since it only says that no intervention means zero cost which is also a minimum cost. Hence, the government that faces a deposit rate
set by the maximization problem of the
bank and a time preference factor of the representative agent
that reflects its
preferences in its utility maximization problem, is able to implement a financial regulation policy at a minimum net cost if it selects the optimum values
and
.
The latter depend on the two prices for current and future consumption as these are the determinate factors that would affect and keep savings at least at previous levels thus making the policy of financial regulation effective. The question that arises is whether this outcome is feasible only in a twoperiod framework or it could also apply in the case of an economy that lives for periods. To this question we shall turn our analysis now.
1.4.2 The Model for T > 2 Periods A firm might have projects with different gestation periods and this is normally the case. This is crucial as far as the longer the period a capital good yields its returns that validate the decision for its installation, the greater the uncertainty surrounding the investment decision. However, both to simplify things and prove our
54 thesis for financial regulation even in the case of successive short run one-period intervals15, we assume that each project implemented by the firm and financed by the bank has a life of one period. Hence, firms and banks solve their maximization problems at each period of time as “production” units (Freixas & Rochet (1997):51) given their respective constraints, namely the availability of savings/deposits and their related financial cost – the loan and deposit rate. In this sense, the time representation of the contract depicted in Figure 1 above, still holds with time deposits of one period reinvested as savings by the households at the bank and hence, loaned to the firm to implement its investment projects at each period of time. Households, on the other hand, are interested in smoothing their consumption patterns over the longer period16. To do this they include as inputs to their maximization problem the expected profits of the firm at each period of time – which they expect to receive as income – and the deposit rate supplied by banks or its expectation. Note that the multiperiod model adds another dimension of uncertainty for the household as far as the latter cannot know from period 1 the projects that the manager of the firm will pursue in period 4, for example, so as to calculate the related expected profits that will flow to them as income17. Then, their expectation for the economic situation and the competence of the manager for the immediate next period just condition their expectations for the ensuing periods. This makes their bilateral dependency in the contract signed with the manager – through the bank – stronger. For the same reason, the household cannot know the deposit rate that will be effective at that future period since this is determined as the residual of the loan rate after the subtraction of the marginal cost of the bank. This is an additional reason to treat the deposit rate in the multiperiod case as the expected deposit rate. In this context, households‟ multiperiod problem is solved on the basis of the discounting of their intertemporal utility by their subjective time preference factor. On the other hand, the 15
This is a rather adverse setting for our thesis to the degree that asset specificity confines itself to only one-period (say one-year) intervals. This means that past (false) investment decisions do not burden the present performance of the firm and hence, uncertainty as a defining factor of business decision is considerably reduced (but not eliminated). However, the necessary condition is that during this short interval renegotiation is not possible. 16 In a sense, each agent faces the horizon of its own capital: short one-period for firms‟ capital and longer over more periods for households in the face of their human capital. 17 The hypothesis that capital is fully depleted in one period means that the basis for financial conjectures on the future performance of the firm is lacking and this might add rather than subtract uncertainty to the household investor that has a longer horizon of utility maximization . However, the household still has the opportunity to estimate an average profit by judging the history of the firm‟s performance given its confidence that these trends will continue in the future.
55 government that aims at influencing the saving behaviour of households, has also a multiperiod problem to solve by calculating the intertemporal net cost of its interventional policy given a desired path for the deposit rate and its time preference factor. In more than two periods, the agent‟s
maximization problem described by
equation (5) becomes:
s.t. (54)
This model follows Sargent (1987:92-93). The last condition has the meaning of excluding the case of perpetual borrowing ((Sargent (1987:31)) so as there is neither outstanding debt at time
nor savings left over. Hence,
deposit rate that predominates during the period
is the random
but is not known before the end of
this period. Again we are referring to the general case with uncertainty both for future income and future deposit rate. The vector of state variables includes of which only the level of deposits held at time
and
can be influenced by the agent and
hence, it is an endogenous state variable. On the other hand, we choose the quantity as the control variable instead of the variable equation of motion for
. Note that the
(the transition equation) can also be written as:
(55)
This means that the agent at time , given his income, consumption and the level of deposits held at this period he chooses the level of saving that would be carried forward as this is expressed in present value terms as expected deposits held at the beginning of the next period
discounted by the expected value of the random
deposit rate that would prevail at the end of the current period. Hence,
56
(56)
indicates the variable whose magnitude the agent can control given the exogenous states and the level of its consumption. Also we assume that agent
is in fact household
which means that
which “lives” forever through the succession of
generations. Hence, the problem now becomes:
s.t. (54a)
Following a dynamic programming procedure, and given that and
, the Bellman equation for this problem is: (57)
Differentiating with respect to
we obtain: (58)
In order to get rid of the
term we are making use of the Benveniste &
Scheinkman (1979) formula (see King (2002)) and the fact that the transition equation as is defined by (56) is not a function of
, (see Sargent (1987) pp. 21-22 and 30-31)
we have18: (59) Then (58) yields the usual Euler equation: (60)
18
Because differentiating now (57) with respect to the state variable
But since
then
we have:
and moving one period forward
.
57 By the same procedure, the maximization problem of the agent (household) described in (17) becomes:
s.t. (61)
with
. Following the same reasoning as before yields the Euler equation: (62) Equations (60) and (62) are the same with those obtained before under the two
period problem, namely (6) and (18). This is the consequence of the assumed timeseparable (recursive) nature of the problem and its dynamic programming approach which obtains the optimum time path of the state and control variables by solving backwards the same two period problem. However, there is a difference concerning the appear to depend on time. We will assume that he makes his decision at period
and
and
variables which now
are known to the agent when
in the sense that government policy for the said
period is known and not random. In this context, the analysis described by equations (24) – (28) still applies. The conditions that should hold for keeping the ratios of marginal utilities before and after government intervention equal, that is:
(63) still depend on the relation between and
and
on the one hand and
on the other hand. Furthermore, in the
-periods context,
should also be modeled so as to
follow a time path. We will use the second of the above conditions to express the equation of motion for the deposit rate variable as: (64)
58 Note that :
(65)
The first relation is incompatible with the equality of the two marginal utilities‟ ratios. However, the other two still imply such an equality given the relation between and
. Indeed, as we have already showed in (29) implies
implies
. On the other hand, we can prove that . This is evident from (66) below:
(66) On the other hand, both expressions (29) and (66) are equivalent in terms of what they imply for the slope of the path of savings between periods. Indeed, if ,
and also
which implies
(66) is satisfied only if
, then
falls which means a steeper path for consumption
and hence, current savings above the levels attained before government intervention in uncertainty concerning the deposit rate. A similar result was obtained in the analysis for the two period model under the assumption that and hence,
.
Furthermore, expression (64) can also be derived by the assumption that depends on the information available to the agents at time . In our case, the relevant information set namely
depends on the values of
and
known at time ,
. In terms of Laffont (1995:56) analysis of information
structures, our model implies an information structure without noise where agents – in this case the bank and the household – receiving the signal implied by the values of and
, they know with certainty the true values of these variables and hence, the
relevant government policy. Hence, the path of the deposit rate, although decided by
59 the bank as non-random deposit rate
of which the household holds an expectation ,
is affected by the government through the selection of the paths of
that are
transmitted as signals to the agents. Given the above characterization of the
periods model, the problem for
the government is:
s.t.
(67)
The problem thus formulated entails two control variables, one state variable,
and
, and
. The government seeks to minimize the value function
which
is the discounted sum of the intertemporal net cost of intervention with being the relevant discount factor. In order to achieve that, it must choose a path for the control variables subject to the equation of motion of the state variable. The initial value of the interest rate is assumed given and the same holds for the time span of this operation, that is . The problem can be solved using optimal control techniques and forming the relevant Hamiltonian function, which is turning the objective to:
s.t.
(68) The current value Hamiltonian then is: (69) and the Lagrangian becomes:
60
(70)
Then by the maximum principle conditions we obtain:
(71)
(72)
(73)
(74)
Furthermore, taking the second derivatives
and
yields:
(75) Since (75) satisfies the second order necessary condition for maximization where and
,
the vector of control variables, then the Hamiltonian is indeed maximized by .
61 Substituting (71) and (72) in (73) and (74) we obtain:
(76)
(77) From (76) we can see that the costate variable is constant so as also
. Hence, it is
. Substituting this value in (77) we obtain for the state variable:
(78) Since,
and
are time-invariant parameters in our model then the deposit rate
remains constant through time for
and hence:
(79) Then substituting (79) in (71) and
in both (71) and (72) we obtain for the
control variables:
(80)
62 and
(80a)
(81)
Before embarking on the economic characterization of the solution let us check whether the latter satisfies the sufficiency conditions for maximization of –
under
the maximum principle. The Arrow sufficiency theorem (Chiang (1992), pp. 217 – 218), indicates that the conditions of the maximum principle are sufficient for the –
global maximization of the objective functional if the maximized Hamiltonian that is the Hamiltonian evaluated along the variable
for given
. Forming
paths is concave in the state we obtain:
(82) Then forming
for
we obtain:
(82a) Since, by (82) and (82a)
is linear in
for every then it is also concave in
and
hence, the Arrow sufficiency theorem is satisfied. Furthermore, the transversality condition for this truncated vertical terminal line problem19 (Chiang (1992: 183) is: (83) 19
That is a problem with fixed terminal time and a free terminal state but subject to the condition where is the minimum permissible value of the state variable (Chiang (1992:182)).
63 For
the transversality condition is satisfied for
if we set
. This holds
, that is if we assume that agents will demand a deposit rate
path not lower than that prevailing in the initial time given the unchanged overall risk conditions of the economy. If this is the case, then:
(84) Hence, by (79), (80), (81) and the satisfaction of the transversality condition by (83) and (84), the maximization of
yields constant paths for the state and the
control variables. The paths for the control variables,
and
which by (65) places us in the case where
imply that as can also
be confirmed by (84). Hence, the government manages to minimize its net cost function through time by selecting its rate of time preference – the latter affecting the paths of the control variables – which enters, along with the rate of time preference of the agents, the determination of the deposit rate path that leaves the level of savings at least at its initial level. Note that
given by (79) is not the actual deposit rate set by banks
subject to government restrictions which in fact is
. The rate given by (79) and
affected by the rates of time preference of the government and agents is the effective deposit rate envisioned by savers that takes account also of the non-pecuniary benefits of safeguards provided by the government. Hence, although the government cannot decide the deposit rate by solving its minimization problem, it can affect its effective level, namely the level that would leave savings at least at their initial level. However, these paths should satisfy certain conditions in order to be economically meaningful in the context of our model. At first, 1 and
should be less than
greater than 1 to justify government intervention. This is indeed the case if . Furthermore,
should also be less than 1. This later condition poses an
interesting restriction on the assumed values for the parameter time preference for the government with respect to preference for agents.
which is the rate of
which is the rate of time
64
(85) Then (85) holds for a rate of time preference for the government
which is low
enough which means a government that is implementing its interventional policy by imposing a low time premium to its intertemporal objective functional. On the other hand, a high
– which is the same as a low
– raises the present
value of future net cost from government intervention. If we conceive
as the
“price” of future Net Cost by intervention then a government would attach more value to future rather than current Net Cost in order to avoid or postpone the political cost. As far as future Net Cost is more valuable to it, it discounts it at a high rate. Hence, normally, a government would prefer to impose a high determines the optimum constant paths of
and
higher tax on deposit interest income for given although the government would prefer a high given by
as indicated by (85). Hence,
to obtain a low
, a low
. Since,
entails a low
along with a higher
and a
. Therefore,
it is confined by agents‟ preferences is in fact a “subjective” rate of time
preference of the government, but a rate whose bounds are determined by the perceptions of agents as the actions of the latter constitute the true objective of government policy for financial development. Agents will prefer a high means a lower
, since this would entail a higher
which
or a lower tax on deposit interest
income. Their preferences are depicted in (85) which confines
to low levels.
However, this is only the weak condition imposed on the government‟s time preference factor. The strong and more restricted condition is given by (86) below and indicates not just a range of values but instead a specific value for that,
with
given
will
leave
the
interest
rate
, the one unchanged.
(86)
65 Therefore, although the government would prefer a high preferences given by both that for
and
it is confined by agents‟
as indicated by (86). However, (86) also implies
to be positive we must have (87)
What is the meaning of this condition? Note that if
was equal to 1 then
,
and no government intervention takes place. In this case, by (79) given the minimization problem (67). Hence, (87) simply says that government intervention would take place – or
– only if the deposit rate set by
banks before government intervention is higher from the level indicated by since
. Now,
is the unit price at which the government extracts revenue from savers through
seignorage by the relation supplying safeguards by the relation
and
is the unit price paid to savers for and since their difference enters the
Net Cost function of the government then (87) says that a cost minimizing government will intervene only if the unit price of its revenue exceeds the unit price of its cost. Hence, the condition
sets the lower bound at which
government intervention should take place in a cost minimizing framework.
1.5. Implications of the Model An important point that this model makes is that government decision for financial repression/regulation, if taken, can be efficient from a cost minimization point of view, under some conditions. The fundamental prerequisite for the success of this policy is that the decision to lower market rates should be accompanied by a further decision to provide safeguards that, in a contracting context, would play the role of guarantees that would ultimately act as a non-pecuniary compensation for the decreased return on households‟ deposits. Another important point that this model makes is that these guarantees are able to preserve savings at least at the previous – before intervention – level. The final point is that, through the above reasoning, tax in the form of tax on deposit interest income takes on a meaning that contributes rather than impedes economic development. This is because, receipts from this tax are now
66 used to provide the necessary safeguards which alternatively means, that they are used to boost institutional and hence, economic development. Usually, the loanable funds framework assumes that an increase in money supply that in turn increases the availability of funds above agents‟ savings, is used to cover the gap between increased investment demand and the previous level of savings. However, the side-effect of this policy is to lower the real return to capital by the ensuing inflation. Hence, in this context, the increase in money supply is essentially a financial-nominal rather than a real variable, the latter being assumed in this model for savings (Chick(1983:178-181, 184-185)). In the model of this paper there is no money demand and hence, no modelling of any inflation tax. On the contrary, we talk about an explicit tax on deposit interest income which is effectively a transfer of real resources from agents to the government. However, what we propose in our model formulation is that viewing financial repression/regulation as governance structure gives a new meaning to this taxing policy of the government as a means to finance the necessary institutional apparatus of the economy along with its transformation, the latter being a necessary ingredient of economic development policies as Stiglitz (1998) puts it. If this is the case and this policy is successful then, given the adequate time span for expectations‟ adjustment, the gap between savings and investment will be covered not through the unsustainable inflationary money creation but through the mobilization of savings through the effect of the safeguards variable on them. Then, this tax becomes only the fee for the safeguard operation that ultimately would minimize any loss cost to lenders/savers. In this context, institutional development becomes a necessary ingredient of economic development and to this respect, government intervention that supports institutional development becomes a justification of financial repression/regulation as a governance structure. What does this model imply for the evolution of financial systems and financial development? Institutional development in the area of finance should normally take the form of market-set low interest rates accompanied by an extended legal system of investor protection and an institutional infrastructure for efficient information dissemination, where both will increase the marketability of financial claims. In terms of this model, both these conditions should be represented by a low
value of the loan rate l indicating decreasing institutional risk and intrinsic risk as the two kinds of risk are interrelated. The lower loan rate should be reflected partly to a
67
lower marginal operating cost of the bank
, to the degree that lower institutional
risk entails lower verification costs. On the other hand, to the extent that the noisy institutional environment has also exaggerated intrinsic risk, a part of the decrease in the loan rate should also be reflected to a lower deposit rate
. Hence, one could
envisage the process of institutional evolution as both and approach their unity values from below and from above respectively accompanied by an equivalent decrease in the value of the two rates of interest and the verification cost which means a lower degree of asset specificity. However, as the multiperiod model indicates, this is not the case. Since, and
, for
we must have
. If we
conceive the government as an agent deriving utility in political terms, that is, caring for its re-election, then it cannot prefer a rate of time preference that would impose equal weight on current and future periods concerning the Net Cost of its interventional policy. In this sense, neither
nor
and
can approach unity
through time. On the contrary, we can conceive financial development as a two-fold process. The first step is the implementation of government‟s guided safeguards as these are expressed by a
above unity operating both on banks‟ charged rate and the
saving decision of households. Then the second and more substantial step is the embodiment of these safeguards in the attitudes and behavior of agents. For given level of risk – whose effects these safeguards come to diminish – that is a given level of the interest rate
, financial development can only entail a change in agents
preferences for future consumption – or for higher saving – namely a lower parameter. Indeed, for given interest rate, a lower hence,
and
may cause a higher
by (79) and
closer to unity. Does this mean that interest rate would eventually be
the same as before? No, since maintaining the effective deposit rate at the level is equivalent to shifting the saving schedule to the right by the effect of it and this entails a lower actual rate at Then, the substitution of the effect of
on
as we can see from Figure 2 below. by the effect of
on savings as financial
development proceeds and given the decrease of the verification cost, will provide a lower margin at the level development entails a
. However, note that even if
, financial
and hence, a lower marginal cost of banks, although in
68 this case
. This is because lower institutional risk now emerges not from
government guarantees within an underdeveloped institutional infrastructure but from
Figure 2: The Loanable Funds Market
the already built developed institutional infrastructure itself as expressed in the
marginal operation cost of banks. Then, what agents really do when lowering their rate of time preference is in fact the embodiment of this development in their perceptions and confidence concerning the financial system. In effect, financial development is a double trade-off effect. On the one hand, a lower price of risk – a lower risk premium – necessitates a higher level of guarantees for agents‟ investments in the probabilistic sense, that is, on average, given the available information for the state of the economy and given the confidence of agents for these average estimates. On the other hand, a higher level of guarantees might mean initially safeguards provided by government institutions, given their better position to gather and assess various pieces of information, in the context of an underdeveloped market structure. Then, the second trade-off, emerges in the form of substitution of market-based safeguards for government safeguards as the institutional structure of the former develops. In the previous model this means the substitution of
69 for
with respect to the role played in the saving behavior of the agents. Of
course, all these depend on the condition that the state has functioned consistently towards institutional development with all that this entails for the use of the receipt from tax on deposit interest income, the horizon of government policy and the efficiency of its administrative apparatus, namely given the bureaucratic costs mentioned by Williamson (1991a). The previous analysis indicates how it is possible to obtain values of
and
close to unity, or to minimize direct government intervention. Does this imply that we can reach, at least theoretically, a state of affairs where financial regulation is redundant? Our impression is that this is not possible. As Dow (1996) indicates, financial development goes hand in hand with the need for regulation, although the latter might take more sophisticated forms. What is at stake is the system‟s fragility and the need to preserve its stability. To put it in the context of the previous model, a low value of
depends not only on the establishment of confidence on the system by
the past values of
, but also on the established expectation that the state would
provide the adequate safeguards if these were needed in adverse times in the future. In this sense, prudential regulation entails not only a lender of last resort but, more generally, a safeguard provider “of last resort”. By this peculiar notion we mean the need for a continuous background presence of the state in the financial system as the ultimate guarantor and guard of its liquidity and stability. This entails the continuous efforts of the regulatory authority as a monitor and supervisor of the system that enhances rather than hinders competition in the market by lowering the effects of asymmetric information. If this is the case, then unity by a small amount
will be lower only if
close to zero, so as
is above
is the signal provided by the
government to the market participants that it will act in a safeguarding way if needed, that is for a rising value of
in turbulent times, and that it enacts its monitoring and
supervising role in normal times. By the same token but rather close to it, the difference being a small
will never be equal to unity that represents the price agents
have to pay for having a regulatory authority acting as a safeguard and monitor of the system. This is, as Llewellyn (1999) puts it, the “insurance premium” that agents pay. Then, if with
is the hypothetical benchmark rate of an ideal unregulated market,
,
is the prevailing interest rate in a world with developed and
70 prudentially regulated financial markets plagued not only with some sort of asymmetric information but also with fundamental uncertainty.
1.6.Connecting the Model to the Literature As we have already seen above, orthodox models of financial repression usually introduce an inflation tax in order to represent both the mechanism of lowering the real loan rate and the receipts obtained by government through that tax. Although our formulation does not include a money market, a comparison can be made between the inflation tax of the literature and our explicit tax on deposit interest income. Hence, posing our modeling in the context of the orthodox financial repression/regulation literature we can envisage the expression for the enforcement cost as an expression of the existing inflation rate in an economy. To do this assume
that d is both the nominal and real expected deposit rate at zero inflation and d is
the corresponding real rate where d < d for positive inflation rate. Then the
difference
^ e
d d 1 d p
is the expected inflation rate because of
government intervention. Now, given the monetarist approach to inflation that the orthodox approach accepts and following closely Fry (1981) we can represent the expected inflation rate as the difference between nominal money supply rate of growth and real money demand rate of growth. i.e. M D t M S t d ln d ln D ^ e Pt d ln M S t d ln M S t d ln m D t m t p dt dt dt dt dt
(88)
In the spirit of the monetarist doctrine we can equate the rate of inflation and hence the enforcement cost with the growth of money supply over real money demand to obtain: M S t d ln D ^ e m t 1 d p dt
(89)
The above expression (89) indicates that the enforcement cost – or the tax on deposit interest income receipts – equals the growth of nominal money supply over real
71 money demand for given level of asset specificity. Hence, for given level of asset specificity – and given the acceptance that inflation is a monetary phenomenon – our model agrees with the traditional theory that the management of money supply by the government can lead to the appropriation of rents in terms of the enforcement cost fee at the expense of private investors. However, we stress the given level of asset specificity because this is what is both completely ignored in orthodox financial repression/regulation models and at the same time makes the difference in our model. The degree of asset specificity enters the two-period model as a parameter and affects the optimal values of and together with the other parameter . Furthermore, it determines the level of the constraint g 1 . If the degree of asset specificity changes then it will affect the optimal value of the net cost function through 1 * which means that it will also affect the required monetary growth in the above context. On the other hand a very low degree of asset specificity, that is an interest rate close to international levels, entails a low level of overall (intrinsic and institutional) risk and hence, a value of 1 , which means very low monetary growth and hence inflation rate. However, the most important omission in orthodox literature is the disregard for any possibility that the state will act as an initiator of institutional transformation. Considering the level of interest rates as an indicator of asset specificity leads us directly to the question of available safeguards that should be the supplement of any policy that decreases the price of capital. If this is the case, then financial repression/regulation as policy may not be harmful to private incentives, ceteris paribus, in the long run. In this sense, there is a time effect, not apparent in the twoperiod model but evident in the multi-period case. The interest rate will not be a parameter in the long-run as neither will be the time preference of agents and the variables
and
. On the other hand, a safeguarding policy is a policy of
institutional transformation that needs time. This means there might be a lag in the responsiveness of savings determined by the time difference between the immediate effect of the enforcement cost – the decreasing returns on savings – and the longer time needed so as for institutional developments to become credible to investors. Hence, the variable may act with a lag, but it will be finally effective as far as the state proves to be faithful to a long-run institutional transformation policy. Besides, this point of view follows the contemporary line of thinking in development finance
72 where institutional development and change is deemed to be a crucial factor in economic development (Stiglitz (1998)).
On the other hand, in the context of the neostructuralist model l might indicate the higher curb market rate that enters the cost function of firms and thus leads through a different channel to a cost-push inflation that cannot be tempered with monetary means. A rise in the market loan rate (assumed for simplicity equal to the
deposit rate l d ) initially after financial liberalization as government intervention is
reduced (i.e. l rises as increases) might lead to a shift from curb market loans to bank deposits and also to a squeeze of firm credit because of the official reserve requirements. This reasoning justifies the implication of our model for the need of continuing government intervention if the level of asset specificity demands it. If curb markets maintain their decisive role in a financial system then the degree of asset specificity and the related level of institutional underdevelopment must remain high. Furthermore, the features of such markets such as the importance of personal relations as a substitute for collateral, the close circle of information dissemination and also their shortcomings as the shorter-term and limited scope of their loans indicate the de facto existence of a bilateral dependency situation in financial transactions that cannot be left unanswered by the state. However, and despite the above theoretical considerations, a plausible question arises concerning the explanatory usefulness of our model against empirical and historical factuality. No mathematical model can encompass the complexity of the real world, and our model is not an exception to this rule. However, we think we have grasped, through its basic propositions and implications, some essential elements of reality that would permit a first understanding of financial repression/regulation and financial development in the context of institutions as governance structures. Both in the writings of the financial repression/regulation literature such as Shaw (1973) and Fry (1995) and in more recent contributions of Rajan & Zingales (1998b, 2003a,b) there is a recognition of two major periods in the evolution of financial systems. The period of financial repression commencing in the middle-war years and lasting until the 70s and then the period of financial liberalization. In addition, Rajan &Zingales (op. cit.) make the interesting observation that financial repression/regulation was in fact a reversal of a previous rather liberalized regime in
73 many developed countries. Clearly, the Great Depression along with political reasons related to policies to cope with it but also to war preparations during the 30s, opened the road to such reversals, according to Rajan & Zingales (2003b:201-225). Our model gives a first mathematical representation of these observations. In this model, increasing uncertainty and instability of the economic system because of diminishing demand and other external extra-economic shocks which are also reflected in the insufficiency of the prevailing institutional framework is represented by a rising asset specificity which is the same as a rising risk-adjusted loan rate – the normal response to such crisis situations. Hence, we can envisage the two situations described above, that is that of rising asset specificity and then the reversal, as the two historical situations encountered from the middle-war till nowadays. An example of rising asset specificity is that which followed the Great Depression and lasted until the early seventies. Furthermore, an example of the reverse movement towards lower asset specificity and flourishing markets is the one started during the eighties and lasted until the new worldwide financial crisis of 2008. The common factor of these situations is the need of the institutional system to adapt to the changing conditions in the economy through financial regulation initially and financial deregulation afterwards. However, the question arises: Was financial repression/regulation or “relationship capitalism”, an extra regime for extra situations as (Rajan & Zingales (2003b)) seem to assert? Note the difference between the orthodox McKinnon-Shaw school characterization of financial repression/regulation as false policy and the above recognition of a compelling regime for particular circumstances. The advantage of the latter is that it judges historical situations respecting the historical conditions that bore them. But, is this adequate as an explanation? Was financial repression/regulation only a short interval in an, otherwise, almost linear course of financial development? The question is not exclusively historical since approaching history without theory is as much misleading as ignoring history altogether. In this context, our model tries to find a way out of the problem by insisting on the governance characteristics of any financial structure and their close dependence on the needs of the real economy. Besides, as Williamson‟s (1995) “remediableness” criterion indicates, we cannot compare the existent with the optimum but never existent. Our choices must take into account only the feasible alternatives, and these depend on the governance
74 characteristics of each choice in a world of uncertainty, opportunism and bilateral dependency. Financial development in our model is a situation ultimately represented by a
decreasing and d through time as the emergence of new more efficient institutional structures decrease the verifiability costs of the debt claims in a market governance context. However, the relation of governance mechanisms to real economic conditions must not be out of our sight since institutions respond to real economic situations. In this sense, institutional development cannot be a linear unidimensional process where less developed economies follow the lead of more developed ones.
Although
Williamson (1996:60) considers his distinction between “statistical risks” and “idiosyncratic trading hazards” as different from Knight‟s (1921) contradiction between risk and uncertainty, we cannot help it but view Transaction Costs Economics formulations as a translation of the irreducibility of uncertainty to measured risk within a high-transaction costs environment. In this sense, uncertainty is not subject to probabilistic calculations because the costs of doing it are extremely high. Hence, the notion of “transaction costs” is in effect a way to express a qualitative feature of reality as a quasi-quantifiable characteristic. Although “hazards are due to the behavioural uncertainties” because of joined “incomplete contracting and asset specificity” (Williamson (1996: 60) these uncertainties have to do with the fundamental uncertainty that surrounds the real economic conditions. If this is the case, then, as our model indicates, no government can decide the level of the risk-adjusted rate. The latter is determined by the conditions of the real economy, such as the level of demand, the rate of profitability, extra-economic shocks, international conditions etc. The question then is whether the institutional infrastructure of the economy is ready to adjust to the uncertain turns of the real world economy. Ideally – and probably only in the economist‟s fiction – we might be in a situation where 1 and there is no need for government intervention as the market works efficiently, solving information and safeguarding problems of investors autonomously. However, it might also be the case that factors in the workings of the real economy – as in the case of the 30s – lead to a situation where the market itself functioned in a noisy way and finally collapsed under the pressure of investors‟ panic. Such a situation demands a change in the governance mechanisms of finance even in
75 the case of countries with previously developed financial systems. Therefore, although we can justify Rajan & Zingales‟s distinction of “relationship” versus market capitalism and also the argument for the “great reversal” that followed the Great Depression, we take a distance over the extra character of such events. What happened in the past, may also happen in the future. On the other hand, we will agree with Rajan & Zingales (1998b) that relationship-based systems are preferable to arm‟s length systems in the case of less developed economies with high investment opportunities relative to the available capital and low institutional development concerning contract enforcement. But again, the case is not restricted just to less developed economies. Remember that in our model savings take the form of deposits at the banks which are assumed to be the only financial institutions that represent – intermediate – the capital market relationship between lenders/savers and borrowers. To the degree that banks, in this context, act as mere intermediaries being paid a fee for this function, the effects of rising risk on the level of the loan and deposit rate affect directly the decision of agents on assets held – namely the volume of their deposits. In this context, the random nature of both the loan and deposit rate takes on its full meaning, especially in situations where adverse economic conditions raise both intrinsic and institutional risk. This is evident in the case of panic in the capital market where agents are not anymore confident both on the solvency of the banks and the success of the projects held by firms. For example, assume that banks face difficulties in obtaining the full amount of the principal plus interest of loans at the end of the period and reserves are inadequate to cover unexpected withdrawal of deposits20. Since, agents consider less probable that firms will have positive profits saving becomes more inelastic with respect to the deposit rate. In this case, they might prefer to increase current consumption rather than leave aside resources in the form of savings with uncertain – not just risky – future value translated to future consumption. The immediate effect of this decision would be a decrease of deposits that would worsen the position of the banks. In this environment with rising asset specificity as
the marginal verification cost of banks rises, the deposit rate d will also rise along 20
Unexpected withdrawal of deposits in this case might mean that agents do not renew their deposit contracts with the banks at least at the previous levels so as for agent . Hence, agents demand the proceeds of their placements which the bank is unable to offer in full at that moment given that reserves are inadequate to cover the difference between deposits demanded and paid.
76 with the loan rate, in the banks attempt to keep the flow of savings at previous levels. In the model described in this paper, an exogenous change in the preference for postponing consumption – that is a preference for a decrease in savings – can be
Figure 3: The effect of a capital market panic
represented by a rise in the subjective time preference factor which is the price of future consumption. This should shift the savings schedule in Figure 3 to the left thus resulting in a higher equilibrium
and
, a higher margin
and a lower level
of savings and investment. In such a situation, what investors demand most is safeguards for their placements. Then, a government policy that intervenes in the market by providing a rising – though at the expense of a falling – is indeed what agents need for a restoration of their confidence in the financial system and the capital market. Note, that this is the reverse trade-off between and than that described above as the process of financial development. However, it indicates clearly that “reversals” can come in both ways. In this sense, our model justifies financial repression/regulation policies not only for Less Developed Economies but also for developed economies placed in a situation such as the Great Depression or more generally in cases of crises. However, the emphasis should not be placed on the enforcement policy represented
77 by the falling , but rather on the maintenance policy that the rising sets forth. In a sense, repeating Keynes‟s (1936:164) disbelief about the decisiveness of the interest rate to affect investment we should place more emphasis on restoring investors‟ confidence within an uncertain environment rather than on decreasing the price of liquidity preference by decrees. To put it differently, financial development is quite a matter of psychology of the participants in the financial markets as this is reflected in their rate of time preference
. The value of
and its movements, for given interest rates and
, in
the context of a fundamentally uncertain environment, reflects the perceptions of agents for the conditions in the market. These perceptions are nothing more than conventions held on the state of safeguards provided in the marketplace. Hence, the state has a role to play not only in economic development but also in financial development. This is because, for agents‟ conventions to hold, the crucial variable is the government-safeguard variable that indicates the process of institutional transformation initiated by the political authority on the one hand, and its determination to act in this direction on the other. In this sense, the model fully agrees with the kind of prudential regulation entailed in the financial regulation literature to preserve systemic stability such as Dow (1996) and Carmichael (2001). For Dow (1996), the role of government regulation to guarantee private sector institutions and conventions in the face of fundamental uncertainty is crucial for the efficient functioning of the financial system21. On the other hand, according to Carmichael (2001) regulation is justified when the costs of market failure are greater than the costs of intervention. This, we think is exactly the case when information asymmetry and financial instability call for a regulation/intervention policy in the form of a above unity. Furthermore, to attribute financial and, more precisely, banking regulation to imprudent governments that seek “tax” receipts from repression policies, as Benston & Kaufman (1996) do, might be a testable judgment but not a theoretical truth. Government mismanagement, in the sense of over-regulation, is equally possible as it is a sound regulatory policy which looks to enhance rather than impede the development and stability of markets (Llewellyn (1999)). As Stiglitz (2001) indicates, financial history of modern market economies is full of crises episodes 21
Dow (1996) stresses specifically one of these conventions, the one which relates to moneyness. In this sense, money as a special asset in a fundamentally uncertain environment performing the function of liquidity, entails the need for banks (the producers and managers of money) to be prudentially regulated in order for financial and economic stability to be preserved.
78 where regulation initiated by the government was the only force to put the economy back to track. Besides, Stiglitz (2001) does not hesitate to defend a policy of deposit rate ceilings – coupled with other regulatory measures such as capital adequacy requirements for commercial banks – in order to preserve bank profitability and prevent them from engaging in excessively risky activities. In this sense, price restrictions serve the additional goal of maintaining the stability of the system. Furthermore, we stressed that the success of administered interest rates policy to boost investment in an institutionally underdeveloped environment depends crucially on the credibility of the state management of . In this sense, the TCE model of financial repression/regulation is conformable to the view that political decisions make the difference given the external constraints. Hence, we agree with the strand of literature that is preoccupied with political economy issues in the context of finance. For example, Pagano & Volpin (2001) treat policy makers as self-interested agents motivated by political incentives that might explain the reversals in financial development. The advantage of this approach is that it gives a micro-economic and micro-social explanation of state interventionism. Hence, in the context of our model, whether the state will choose a prudent policy with * and * it might depend, as Pagano & Volpin (2001) indicate, on the balance of power among different pressure groups that affect government policy. For example, a value of < * with
≤ * indicates a policy favourable to firms‟ managers that present artificially high profits at the expense of savers that do not obtain adequate compensation in the form of safeguards. It also indicates a short-sighted policy that decreases total cost of the financial repression/regulation policy given by (31) but it puts the maintenance of this policy at risk in the course of time. It finally reveals that institutional development is not in the government‟s concerns which is used to act through decrees rather than by providing incentives to individual agents to act in a market environment in the future. In addition, a change in this power structure in society gives rise to a change in regimes. Macroeconomic discipline given by a change in the international environment , for example during the ‟80s, guided many economies to forced change in financial regimes towards market liberalization. The issue is whether these economies were prepared for such a liberalization shock by a consistent government policy towards institutional transformation or not. These observations are in accordance with Williamson (1994) who indicates the short-sightedness of political
79 reasoning based on the political binding of the electorate to a certain party and the ensuing preference for short-term political gains (for example, re-election or clientelistic relationships). Finally, the model can encompass views in the literature that relate financial development to the institutional arsenal of an economy pertaining to the protection of minority shareholder interests such as Modigliani & Perotti (1997) and La Porta, R., F. Lopez-de-Silanes, A. Shleifer & R. W. Vishny (1997, 1998). Although we are cautious on the result of the latter group of authors concerning the determinate character of the legal origin of a country for its institutional development, we consider the point made for the correlation between the development of capital markets and legal protection of investors very interesting. Our model has used for simplicity the paradigm of only one means of external finance, that of debt in the form of loans extended by banks. However, the essential results for financial development do not change if we assume instead a minority equity claim. Although the hazards encountered by debt holders and equity holders are different from the perspective of corporate governance, they are quite similar from our perspective of financial repression/regulation as governance structure. This is because, from the perspective of capital market development, a lower cost of capital because of adequate investor protection (either a debt holder against shareholder and management opportunism or a shareholder against majority shareholder and management opportunism) means a higher valuation of both debt and equity claims and hence greater degree of marketability for both or lower non-marketable transaction-specific costs. Furthermore, for both types of securities holds what Modigliani & Perotti (1997) say that their value depends crucially on the enforcement of the rights attached to them given the existent legislation. In this sense, a high interest rate in our model can be translated as a high voting premium (partly reflecting a control over the firm premium) because of weak protection of minority shareholders in Modigliani & Perotti (1997) model22. Such high voting premiums reflect the higher cost of equity capital for new innovative firms that prefer equity to bank financing. These premiums impede external equity finance and hence, contribute to underinvestment from these firms. The feedback effect is that even if minority shareholders incorporate in their 22
As Modigliani & Perotti (1997) indicate poor protection of minority shareholders attenuates their claims, increasing correspondingly the benefits of those holding control stakes. This should be reflected in a discount over market prices of equity at which the latter are to be sold to would-be minority shareholders.
80 pricing the adverse consequences for their claims emanating by their weak legal protection, the capital market will continue to be negatively affected by thin trading because of low demand of securities by small investors. However, our model is even broader from these explanations as it relates the behaviour of agents and the relevant institutional context to the real economic conditions and also to the relevant political decisions which will cope with them. On the other hand, we will agree with Modigliani & Peroti (1997) for the need of some kind of government regulation to “clarify the „rules of the game‟” as a prerequisite for financial development.
1.7. Conclusions This paper addressed the issue of financial repression/regulation and its relation to financial development from a transactions-costs perspective. In this sense, it aimed at contributing to the literature both of financial repression/regulation and financial systems‟ choice. The crucial element of this endeavour is the connection of the administratively set interest rates along with safeguard provisions. The latter should both alleviate the negative effect of rates set by fiat on savings and contribute to the institutional transformation of the economy. This could be achieved by setting forth mechanisms that introduce a more transactions-costs economizing contracting scheme between firms and lenders. The substitution of free market mechanisms for government sponsored hierarchical modes depends on asset specificity, which in finance takes the form of increased verification costs of asset returns and depends on the real and institutional domestic economic conditions. Hence, the paper argues that financial repression/regulation is in fact a policy of adjustment of the economy to adverse economic situations, such as but not confined to the magnitude of the Great Depression in the 30s‟ or alternatively, a policy of economic and institutional development for both LDCs and developed economies. On the other hand, financial regulation cannot be confined only to emergency cases, as long as a continuous presence of the regulatory authority both as signal of future drastic intervention and as monitor of the system is needed. This “lighter” version of regulation just confirms the fragility of even developed financial markets and the need for regulation and development so as for them to go hand in hand and reinforce each other. The common
81 factor of both is the demands of the real economy and their reflection to the adequate institutional infrastructure of the economy. The paper argues that the success of financial repression/regulation policies depends on the optimum trade-off between the two variables of government intervention, that of lowering the market rate by fiat and the other of providing the necessary safeguards to investors and not exclusively on the price effect on savings and investment as the literature till now maintains. Furthermore, examining the process of financial development we gave a new meaning to both
and
in their
relation to . This new interpretation, which was made possible in the multiperiod model, overcomes any fiat characterizations to the degree that agents perceptions embodied in
demand certain values for
and
that justify government regulation
policy. It is in this context that financial repression/regulation is not unconditionally an extra regime to boost demand that is inimical to financial development. However, the role of the state to pursue a long-term policy of institutional development consistently is crucial. On the other hand, the paper leaves a number of issues unanswered or only implicitly stated. For example, one could argue that the above model is not an adequate representation of financial repression/regulation regimes as far as it does not distinguish between preferential and not preferential sectors and hence, between the various differential rates applied. Furthermore, the model does not take into consideration the effects of degrading incentives of a hierarchy on the side of the managers that receive easy and cheap finance for their projects. These are important points since they enter the analysis phenomena such as credit rationing for the nonpreferential sector, the effect on the financial system by the functioning of curb markets and the success of developmental policies at the level of the firm. Hence, a more encompassing model should take into account these factors. However, we do not think that the essential results of the model for financial repression/regulation as governance structure will change. What will be revealed more clearly is the necessity of an efficiently operating state that constantly resists to the inertia of its apparatus and implements its supervising and monitoring function consistently. The latter, we think, is the more important problem that should be solved in such situations. In this sense, a more detailed exposition of how safeguards operate through new established institutions and how these affect agents‟ expectations is
82 needed. In fact, the model implicitly assumes that transforms itself through time from a variable that represents state safeguards to balance the fiat basis of , to a variable that brings in institutional development. The other side of this internal transformation of the safeguard variable is its substitution by a decreasing time preference variable
. How does this happen? How and which institutions are able to
transform themselves and under which conditions? What has, the experience of financial repression/regulation regimes throughout the world showed to us in this respect? It might be the case, that the Transaction Cost Economics‟ notion of hybrid modes of governance can prove useful in analyzing such institutional transformations. Finally, how can one describe the dynamic path of adjustment both of agents and of government policy to the changing nature of ? In this respect, both the twoperiod and multi-period model assume an instantaneous adjustment of agents‟ portfolio decisions to the signal given by the government when it announces . The model, in this sense, cannot grasp the time difference between the enforcement of the financial repression/regulation policy through the imposition of and its endeavour to maintain it through . As we have said in previous sections of the paper, there might be a time lag before safeguarding policy becomes credible. However, this time lag might also be crucial for the success of the policy during time and depends on the previous record of the efficiency of government intervention.
83
Chapter 2
Development Banking and Institutional Transformation The Case of Greece 1963-2002
84
Abstract
This paper attempts to contribute to the understanding of the process of institutional development in the financial sector from regulation to deregulation. It is proposed that Development Banking institutions are the privileged objects of study towards this aim. Development banks, were established worldwide during the post-war period as a necessary ingredient of policies – supported also by the World Bank – towards economic development. However, the less known and somehow neglected aim of these policy frameworks was institutional transformation or institutional development in countries with insufficient market mechanisms, investment culture and legal systems. Development banks, as hybrid institutions with both profit maximization (or financial viability) and “social maximization” (or remuneration of economic returns) aims, were both the means and the objects of institutional development. In fact, the transformation of a country‟s economy towards industrialization and modernization should be – and we argue that it was indeed – reflected in development banks‟ transformation from traditional cheap credit channels to modern market-supporting merchant and investment banks. Hence, the main thesis of the paper is that understanding the dynamic nature of development banks and its constraints is the key to understanding institutional development and change in the financial sector. The argument is supported by the examination of the historical data available in the Annual Reports of the three development Banks in Greece and especially their financial statements such as Balance Sheets and Profit and Loss Accounts. Then interesting results can be drawn for both the history of development finance in this country and the role of hybrid financial institutions as initiators of institutional change and subjects of its effects.
85
2.1. Introduction
Development finance and financial development seem to relate to different economic environments and theoretical perceptions in the context of the evolution of both individual economies and the world economy. The first prioritizes economic development as a goal with finance as an accommodating factor in the process of achieving the former. The second pertains to a care for development of financial institutions themselves so as to attain more effectively the goals of efficient allocation of financial resources as a prerequisite for economic development. To the degree that this means a reversal of the relation between finance and development, it also indicates a rupture in the continuum of theoretical perceptions and the set of policy priorities. The crucial turning point in this context is the deregulation process during the 1980s and onwards. What was at stake during this period was effectively a major transformation of the institutional infrastructure of the world economies. It was a change in the encompassing financial regime from a strictly regulated to a more liberalized one both at a domestic and an international level. It is common in the economics profession to forget history and consider present economic conditions and perceptions as universal both in time and place. This attitude had the effect of drawing a “veil of ignorance” over the situations that permitted the establishment of regulated financial regimes before the 1980s. However, if we consider past policy perceptions and prescriptions as misleading mistakes then we cannot comprehend the underlying process of institutional development that spans not only from 1980s onwards but even from the end of the World War II. The “veil of ignorance” for one period becomes a similar “veil of ignorance” for all periods. Hence, the aim of this paper is to shed light on the institutional change that characterizes the evolution of a financial regime from regulation to deregulation. Our focus will be the Greek economy during the period 1963 – 2002. Our proposition is to search for a unified – between regimes – entity which had been attributed roles in both financial structures. Hence, the first question we need to answer is whether such an institution in the financial system exists. Such entities, we argue, were development banks that reflected the evolution of the financial system from basically
86 hierarchical to more market-friendly modes of governance. Development banks, we assert, were unique in this respect, compared to other banking institutions as their goals reflected both the aims of development finance and financial development. Hence, the question of understanding institutional development in the financial sector relates to the task of modeling and understanding the nature of development banks as institutions. The second question relates to the specifics of financial development concerning the operation of the banks. Although the goals of promoting both economic and financial development were stated in the banks‟ statutes, the question that arises is whether these were reconcilable in practice. Which were the constraints that development banks had to face in their operation? What was the role of the government concerning their viability? Was there any difference concerning goals and constraints between public and private development banks? Another question concerns the relation between the evolution of the financial system and the internal transformation of the banks. Is our argument, that the history of development banks reflects the process of financial development in the economy, supported by the facts? The paper seeks to answer these questions both at a theoretical and a historical level. Section 2 sets the historical and theoretical context of the discussion for development finance and financial development concluding that a theory of institutional transformation should be the basis for understanding the evolution of the financial system during the post-War period. Section 3 elaborates on this argument by examining the features of development banks as hybrid financial institutions with both private-financial and socio-economic goals. Then the following sections set the debate in the context of the Greek economy. Section 4 examines the evolution of the Greek financial system and the conditions under which the three development banks of the country, ETEBA, ETBA and Investment Bank were established. Then Section 5 examines in three separate sub-sections the transformation of each of the three Development Banks in Greece. Furthermore, Sections 6 and 7 go deeper to the empirical research by examining the reflection of financial development in Greece during the years 1963 – 2002 in the financial data of the three banks. Section 8 embeds the transformation of the banks in the context of the development of the whole economy and finally Section 9 concludes.
87
2.2. The Historical and Theoretical Context The history of development banking and its distinctive characteristics with respect to commercial banking dates back to 19th century economic development policies, especially in continental Europe. The difference between commercial banking practice of providing short-term capital and that of industrial banking for the provision of long-term finance was related to the specific needs of backward countries in 19th century Europe such as France in the era of Napoleon III or Germany for catching up with the industrialization process already commenced at the British islands (Gerschenkron (1962:10-11)). Banks destined to promote economic development such as the Crédit Mobilier in France (Cameron (1953)) or the German Universal Banks (Gerschenkron (1962:op. cit.)) were the paradigms on which development banks‟ proliferation after the World War II was based. According to Cameron (1953), the Crédit Mobilier initiated a type of banking where industrialization and credit mobilization met each other in an organization that was meant to achieve both private financial and social economic gains. On the other hand, the contribution of Crédit Mobilier to the economic development of France and Europe cannot be assessed only on the grounds of financial success of the enterprises it supported. As Cameron (1953) points out, the intangible assets of its operation concerning the diffusion of technical and organizational skills and banking techniques along with the spread of the “idea of development and the spirit of enterprise” were a precious legacy for the future of development policies. We should add that they constituted the prototype for the double role of development finance institutions as promoting both economic and institutional development. On the other hand, Crédit Mobilier served also as a model for the German “great banks” (Cameron (1953)). The latter, according to (Gerschenkron (1962:10-11)) initiated universal banking23 that combined the idea of Crédit Mobilier with ordinary commercial banking activities. German universal banks managed to develop a close relationship with the enterprises they financed both through mechanisms of effectively long-term credit extension and with participation in corporate boards so as to exert control not only on financial but 23
According to World Bank (1989), “universal banking” is used as a term to define the combination of commercial banking (accepting deposits and extending loans) and investment banking (issuance, underwriting, placement and trading of firms‟ securities) along with close banking and industry links manifested in seats reserved for the banks on supervisory boards and proxy voting rights of the banks on behalf of shareholders that have deposited their shares with them (World Bank (1989:50)).
88 also on crucial managerial decisions pertaining to the operation of the firms. For both, the Crédit Mobilier and the German “great banks” the justification for their establishment in the specific environment of 19th century continental Europe was to cover the need for long-term industrial loan capital in backward countries where capital was scarce, entrepreneurial climate was unfavourable to industrial activities and required capital/output ratios related to the size of plants and the scale of the industrialization attempts were quite high (Gerschenkron (1962:11)). Development banking after World War II was justified on the same grounds although its rise and demise was closely related to the rise and fall of alternative views of development finance for Less Developed Countries. We can discern two different periods, each one pertaining to different policy recommendations and theories of development finance closely related to the prevailing economic conditions in LDCs. The first covers the decades of the 50‟s and 60‟s. During this period, there was a widespread conviction among governments and economic theorists for the necessity of development planning as a policy recommendation especially for the “backward” countries, as Gerschenkron (1962:6-9) would call them, namely, the less developed economies (LDCs). The reason for this post-World War II interest for economic development, according to Arndt (1987:49) was the collapse of the colonial system and the new international order marked by the increased influence of the USSR. The theoretical framework of development planning was articulated in two major themes: the formation of capital – both real and human – and the role of international trade as a contributor to growth (Arndt (1987:54)). As Fitzgerald & Vos (1989:18) indicate there was a strong theoretical underpinning of this strand of thinking emerging from the ideas of J. M. Keynes (1936) that cast doubt on the ability of the market mechanism to achieve optimal allocation of resources from the point of view of long term economic growth. Especially, the contradiction between short-term speculative horizons (of the rentier) and long term investment (Keynes (1936:150-161) indicates the inevitable role of the state intervention in favour of social objectives of long term growth planning (Keynes (1936:375-378)). According to Arndt (1987:58-59) major theoretical contributions in this tradition include the conceptions of Rosenstein-Rodan for “planned industrialization” and “balanced growth”, further developed by H. Singer, R. Nurkse and G. Myrdal. The idea was that of a “vicious circle” of underdevelopment that can be broken down only by a substantial initial boost of investment on a broad range of industries under a
89 specific development plan. The long gestation periods before investment in real capital yielded its beneficial results on economic growth, made state intervention necessary for the accomplishment of the developmental goal. On the same footing, import substitution was proposed in the context of R. Nurkse‟s advocacy of balanced growth and P. Prebisch and G. Myrdal‟s thesis that free international trade could not promote growth in LDCs (Arndt (1987:74-75)). It was considered that inelastic world demand for primary products and the combination of monopolistic conditions in the market for manufactures of developed economies versus the competitive conditions in the market for LDCs‟ primary products, resulted in the deterioration of the terms of trade for the less developed “peripheral” economies and prohibited the diffusion of the benefits of technical progress to them. In this context, W. A. Lewis‟s and A. O. Hirschman‟s idea for the need of LDC protectionism around their “infant industries” until they reach a certain “threshold” of development, was introduced (Arndt (1987:75)). According to Arndt (1987:57-58), these ideas had also a strong empirical validation in the historical experience of the 20‟s and 30‟s where “latecomers”, as the Soviet Union, achieved a remarkable step forward in economic development and industrialization, implementing development planning as opposed to the Great Depression that plagued the western market economies. In fact, a combination of these two factors, the theoretical and the empirical one, called for further government intervention in order to guide the process of economic development and industrialization. The financial aspects of this policy recommendation were administered low interest rates and government ridden credit allocation to priority sectors in order to provide funds to, what Rostow (1965:1-21) would call industries in “leading sectors”. As FitzGerald & Vos (1989:3) point out, development finance was seen as a passive supporter of long-term development strategies revolving around policies of structural transformation without paying attention to short-term problems of debt imbalances and possible economic instability. The previous ideas of interventionism/protectionism were criticized by an alternative line of thinking built around the theme of liberalization and especially the beneficial effects of free international trade. The “two-gap” model initiated by H. B. Chenery was the first step in this critique. It was assumed that the key constraints to LDCs‟ growth were two-fold: the insufficiency of domestic savings to support the financing of investment and the inadequacy of LDCs‟ exports – mainly of primary goods – to finance the required imports in capital equipment. The two gaps between
90 domestic saving and investment on the one hand, and exports and imports on the other, could be filled by the inflow of foreign savings and foreign exchange in a liberalized external sector of the economy. In this context, the McKinnon-Shaw financial repression/liberalization model constitutes the financial aspect of the new liberalization doctrine and reflects the theoretical debates concerning economic conditions during the period of the 70‟s and 80‟s. The historical setting was now one of rising inflation and unemployment emerged from the two oil crises of 1973 and 1978-1979. This phenomenon of stagflation led to a radical re-examination of the, till then, followed policies and their theoretical underpinnings. Fry (1995:3-19) gives a clear picture of this “revolution” at two levels: i) a questioning of the instruments used during the 50‟s and 60‟s for promoting economic development. These included the imposition of interest rate ceilings, the obligation of commercial banks to hold high required reserves with the state-controlled Central Bank and the administrative direction of funds to selected investment programs. ii) The questioning of the theoretical foundations of such policies and especially the validity of the Keynesian liquidity trap and hence of the need for government deficit spending. It is notable that, because of the recent economic experience in that time, inflation was set at the centre of economic problems, and all the previous policies were seen from this angle. On the other hand, a new perspective was adopted concerning the relation between economic development and financial development so as for the causality to run from the second to the first. In this context, Shaw‟s (1973) “debt-intermediation view”, following Goldsmith‟s (1969) observation concerning the correlation between financial development and output growth (Fry (1995:28)), puts emphasis to the role of financial institutions and financial deepening to improve the allocation of credit by unifying a fragmented capital market in less developed economies and diminishing uncertainty concerning the future rates of return on both real and financial assets (Shaw (1973:48-49,72-73)). In this sense, inside money24 becomes important in a model where there is a positive relationship between financial intermediation and incentives to save on the one hand and quality of investment on the other hand (Shaw (1973:72,75)).The functions of 24
According to Gurley & Shaw (1960:73, 363-364) inside money is to be distinguished from outside money in the sense that the first refers to government debt (money) issued in exchange for private domestic debt (private securities) while the second pertains to the case of money issue backed by foreign or government securities or gold. The distinction is important for financial development issues as far as an increased weight of inside money indicates increased intermediation of the domestic financial system and the development of financial markets for private and public debt.
91 financial intermediaries that include risk diversification, economies of scale in lending activities and lower transaction costs, are they themselves growth promoting (Shaw (1973:76-77)). Hence, the whole discussion focuses on the adverse (favourable) effects of financial repression (liberalization) with respect to the intermediation of financial system between savers and borrowers. The original thesis raised a number of questions concerning the role of finance in economic development especially in the specific institutional context of LDCs‟ economies. The critique was initiated first by the neo-structuralist tradition as it is found in the work of Taylor (1983:91-103), Van Wijnbergen (1982, 1983, 1985), Buffie (1984), Kohsaka (1984) and Lim (1987). Neo-structuralists do not address the relation between financial liberalization and financial development directly. However, their assumption for the persistence of curb markets in the financial structure of LDCs indicates a rupture in the necessary link between financial liberalization and financial development. Besides, the degree of inefficiency in financial intermediation regarding risk diversification, collection of information and project appraisal along with the segmentation of curb markets is acknowledged (Kohsaka (1984)). Nevertheless, rising interest rates in organized markets do not necessarily lead to financial deepening if unorganized money markets are present to absorb excess demand for loans in the face of reserve requirements of the official banking system as opposed to the curb markets. This means that the curb market rate will remain high and since this is the rate that equilibrates the credit market (Lim (1987)), it is also the rate that enters the aggregate supply function thus causing a cost-push inflation that might counteract the deflationary impact of rising real interest rates on aggregate demand (Van Wijnbergen (1983)). The crucial assumption made by Neo-structuralists is that curb market assets and bank deposits are closer substitutes than unproductive assets and deposits so as for the major shift of funds to take place between the curb market and the official market after the rise in official interest rates. If this is the case then financial deepening is undermined by official reserve requirements that lower loan supply with respect to that prevailing in the curb market. At least this is the short run effect while in the long run a rise in savings might increase loan supply from the official sector (increase financial intermediation) and lower the curd market interest rate (Buffie (1984)). The Post-Keynesian school initiated its own critique based on Arestis (1999, 2005), Arestis & Glickman (2002), Arestis & Stein (2005) and Studart (1995). At
92 first, the assertion that free banking can lead to a stable financial system is doubted on the grounds of Stiglitz & Weiss (1981) asymmetric information between borrowers and lenders and the related notions of adverse selection and moral hazard. Hence Arestis (1999) indicates that rising interest rates may ration out “sensible” borrowers in favour of risky borrowers so as to increase the probability of default because of adverse selection. A related notion is that of moral hazard where borrowers engage in projects different from those approved by the lender. This might increase further the cost of borrowing and accentuate the adverse selection problem. But the same problems can arise in the relation between depositors and banks in the face of inadequate supervision. Arestis (1999), as Mishkin (1996), observes that banks may take on excessive risks in the thinking that if these projects are proved profitable they will be better off, and if they are proved to be bad loans, deposit insurance provides a pillar for security that the Central Bank and ultimately the tax-payer will pay the bill. Both Arestis (1999) and Mishkin (1996) stress the need for developing countries to build an adequate institutional infrastructure that would regulate and supervise the financial system along with measures enhancing the legal framework of market operation and transparency. However, we agree with Arestis (1999) that the above observations can only acquire their full meaning if they are embedded in a postKeynesian view of uncertainty as fundamental ignorance about the future, not reducible to probabilistic calculations of risk. A way to handle this kind of uncertainty is the establishment of conventions such as contractual arrangements, along with institutional
developments
related
to
banking
supervision
and
regulation.
Nevertheless, we need to note that the meaning of “conventions” in the postKeynesian terminology is that they are vulnerable to the mass psychology of the public (Keynes (1936): 154). Hence, there is nothing inherently stable in these institutional formulations. However, an equally important deficiency of the McKinnon-Shaw thesis according to Arestis (2005) is the neglect of the role of the stock markets both by the original McKinnon (1973) and Shaw (1973) books and by subsequent proponents such as Fry (1997) who considers the role of stock markets in financial intermediation less important than that of commercial banks in developing countries. According to Arestis (1999) stock markets are crucial in the process of financial liberalization for three reasons: i) higher interest rates make borrowing more costly and encourage firms to issue equity; ii) stock markets are a major means through which international
93 funds enter the economy; and iii) stock market development is very often a condition of financial liberalization policies encouraged by the IMF and the World Bank. However, according to Singh (1997) stock markets in LDCs exhibit problems such as excess volatility, lack of transparency and insider trading. This is because, the instant liquidity feature of stock markets when combined with poor regulation and inadequate information dissemination in emerging markets, contributes more to arbitrary pricing of securities and unjustified volatility of stock prices rather than to efficient allocation of resources. In this context, Arestis (1999) makes an interesting distinction between short-run and long-run capital inflows in an emerging stock market after financial liberalization. Short-run capital flows relate to speculation activity that is facilitated by stock market deregulation. The main consequences of these flows are destabilizing for the following reasons: i) They often lead to a sharp appreciation of the exchange rate and loss of competitiveness or an accommodating monetary policy to fix the exchange rate but produces inflation. ii) Because of capital inflows, asset prices rise which result in rising wealth of their holders that may end up to an increase in imports demand for consumption on the one hand, and increased optimism of financial institutions and rise in speculation on the other. iii) The short-term nature of these capital flows indicates the easiness of their withdrawal after an even small adverse shock in the economy and hence the sharp decline of asset prices and the exchange rate with the related consequences for the stability of the financial system and the real economy. Whereas, long-term capital flows in the form of direct productive investment are not speculative and can contribute to increased growth through both their direct impact on investment and their indirect effect on the whole economy through technology transfer and skill diffusion effects. Arestis & Glickman (2002) explain the crisis in Southeast Asia in 1997-1998 by resorting to an open-economy Minkyan framework. Specifically, domestic financial liberalization along with free capital flows increased the indebtedness of firms in these economies and the ratio of foreign debt over foreign currency reserves of each state in this region. This transformed sovereign states into speculative and Ponzi units lacking both the regulatory instruments and the institutional infrastructure that would prevent euphoria in capital markets to become a full-blown crisis or at least to mitigate the latter. In this context, Arestis & Stein (2005) “institutional perspective” is introduced as an alternative to mainstream financial liberalization
94 model. A system of legal rules, norms and incentives that would prevent corruption and enhance transparency is necessary. Also the existence of adequate bankruptcy laws along with prudential supervision and regulation of the banking system is inevitable to prevent financial crises that might emerge because of the financial liberalization process. In short, an institutional perspective of finance that would enhance the capacity of financial organizations to transform themselves according to the needs of economic development is the general motive of the authors‟ view. However, what is crucial in this argument, as it is apparent in Arestis (1999) is the recognition of the underlying Keynesian fundamental uncertainty that surrounds the financial liberalization process. Such an uncertainty can only be coped with an active regulative role of the state to form the appropriate legal framework of institutional arrangements and conventions, thereby acknowledging both the need of smoothening the process and its limitations. As Studart (1995: 48) puts it, the post-Keynesian view is the one where finance precedes saving in the context of a finance-investment-saving circuit. On the other hand, the “liberal” view pertains to a loanable funds framework where the causality runs from saving to investment. Arestis (2005) indicates the direction of this causality as a shortcoming of the orthodox financial liberalization approach. According to the post-Keynesian tradition the causality runs from investment, as spending that generates income, to saving as a function of income and not the other way round. Hence, in this sense we can argue that the inadequacy of saving in LDCs is not due to below market interest rates but due to inadequate growth of output and income of which saving is a function. More importantly, this argument stresses the role of banks as lending seeking institutions independently of the accumulated savings (deposits) so as, within the banks themselves, the causality also to run from lending to deposits (as loans generate more deposits) rather than the other way round. Hence, investment is more importantly dependent on profit expectations and aggregate demand rather than on savings. The last observation on the role of banks in financing investment is of major importance in LDCs because of the predominance of banking institutions as intermediaries between surplus and deficit units in the supply and demand for funds. However, this role is better understandable in Studart‟s (1995: 63-65) framework of “functionality of the financial structure”. The concept of “functionality” connects directly the existent financial structure to the financing needs of the economy in the
95 process of economic development. A financial system is functional, according to Studart (1995:64), if it provides the adequate finance for investment maintaining, at the same time, its stability – or avoiding financial fragility. However, what differentiates this view from the “liberal” one is the break in the necessary link between financial liberalization and economic development. Financial liberalization was meant to promote financial development as a prerequisite for economic growth in a unilateral relationship among them. On the contrary, according to the postKeynesian view, the needs of a growing economy bring about the need for financial development as finance becomes more “functional” in promoting economic development. Both the experience of British industrialization which reveals a “spontaneous” process of development of financial markets and the paradigms of German universal banks or the Japanese “zaibatsu” that indicate a close relationship between banks and industry, were caused by the needs of economic development for the establishment of adequate financing and funding25 mechanisms (Studart (1995:7173)). In this context, Joan Robinson (1952:86) points out that “where enterprise leads finance follows” as high prospects of profit that give rise to “a strong impulse to invest” find their way through the development of institutions that accommodate financing needs. Hence, Robinson (1952: 86-87) refers to the examples of institutional developments such as the invention of the corporate form of the jointstock company or the new lending form initiated by the practice of German banks‟ participation in industry. In the sense of these views, financial liberalization cannot be assessed as promoting economic development independently of what is “functional” for an economy with specific institutional characteristics (Studart (1995:74-75). Besides, we should add, that financial development cannot be assessed independently of what is “functional” for economic development for different economies, with different institutional endowments in different historical times. Furthermore, what the “liberal” view stresses concerning financial development are the benefits of enhanced financial intermediation per se. Indeed,
25
Based on Keynes (1937), Studart (1995:58-59,64) identifies finance with the short-term credit obtained by the entrepreneur (often in the form of bank loans that “create saving”) and funding with the issue of securities in financial markets that would enable entrepreneurs to “fund” on a long-term basis their short term obligations (Keynes (1937)) (allocation of saving through funding (Studart (1995:64)). The problem with the backward countries is that they exhibit underdeveloped funding mechanisms (financial markets) and hence, they need to devise “compensating structures” such as long-term bankindustry relationships or increased government involvement through developmental agencies and institutions that reduce the risk undertaken by private agents (Studart (1995:74)).
96 Levine (1997) identifies the functionality of the financial system with its ability to decrease risk by enhancing liquidity and diversifying idiosyncratic risk, allocate capital efficiently to investment uses by lowering the costs of acquiring information and coping with principal-agent problems among firms‟ stakeholders, pooling and channeling savings between surplus and deficit units and facilitate the exchange through contracts that lower transaction costs. However, the underlying unifying principle of this kind of definition of financial development is what Fry (1995:293316) indicates as the minimization of transaction and information costs. For the post Keynesian view, financial development is rather understandable as “active” intermediation as far as banks assume an active role in lending activity. In the finance-investment-savings circuit, banks channel newly-created money to finance investment and promote economic development, while financial markets promote the stability of the system (Studart (1995): 64-65) through funding mechanisms that enhance liquidity and diminish financial fragility. In this sense, financial liberalization might be a detrimental policy for enhancing financial development and boost investment if, as Arestis (2005) indicates, it leads to increased financial fragility through more risky banking activity, and promotes speculative activity in the stock markets by the facilitation of short run capital flows at the expense of long term capital inflows in the form of direct investment projects (Arestis (1999)). That is, mere increased intermediation irrespective of the structure and needs of the real economy might yield adverse effects for the volume and stability of economic growth. Furthermore, the existence of banking oligopolies in LDCs – in contrast with the McKinnon-Shaw perfect competition assumption – it might lead to high interest rate margins and lower any assumed financial deepening, especially in the context of inadequate bank regulation. In this context, we may also add that the need of domestic banks to cope with increased competition might strengthen the oligopolistic structure of the industry through mergers and acquisitions. In the context of the previous discussion development banking is treated in an ambiguous manner according to the predisposition of each school of thought relative to government intervention in promoting economic development. Consequently, development banks are seen either as a distorting element of financial repression that impedes economic and financial development or as a means to promote economic development in situations of thin financial markets. Indeed, Fry (1995:362-365) debits Development Banks with their inability to mobilize domestic savings – although it
97 recognizes that they managed to attract foreign capital – and their poor performance in allocating capital effectively to productive investments. Furthermore, he indicates that the emergence of a number of specialized institutions charged for the financing of specific priority sectors lead to a segmentation of the market for credit with the effects of decreased competitions among financial institutions and high intermediation costs. On the contrary, (Studart (1995): 75) conceives development banks as “compensating mechanisms” to overcome the problem of thin capital (funding) markets. On the same footing, Chang and Grabel (2005) see development banks as one of the means for providing long-term finance in underdeveloped financial systems according to the doctrine that a financial system is “functional” as long as it accommodates the financing needs of economic development. Clearly, behind these conflicting views rests the controversy concerning the causality between financial liberalization and economic development. If the causality runs from financial system liberalization to economic development then development banks are only a part of a distorting regime. If, on the other hand, the “functionality” of a specific financial structure depends on whether it serves the needs of economic development for given institutional characteristics of an economy, then their existence is justified in underdeveloped institutional environments for both financial and economic development. Taking stock of our discussion so far, we can identify financial development with increased intermediation between deficit and surplus units in the service of the following ultimate goals: i) increase in the volume and the efficiency of allocation of resources for investment and ii) maintenance of the stability of the system by implementing a successful transformation of short-term saved funds to long-term invested funds. However, as the above discussion reveals, disentangling the puzzle of the relation between economic and financial development is a difficult task as it seems that there is no common ground for the above mentioned views to be assessed at a theoretical level. We believe that certain features of the debate in development finance contributed to this difficulty: a) the conducting of the discussion exclusively at a macroeconomic level without paying adequate attention at the microeconomic effects and foundations, and hence, b) the examination of institutions as a static constraint of economic activity – at a macro level – rather than as a factor of transformation of economic relations and hence as contributors to financial development.
Indeed,
identifying
financial
development
with
enhanced
intermediation, implies identifying the former with the appropriate nexus of
98 institutions (markets, banking firms etc.) through which intermediation is implemented more or less successfully. Although, economic and financial development are made visible at the macroeconomic level, the policies pertaining to them – in order to be effective – must take account of the agents that would set them in motion. Hence, modeling the microstructure of the economy is necessary. On the other hand, an abstract set of axiomatic a-historical hypotheses might not yield the desired result as long as the object of financial development is both dynamic and institutional in its nature. Hence, we need an approach that would take into account both of these factors: the need for microfoundations and the central role of institutions. Both of these prerequisites can be found in the theoretical framework for institutional evolution inspired by North (1990, 1991, 1995). According to North (1991), institutions determine transaction and production costs and in this sense, economic history is the narrative of institutional evolution and transformation. This is because, institutions build the incentive structure faced by the agents of an economy and in this sense, they determine the direction of change in economic life. What is crucial in this argument is the existence of an “institutional matrix” that defines the opportunity set or the “pay-offs” of agents in selecting particular actions (North (1995)). Then, the viability of organizations – that is “groups of individuals bound by some common purpose to achieve objectives” (North (1990:5)) – depends on the structure of the incentives given by the existing institutions and the reply of agents to them. However, this is a two-sided relation. On the one hand, the institutional framework determines the kind of maximizing behaviour for the organization. On the other hand, this maximizing behaviour is a source of institutional change (North (1990:78)) as far as relative prices changes – i.e. changes in the prices ratio of factors of production, changes in the cost of information, changes in technology – alter the incentive structures. (North (1990:83-84)). But institutional change can only be incremental and subject to the bargaining power of different groups of agents so that organizations prevailing in this bargaining game are able to affect the polity towards change of political rules (North (1990:79)) which entail change in economic rules concerning the specification and enforcement of property rights (North (1990:47-48)). In addition, there are increasing returns to existing institutions in lowering transaction costs as initial set up costs for new institutions are high, the kinds of knowledge and
99 skills that pay off are specific to the incentive structure of the existent institutional framework (North (1990:78)), while coordination between contracting parties on the expectations built in formal rules and informal constraints evolving within the existing institutional structure will decrease uncertainty (North (1990:95)). In this context, path dependence is inevitable in determining the future course of the economies as “yesterday‟s choices” which “are the initial starting point for today‟s” choices (North (1995)). Then North (1990:137-138) asks “how does one reverse the increasing returns characteristics of a particular institutional matrix?”. The answer given justifies the crucial role for the polity to implement such policies that would change the incentives of action through changing the relative prices and hence, the perceptions, norms and ideologies of groups that are willing to undertake radical changes. In short, North‟s (1990:112) model seeks to understand both institutional persistence and institutional change in a framework characterized by an existent incentive context that determines action in the face of incomplete information and subjective apprehension of reality that justify the existence of positive transaction costs. Then, the key to the future course of an economy is the ability or inability of incremental change derived by the maximizing behavior of organizations to overcome the increasing returns characteristics of existing institutions in decreasing transaction costs. Such a reversal of path dependency can come about from unintended consequences of chosen actions, external factors but mainly by purposeful action of the polity for radical change as this is supported by the groups of constituents that favour such change (North (1990:138)). Our suggestion is to approach development banks within the above theoretical context. In this sense, development banks are dynamic entities within a dynamic economic and financial system where causalities run in both directions. The existing financial regime affects the form of financial institutions – and hence, of development banks – while the latter also affects the evolution of the former. However, the distinctive characteristic of these banks is their purposeful establishment under state sponsorship in order to reverse the elements of path dependency in the economy towards backwardness. What is at stake is institutional development and transformation in its historical evolution. In this context, the main argument of this paper is that development banks, not only cannot be studied independently of the prevailing financial system and its changing nature, but also that in their inherent
100 dynamic nature, they are in fact a reflection of the development of the financial system of an economy. As instruments of institutional change reflect both the elements of path dependency and the results of incremental institutional change.
2.3. Development Banking and Financial System Development: In the Quest of their Relationship
The history of development banks is closely related both to the financing of economic development and to financial development or underdevelopment. It seems that the presence of both economic backwardness and inadequate institutional infrastructure calls for the establishment of special financial institutions such as those characterized as “development banks” or “development finance companies” (DFCs) (Gordon (1983)). The double coincidence of underdevelopment described above pictures itself in the provision of long term financing. Normally, funding of investment projects should emerge from the capital market, that is, from a market mechanism, which theoretically assures increased liquidity for investors and continues public assessment of the firm‟s performance, thus higher efficiency. However, economic and institutional underdevelopment indicate the existence of only a few large established firms that could resort credibly to the capital market for long term finance, and also increased risk aversion of savers for such risky investments. On the other hand, the presence of underdevelopment also indicates the existence of unexploited investment opportunities and hence, the possibility for profitable investment if initial financing were possible. The presence of high interest rates because of the riskiness of the general economic environment of a less developed economy is a great impediment to the implementation of these projects. Nonetheless, a great deal of this aggregate risk has to do with institutional underdevelopment and the entailing inadequate protection of individual investors. Development banks came to close this “underinvestment” gap as far as their double role was provided as an answer to both economic and financial underdevelopment. Development banks were entitled to provide long term finance to leading sectors of the economy that had acquired increased importance for the
101 development of the backward country. From this respect, they gave an answer to the problem of economic underdevelopment. On the other hand, they were also designed as institutions aimed at covering the institutional “gap” in areas such as entrepreneurship/ promotional activity, modern corporate management (including financial management) and capital market development. Indeed, Gordon (1983) remarks the establishment of DFCs from 1948 onwards with the mandate to provide loans or equity financing to mostly industrial projects with high economic priority and reasonable financial and economic return. For this purpose, these institutions were provided with government subsidized loans with low or zero interest although this was meant to be a temporary solution to their financing problem. Eventually, DFCs should rely more to the market in order to obtain funds through the sale of their own securities. Such an operation along with the placement in the market of their matured portfolio of firms‟ securities would also help capital market development. In addition, DFCs should contribute to institutional development through the promotion of more rational appraisal methods for investment projects, improvement of accounting and financial reporting practices of their clients and by training them in modern management techniques. Specifically, Diamond & Gulhati (1973) consider institutional development brought about through the operation of DFCs (Development Finance Companies) as one of the main reasons for which the World Bank was interested in supporting those institutions. Institutional development and change were implemented through the activity of DFCs to build entrepreneurial and technical skills, professional staff and leadership abilities which would have brought about the necessary momentum for institutional change. As Diamond & Gulhati (1973) put it, DFCs are considered by the World Bank as permanent agents capable of transforming the economic and social environment of LDCs by providing locally devised solutions to locally emerging problems. On the same footing Diamond (1982c) indicates that the developmental role of DFCs is not exhausted in the provision of finance but it is extended to the transformation of existing conditions in an economy through active rather than passive intermediation that includes the development of skills and the acquisition of habits and attitudes that would change the way of thinking of the local business community. On the other hand, the promotional role of a DFC – that is its “direct entrepreneurial activity” in undertaking the initiative to set up businesses in targeted sectors is examined by Kuiper (1968a,b). Promotional activity is considered the
102 ultimate and perhaps more risky contribution of Development Banks in institutional and economic development ranking third in the hierarchy of DFCs activity after longterm financing and equity participation. The objective is to set up a business with the intention to give the control at a profit to prospective entrepreneurs in the future. In fact, the Bank is assuming an entrepreneurial role concerning the identification, formulation, initiation and execution of a project given that the entrepreneurial class of the country is small and with poor industrial experience. However, there are risks in engaging in an activity that would affect the Bank‟s profitability if unsuccessful because of the burden of unsalable equity stock of such enterprises. In this sense, the relationship between the Bank and the enterprise it promoted or sponsored ought to be one of close monitoring and control. Besides, the difference between a Development and a commercial Bank was that the former did not condition its financing on tangible securities but rather on an intangible asset such as its close relationship with the firm‟s management. Furthermore, the lack of managerial skills in LDCs necessitated in many cases the representation of the Bank in the board of directors and/or its direct participation in management. The risk taken in the last case was the confounding of the roles of entrepreneur (risk-taker) and that of the financier (risk-avoider) in the same person that represents the Bank. Finally, Gustafson (1968a) stresses the importance of capital market development as a goal for DFCs policies. At the institutional level, this meant not only the design of new financial instruments with attractive risk-return features for the agents, but also a long process to change investors‟ attitudes. In this sense, capital market development entailed the operation of an orderly market with increased liquidity and limited fraud. It also presupposed a whole range of institutional changes that would have promoted business ethics towards public disclosure of financial accounts along with standardization of accounting practices with the aim to protecting minority shareholder interests and hence, dispersing equity holdings. Towards these goals DFCs were meant to educate their clients in modern business practices and suggest the government changes in the law that would have helped capital market development especially as far as taxing of securities‟ earnings policies were concerned. It seems to us that Development Banks played the role of capital market substitutes, not just in the sense of providing a kind of finance that a market should have provided in normal conditions. More importantly, they implemented such a role
103 at the institutional arena. If investors were uncertain about the liquidity of direct placements in new firms, development banks could guarantee the marketability of firms‟ shares by the close screening/monitoring operation they implemented on firms‟ projects and their expertise in doing such a job. This is a post-investment service that a development bank could provide by placing the securities of a successful firm, initially financed by the bank, to the market. In this sense, Gustafson (1968a) stresses the importance of DFCs own share portfolio “rolled over” in the market but also the participation of the bank in particular firms as a factor that increases the public‟s confidence on future public equity issues of these firms. However, this post-investment service of the bank is based on its during-theinvestment capital market-substitute role. Indeed, the bank acted “as if” it was a capital market itself when it decided where to invests the public‟s funds – borrowed from domestic or abroad sources – when it demanded repayment not only in the form of interest but also in the form of dividends and possible capital gains from firms‟ shares that it holds. The latter provides a direct link between the bank‟s operation and the development of the capital market to the degree that the capital market-substitute initial operation of the bank transforms itself, not to an impediment but to a promoter of the capital market both in terms of the volume of transactions and in terms of the required rate of return. This demands that DFCs should aim at selling firms‟ securities out of their portfolio at market prices as Gustafson (1968a) points out. Hopefully, these prices would reflect lower required rates of return as bank‟s close monitoring of these firms becomes an additional safeguard for the individual investor and hence lowers the initial high required rate of return in the market so as for the latter to be more easily accessible by prospective firms. In this respect, the role of development banks to curb the institutional impediments for financial development in a backward country is crucial. Seeing things this way, illustrates the dynamic nature of development banks and their normal transformation to investment banks after a sufficient level of financial development and proper capital market functioning. The dynamic nature of these institutions is acknowledged by Diamond (1982a) and translated in the need for a continuing reevaluation and reorientation of banks‟ goals based on their growing experience and the evolving national policy objectives. The sources of change identified in Diamond (1982b) contain changes in government policy, in the structure of the real economy and in the financial sector as the latter develops. In this sense, a
104 dynamic institution means an institution inherently capable to transform itself as the external environment changes. This transformation, according to our view, emerges normally from the above described double role of these banks as both long-term financing institutions at depressed rates and capital market substitutes-promoters at market rates. The first kind of operation normally loses its central meaning after the development of the capital market and proliferation of financial institutions. Indeed, as Diamond (1982b) observes, a development bank might need to adapt its operation to the changing environment by diversifying its activity towards “universal banking”. In this sense, the second role increases in importance as financial institutions develop. However, there is an ultimate important constraint in a development bank‟s operation according to the previous analysis. This constraint relates to the original double role of a development bank as both a financial institution and a promoter of economic development and pictures itself in government policy and the way this affects bank‟s financial viability. The problems related to the need for both economic and financial evaluation of projects and the crucial role of the government in this respect have long been recognized in the literature as Mathew (1968, 1982), Bhatt (1982) reveal. Bhatt (1982) sets three criteria that a project should satisfy in order to be accepted for financing. These include the financial rate of return related to financial soundness, the economic rate of return concerning the generation of income and saving and finally the yield of the project in terms of competitive efficiency (the domestic cost per unit of foreign exchange saved). Then these measured rates of return should also act as communicative devices between the bank and the government in the effort of the former to affect the policies of the latter in rendering, for example, economically sound projects to financially viable ones. Mathew (1968), on the other hand, indicates the paradox of private DFCs that should reconcile their financial performance as private enterprises with the fulfillment of government‟s developmental goals. In this respect, the high risk of their financing, especially of small firms, along with the below market rates charged put these DFCs in the position of depending directly to the government‟s support for their survival. The main concern is that financing financially unviable projects that are important for government‟s developmental purposes threatens the existence of Development Banks as Banking firms. Furthermore, government interference when accompanied by corruption phenomena renders the relationship with DFCs even more problematic. The problem becomes even more complicated when an unfair competition is observed
105 between private and state-owned DFCs at the expense of the former. Mathew (1982) returns to this problem to indicate that financially viable Development Banks along with the limited government interference in their management are the only guarantees of public interest. These are important as far as the access and credibility of DFCs to financial markets is at stake. Besides, the goal of development banks to reverse the path dependence of underdevelopment can only be successfully serviced if market orientation and disentanglement from government financial support is followed. However, as World Bank (1976) indicates, continued dependence of DFCs on official funds emerges because of government administered low lending rate policies, underdeveloped capital markets that prohibit DFCs from mobilizing domestic funds and government regulations that impede foreign borrowing by DFCs or favours government securities at the expense of banks‟ securities. The problem also extends to the appropriate financial management policies for Development Banks themselves as Gustafson (1968b), Raghavan (1982) and Gill (1982) report. This is because, depressed profitability reflects itself to diminishing returns for the Bank‟s shareholders and also restrict the opportunities of the later for alternative sources of finance beyond government funds. Specifically, Gustafson (1968b) stresses the need for DFCs‟ management to act as if maximizing shareholders‟ wealth in addition to their ability to raise additional equity and debt capital from the markets thus limiting concessional finance by the state agencies in the future. To this end, debt/equity ratios should be established to that level so as not to place the Banks‟ solvency at risk at hard times. Furthermore, ratios such as lag in collections of loans (defaulted interest plus principal over total interest plus principal) and soundness of portfolio (defaulted loans over total loans) should be taken into account as indicators of the assumed risk. On the same footing, Raghavan (1982) indicates the need for a readjustment of DFCs financial policies towards market sources as far as the expansion of their operation and the related demand for funds renders official sources inadequate. In this sense, measures to enhance profitability by increasing interest rate spreads should be taken. Hence, Gill (1982) deems appropriate the change of attitudes within the DFCs‟ financial management towards the acceptance of the discipline of the market to the degree that the sophistication of the economy increases and Development Banks face increased competition by other financial institutions and the capital market. In agreement with these authors we think that although a development bank has to assess both the socioeconomic return of a
106 project to be financed and the financial return, the later is more important for its financial development promoting function. This is because, no investor would trust the bank‟s monitoring as a safeguard for its investment in the firm‟s securities if financial return is not an important – at least in the long term – factor in the evaluation of projects. The previous discussion delineates the problem of the difficulty to model development banks using the conventional tools of economic theory. Development banks – or Development Finance Companies as they were termed by the World Bank (1976) – are encountered in the literature of development finance more like an empirical object rather than as a field in banking theory that needs a modeling of its own. We think that the reason for this theoretical neglect is related to the distinctive characteristics of these institutions that render traditional banking theory questions only partially relevant to their case. Development banks are characterized by two major features: First, their direct dependence, concerning their form and means of operation, on government decisions and the general institutional infrastructure. Second, the element of institutional transformation which is inherent in their nature and is related to their goals by statute. Concerning the first characteristic, it could be argued that this holds for every financial organization that operates within a regulatory framework tailored by the government. However, the degree of dependence of Development Banks on this institutional environment is much deeper than in any other case for three reasons: 1) these banks acquire the bulk of their funds at administratively set low interest rates which can only be possible if there is a government policy that guarantees the level of these rates. This makes it possible for development banks to extend long term finance to enterprises at below-market rates. 2) The spread between loaned and borrowed funds‟ rates is not always at the discretion of the banks‟ management, although this holds for commercial banks too under financial repression. However, as for Development Banks, they did not usually have the ability to manage the synthesis of their assets and liabilities at discretion, their dependence on government decisions was crucial, and determined their nature as banking institutions that are effectively “nonbanks” (Fry (1995)). On the other hand, their loan activity was closely related to the priorities set by the government concerning the financing of certain sectors of the economy. 3) The prevailing financial regime is crucial for the smooth operation of these banks as it is apparent from point 1) above. Furthermore, to the degree that
107 development banks are derivatives of financial repressed regimes, a change in the institutional environment affects radically their mode of operation calling for a rapid institutional transformation, this time in the internal structure of these banks. The last observation introduces us also to the second distinctive characteristic of Development Finance Companies. Development banks, are not only open to the influence of the general financial structure of the economy, but they are also meant to influence it through their ways of operation. Hence, Development Banks were established to fulfill a double role. At first, they were meant to extend long term loans to preferred sectors of the economy at low interest rates so as to accelerate economic development especially in less developed economies. Secondly, they were supposed to act in a way that would contribute to the development of the capital market through consulting of the government and private enterprises and also through the placement of private, public or their own securities to the stock exchange. As far as such an interactive relation is established between development banks and the institutional infrastructure, institutional transformation also becomes an inherent characteristic of these banks that need to transform themselves from traditional development banks to merchant banks to the degree that the capital market plays an increasingly decisive role in industrial funding. The questions that a theoretical literature poses are important to the degree that they advance our understanding of the related theoretical object. Bhattacharya & Thakor (1993), indicate the following major questions of modern banking theory: 1) the question of existence of financial intermediaries. 2) The problem of credit allocation and credit rationing. 3) The liquidity transformation function of banks when they fund illiquid assets with liquid liabilities. 4) The maturity transformation between short term liabilities and long-term assets. 5) Banking regulation, its desirability and limits. 6) The borrowers‟ choice between banks and the capital market as a financing source. 7) Unresolved issues such as the role of financial institutions in financial innovation, the differences between financial systems etc. Are, any of these questions, illuminative of the nature, operation and role of development banks? Some are only indirectly relevant while others are rendered irrelevant by the financially repressed regime. For example, the question of liquidity and maturity transformation is not posed in the case of development banks as far as they funded their long term loans with subsidized long term borrowing from the Central Bank or international development institutions such as the World Bank and the European Investment Bank.
108 Demand deposits were not allowed and only in some cases time deposits were accepted. Hence, the liquidity and maturity features of assets and liabilities were almost matched. The problem of credit allocation is also irrelevant as a choice problem since development banks were entitled to extend loans in predetermined, by the government, sectors of the economy and hence, credit rationing was a government policy rather than a bank policy problem. Of course, there is an issue here concerning the financial viability of the projects chosen among those proposed within a priority sector, but this has to do with the ability of the bank‟s manager and the technical competence of its personnel and hence, it is not related to issues pertaining to banking theory. Finally, the question of why financial institutions exist pertains to every kind of financial organization as it is related with transaction costs reduction especially in the face of informational asymmetries. However, such an encompassing question will not help us identify what is special about development banks. Only the questions concerning the choice between banks and capital markets and also those relating to financial systems structure and financial innovation are indirectly relevant to our problem. Of course, development banks were usually established in situations where the capital market was non-existent or very thin, so that there would be no realistic issue of choice between banks and capital market for most firms. However, focusing on this dilemma, helps us understand the role of development banks initially as capital market substitutes, and later as capital market development supporters. Hence, issues that are assumed by the literature to affect the decision between banks and capital market such as the credit reputation of the borrower, the managerial skills and experience or the informational rent extraction by banks have an indirect relevance to development banking. Development banks as capital market substitutes were meant to support borrowers that could not resort to the capital market either because of not previously established reputation or because of inexperienced management. On the other hand, as capital market promoters, development banks were meant to build managerial skills and firms‟ reputation so as for the latter to be able to obtain funds from the market in the future and thus avoid the extraction of informational rents from commercial banks. In effect, they were supposed to make the above dilemma between commercial banks and capital market a realistic one. In this respect, the issues of financial innovation and financial structure are closely related to the institutional environment within which development banks functioned and which affected their mode of operation as we saw above.
109 However, development banks are financial institutions and as such are subject to risks as every other financial intermediary. Swank (1996) describes two major and three derivative kinds of risks. According to his analysis, there is the credit risk or the risk of borrower‟s default, and the funding risk or the risk of withdrawal of funds by depositors. In addition, maturity mismatching gives rise to interest rate risk, while holding of assets with variable values may entail price risk or exchange rate risk. Only the credit or default risk seems directly relevant to the development banks‟ case. Certainly, there is no liquidity or withdrawal risk. Furthermore, as much as there is no significant maturity mismatching, there is no interest rate risk in the sense we encounter it in commercial banking. Finally, price and exchange rate risk might be relevant to the degree that there is a significant portfolio of securities in the assets‟ side of the balance sheet or foreign borrowing exposes bank to risk from exchange rate fluctuation. However, the question remains whether there is a major kind of risk that characterizes the nature of development banks. Having in mind the above risk classification, Swank (1996) analyzes four types of banking theories: 1) Risk management theories that evolve around one major risk aspect of banking operation as those described above. 2) Portfolio models that conceive the bank as a risk-averse manager of a portfolio where the liabilities of the bank are treated as negative assets. 3) Imperfect-market models that focus on the competitive structure of the banking industry. 4) Real resource models which treat the bank not as an investor – as the portfolio models do – but as a producer of financial services with the related inputs and output. The above models shed light on the notion of the banking firm focusing on different particular aspects of banking depending on the problem that each researcher wants to address to. Are these models helpful to us? In previous paragraphs of this section we indicated the two distinctive characteristics of development banks: the critical dependence on the financial regime and the dynamic feature of institutional transformation. The first feature relates to points 6) and 7) of Bhattacharya & Thakor (1993) for the reasons outlined above although the issues are left indeed unresolved since the role of the government is not explicitly examined in a political economy framework. The second feature that concerns the internal structure of development banks and its transformation, is only partially affected by the risk discussion of Swank (1996). Even if we acknowledge the existence of credit risk or price risk or even interest rate risk in the second phase of the life of development banks when they became merchant banks in a liberalized
110 environment, even in this case we will not have found the “defining” kind of risk for these kinds of banks. A point of difficulty here is the non-static nature of these institutions which relates to their deep dependence on the prevailing financial regime. In this sense, isolating only one of the above kinds of risks or focusing on specific aspects of their operation as financial services producers, or portfolio managers, or risk managers will give us only partial answers for the nature of these banks, focusing only on one side of their operation. Our suggestion is that we should search for an encompassing dynamic theory that would examine development banks in their entirety as institutions that affect and are affected by the financial system and also that have an inherent feature of institutional transformation. If this is the case, then the major risk that characterizes the nature of development banks is not a pure financial risk but rather an institutional risk. It is the risk that the bank faces as the mode, scope, prospects and financial healthiness of its operation depends not on its own decisions but on government decisions concerning the prevailing financial regime. Then pure economic risks are rather derivatives of this major institutional risk. Even the “escape route” in the internal structure of development banks that relates to the holding and trading of securities and the development of capital market, can be rendered a “dead end” if the government is not prepared to amend the institutional infrastructure of the financial system. This means that even the double role of development banks to which we referred at the beginning of this section is subject to the authorities‟ decisions. This approach is in accordance with North (1990, 1991, 1995) as far as we consider development banks as instruments of institutional change sponsored by the state. Even the long-term financing activity of the banks can be considered an element of institutional change to the degree that it contributes to the changing structure of the economy towards industrialization and modernization. But also, the whole range of activities that we described above including promotional activities for new business, development of expertise, new methods of management and control, new accounting standards, new business ethics and of course the development of the capital market contribute to the institutional transformation of the economy. As far as the financial sector is concerned, the role of development banks to overcome the vicious circle of path dependency is crucial and it is the derivative of all these activities. Of course, path dependency can emerge again to the degree that the state supports short-run
111 political rather than long-term developmental goals. But even in this case, these effects should be reflected in the performance and operation of the banks. The above indicate that it is not possible to examine a development bank as any other banking firm. More importantly, it is not possible to examine these institutions independently of the prevailing financial regime and the role of government policy. Furthermore, such a study is by its nature a dynamic and interactive one by focusing not on the static features of a development bank as any other firm but on its evolution and transformation along with the evolution and development of the financial system itself. If this is the case, then an analytical methodology embedded in historical financial data analysis is the proper apparatus of research.
2.4. Real Economy and Financial Sector Development in the post-War Greek Economy: A Process of Transformation
Implementing a historical analysis of economic institutions presupposes the choice of a specific historical period and economy as the object of research. In our case, the post-war Greek economy and especially the period between early 1960s and early 2000s constitutes the body of research on which we will try to establish our arguments. The choice for this period relates both to the operation of the three Greek Development Banks, ETEBA, Investment Bank and ETBA and also to the fact that this was a period of major economic and institutional transformation for the whole economy. Brenner (1998:9), in his paper on the post-War World Economy, acknowledges three phases in the world‟s major economies: The long boom (1950 – 1965), the interim period when the transition from boom to crisis takes place (1965 – 1973) and the long downturn (1973 – late 1990s). For example, the data for manufacturing in the G-7 economies indicate that the average net profit for the period 1950 – 1970 was 26.2% while it fell to 15.7% in the period 1970 – 1993. As Brenner (1998:7) mentions depressed profitability during the latter period was the cause for the decline in investment and output growth which both contributed to falling
112 productivity rates and the rise in unemployment. Indeed, unemployment rates in private business were on average 3.1% in the period 1950 – 1973 but rose to the level of 6.2% on average in 1973 – 1993 (Brenner (1998:5, Table1). The rupture between the pre-1973 and the after-1973 period is also observed by Maddison (1983). In his survey of six major economies (France, Germany, Japan, the Netherlands, UK, USA), he observes an average annual growth rate of GDP in constant prices of 5.3% between 1950 – 1973 compared to 1.9% for the period 1973 – 1982. Besides, in a recent paper, Maddison (2005:12, Table 6) covering a wider time span estimates the per capita GDP annual average growth rates for Western Europe to be 4.05% for the period 1950 – 1973 and 1.88% for the period 1973 – 2001. The main causes for this reversal were for Maddison (1983): i) The long-term fall in productivity rates as the gap between the US economy on the one hand and the European economies and Japan on the other was being bridged in the post-war period. ii) “System shocks” in the sense of the change in the economic environment provoked by the breakdown of the Bretton Woods system and the ensuing oil crises. The uncertainty that followed affected both entrepreneurial expectations and the ability of governments to answer successfully to the new challenges for policy. iii) Changes in the “establishment view” of economic policy. By “establishment” Maddison (1983) means officials in central banks and ministries of finance along with politicians and academics which jointly constitute the elite of economic policy decision-making. The change of the point of view refers to shift from the Keynesian-inspired mixed of policies in the 1950s-1960s to the new consensus founded on the ideas of Monetarists and New Classicals. The new consensus rejected the demand management-fine tuning approach and more generally the idea of big government and the welfare state propagating the need for fiscal restraint and the ability of market self-correction even with employment and output losses. In this sense, a part of the fall in output and the rise in unemployment rates may be considered the outcome of a deliberate policy that has as its major concern to curb inflation. These changes in international economic performance were accompanied by the altering international financial environment. As Pilbeam (1992:282-289) reports, by the end of the World War II, the new international monetary order was decided at Bretton Woods, New Hampshire in 1944 with the participation of 44 countries. The aim was the establishment of an international system that would prevent episodes such as the breakdown occurred in international economic relations in the 1930s
113 characterized by the giving up of the gold exchange standard, protectionism, competitive devaluations and deflation. Floating exchange rates were considered culpable of uncertainties that prevented the development of international trade and encouraged destabilizing speculation. Bretton Woods effectively established a fixed exchange rate system based on the dollar-gold fixed price at 35 dollars per ounce. In addition, the International Monetary Fund (IMF) was set up so as to monitor and promote international monetary cooperation and to guarantee the orderly operation of the fixed exchange rate system and help the growth of international trade. The Bretton Woods system operated successfully from March 1947 to August 1971 when it broke down because of the massive increase in US balance of payments deficits and the inability of the dollar to support its convertibility to gold. The result was the abolition of fixed exchange rate regimes that added to the general economic turbulence which ensued the two oil crises in the 1970s. According to Pilbeam (1992:298,368-371) the answer of the European economies (those belonging in early 1970s in the European Economic Community) was the establishment of the Snake on 24 April 1972 as a system that allowed the floating of currencies between the member countries and the dollar within predetermined boundaries. The Snake was replaced by the European Monetary System (EMS) on 13 March 1979 which entailed the establishment of the Exchange Rate Mechanism (ERM) and the European Currency Unit (ECU). The rationale for all these efforts was the establishment of a zone of monetary stability between the European countries. However, these developments were also the initial necessary step towards the European Monetary Union (Pilbeam (1992:358)) an idea that preoccupied the European policy makers during the 1990s. The Greek economy fitted into this international context by exhibiting two patterns of growth during the post-war period. According to Alogoskoufis (1996), the period from 1954 to 1973 is characterized by high growth rates of about 7% on average, along with low inflation rates not exceeding 4% on average. The picture is reversed for the ensuing period 1974-1993 with a percentage growth rate as low as 2% on average and an inflation rate of about 18% on average. The author calls these two periods of the Greek economy “the two phases of Ianus”. On the other hand, Dimelis, Kollintzas & Christodoulakis (1996) find the point of inflexion in the path of Greek economic development around the early 80s. Hence, they argue that the Greek economy was growing “relatively too fast” till 1980 and “relatively too slow” afterwards. Taking as point of reference the growth rate of GDP per capita, they
114 indicate that average annual growth rates as high as 4.58% (1950-59), 6.80% (196069), 3.68% (1970-79) were succeeded by quite lower average growth rates of 1.10% (1980-89) and 0.60% (1990-94) (Dimelis, Kollintzas & Christodoulakis (1996:74, Table 1). Despite the differences in opinion concerning the exact turning point in Greek economic growth, there is agreement on the deterioration of economic performance during the 80s and 90s. However, Bosworth & Kollintzas (2001:177) indicate the recovery of the economy after 1995 with the growth rate being 3.3% on average for the period 1995-2000. Hence, it is quite fair to describe the course of the Greek economy during the post-war period as being characterized by a great cycle (Drakatos(1997)). According to Drakatos (1997) this cycle can be described as follows: i) A phase of “reconstruction” just after the World War II and the devastation of the country by the Civil war. The period 1945-1952 was characterized by the demand for economic stabilization along with the reorganization of production. A major development of that period was the establishment of the Monetary Committee in 1946 with the aim to controlling money issue although it became quickly the governmental agency for financial issues. A success that could be attributed to the efforts of that period was the curbing of inflation and monetary instability in 1952. ii) A “preparation” phase characterized mainly by the devaluation of 1953 in order to support the competitiveness of the economy, the increase in domestic savings in the form of bank deposits as a consequence of the established confidence on the currency, the establishment of incentives for direct investment by foreign capital such as the Law 2687/1953 and the new incomes tax law of 1955 in an attempt to modernize the domestic fiscal system. iii) The period of development 1957-1972 characterized by a remarkable increase in industrial development and especially in sectors such as aluminum, metal industry, shipyards, petrochemicals, cement etc., the absorption of foreign know-how especially in management techniques, the increase in the relative weight of secondary production at the expense of primary production especially in the years 1965-1972 and macroeconomic stability mainly because of the rapid growth of domestic supply to meet growing demand and the reduced labour demands on it, along with international monetary stability. In addition, in 1961, Greece signed a connection agreement with the EEC. An important element concerning the financing of economic development during this period was the establishment of the three Development Banks: the Hellenic Bank of Industrial Development, the National Investment Bank of Industrial Development and the Investment Bank. iv) The turning
115 point observed in the period 1973-1980 was characterized mainly by the two oil crises of 1973 and 1979 and the turbulence in exchange rates after the abolition of the Bretton Woods regime, the resurrection of inflation that reached levels ranging from 15.5% in 1973 to 24.9% in 1980 and the establishment of conditions of uncertainty and instability that hurt entrepreneurial activity, the inducement to invest and hence the GDP growth. Despite these adverse developments, Greece was accepted to be the 10th member of the European Economic Community as of 1981. Finally v) the phase of recession 1981-1995 characterized mainly by great macroeconomic imbalances and deindustrialization especially during the stagflation period 1981-1985 that was followed by the stabilization programme of 1986-87. According to Garganas & Tavlas (2001:58-59) the latter short-lived for reasons related to the political business cycle. During the periods of 1991-1993 and 1994-1995 further stabilization programmes were implementing aided by the new national goal for nominal convergence with the European average as this was prescribed by the criteria of the Maastricht Treaty: serious reductions in inflation rates, budget deficits, public debt and nominal interest rates. However, what the above discussion reveals is that along with the shift of the Greek economy from high growth to recession, there was a parallel shift in policy objectives from actively planning and organizing economic development to passively accommodating the market forces with the active role now focusing on nominal variables such as inflation. The link between this shift of attention of economic policy and the developments in the financial sector can also be seen in the description of monetary regimes during this period by Garganas & Tavlas (2001). They distinguish two monetary regimes and an interim transition period: i) The monetary regime of 1975-1990 characterized by high and persistence inflation. The authors indicate the inability of monetary policy to cut back inflation as it was constrained by the financially repressed system prevailing in Greece with highly concentrated and regulated banking sector, thin capital markets and the decisive role of the government in setting the objectives of monetary policy. Financial repression reduced the efficiency of monetary policy instruments such as interest rates as it was based on direct control of prices or quantities which were vulnerable to evading practices by agents thus undermining the effectiveness of monetary policy. In short, the monetary regime of 1975-1990 was one of inflationary finance in the face of large fiscal
116 deficits26. ii) The transition period from high to moderate inflation rates during 199194 where the gradual process of financial liberalization/deregulation that began in 1982 but mainly in 1987 increased the effectiveness of monetary policy. Interest rates became the main instrument of monetary policy along with the use of indirect instruments such as open market operations, a refinance facility and reserve requirements all reflecting a policy with an eye to the market. Financial deregulation was effectively completed by 1995. iii) The period1995-2000 which was characterized by a new disinflation regime facilitated by the prohibition of monetary financing of the government‟s budget deficit along with the tightening in monetary policy. The signing of the Maastricht Treaty in 1992 along with the announced objective to join the EMU became the framework for the convergence programme for the period 1994-199927. The main objective of this programme was the sharp curtailment of the large fiscal deficit. A major instrument in this context was the “hard-drachma” policy according to which the drachma would depreciate against the ECU only by 3% per-year without fully offsetting the differences in inflation between Greece and the rest of the Union. Pegging, in this sense, the currency of a country to that of a low-inflation area would pose an impediment to increased government spending and wage setting policies that might add to inflationary pressures thus undercutting the competitiveness of the country. It was in fact, a self-discipline measure that succeeded in lowering inflation and enhancing the credibility of the government to pursue anti-inflation policies. Towards the same objective an important institutional measure was the declaration of the independence of the Bank of Greece in December 1997 with the specific mandate to pursue price stability. On the 16th of March 1998 the drachma joined the Exchange Rate Mechanism of the European Monetary System while in January 1999, when eleven members of the EMS adopted the Euro, Greece participated in ERM II. To make a long story short, the whole period 1995-2000 was characterized by the pursue of Maastricht criteria28 of convergence which led to Greece‟s admission in the Euro area from January 1st 2001.
26
As Bosworth & Kollintzas (2001:153) indicate from 1970s onwards monetary policy accommodating of large budget deficits contributed to the sharp increase in inflation rates. 27 Convergence programmes that were announced subsequently and before Greece joined the EMU were those of 1998-2001 and 1999-2002 with main objectives fiscal adjustments and convergence of the Greek economy to the lower European interest rates (Pantazidis (2002)). 28 Maastricht criteria included the convergence in inflation rates and long-term nominal interest rates along with the compulsory membership in the exchange rate mechanism of the EMS and the criteria concerning the deficit over GDP ratio and the public debt (Garganas & Tavlas (2001:76)).
117 The above description of the economic situation in Greece during the last four decades of the twentieth century demands an explanatory framework in order to discern the salient features of development. This framework is provided by the literature by stressing the role of the state, the conditions of entrepreneurial activity and its practices and the role of the financial system and especially of the banking system. Katseli (1990) introduces the notion of “state corporatism” that characterized the model of economic development in Greece in the post-war period. According to this view, a nexus of, mainly political, relations between the state, banks and traditional industrial families running major private enterprises – occasionally supported also by trade unions – set the form and nature of development but also eventually undermined its future. The main feature of state corporatism was the regulation of conflicts between social and economic groups as a specific model towards industrialization. However, what is of interest here is the influential role of the state concerning the financial sector to the degree that the latter, as Katseli (1990) indicates, acted in support of the corporatist model especially of the close relationship between political and economic interests the latter being represented by the familycontrolled subsidized large firms29. Hence, according to this view, the financial repression/regulation regime that prevailed in post-war Greece was the necessary complement of “state corporatism” that determined the relations between financial institutions, the government and incumbent firms. The effects of this model of post-war development, according to Katseli (1990) were manifold. Financial repression in the service of corporatistic relations between large firms and the state contributed to capital market underdevelopment and reduced entrepreneurship to the degree that financing decisions and project approval rested on the close ties between political agents and the family-controlled firms. A second effect with relevance to the financial sector was the existence of a “dual” structure of the economy and its institutional apparatus which was divided into an official and an unofficial sector. The first was identified with the large subsidized firms benefited by state regulation in the form of concessional credit extension and protection from competition. The unofficial sector, on the other hand, consisted of 29
Katseli (1990) mentions that these large family-controlled firms were those that rendered “problematic” during the 1980s and were included in the restructuring plan of the Organization for Firm Restructuring (OAE).
118 firms with smaller size, less access to bank financing and less bargaining power in the corporatist framework and hence, more competitive in their practices. A distinctive characteristic of these two sectors and the corporatist model that underlies them is the “soft-budgeting” practice of “official” industrial firms. “Softness” of the budget constraint they faced, took the form of price-setting in consultation with the government, particular tax exemptions or concessions along with explicit subsidies and preferential credit extension without considering the ability of these firms to repay. Important institutional implications of the corporatist model were the higher transaction costs for the more competitive unofficial sector and the reduced amount and low quality of information concerning the riskiness and return of firms‟ projects. The flow of information was additionally impeded by the family control of enterprises and by the absence of modern management and accounting practices. The corporatist model was supplemented by the oligopolistic structure of the banking system and the thin capital market. Both contributed to the smooth operation of the system since underdeveloped capital markets were favoured by industrialists that wanted to keep the enterprise in family hands in order to preserve their negotiation power versus the government and the bank oligopolies. Alogoskoufis (1996), on the other hand, attributes the disappointing performance of the Greek economy during the period 1974 – 1993 to the inability of the political system to replace the institutional framework of the post-war period that was conducive to economic development with another one equally successful in this respect. The post-war institutional framework was characterized by a tax system that favoured private investment and protected property rights. Industrial relations guaranteed the return of investment projects as labour wage demands could not exceed productivity rates. However, this was the outcome of an authoritarian political regime that prevailed in Greece after the Civil War. In addition, the Bretton Woods system of fixed exchange rates in which the drachma participated contributed to a stable monetary environment, while fiscal rules that prevailed during that period assigned priority to public investment instead of public consumption and favoured balanced government budgets. Furthermore, Alogoskoufis (1996) considers as a positive contribution to economic development the mix of free product markets after the 1950s and the maintenance of a regulated financial market under the conduit of the Monetary Committee. He considers the financial repression regime as an efficient
119 one in allocating savings to selective sectors with high returns during the post-war period. In short, the post-war institutional framework despite its authoritarian structures and assisted by a stable international monetary environment was the ultimate cause of high growth rates during this period. This framework changes dramatically after the demise of the Bretton Woods system and the fall of the sevenyear dictatorship in 1974. Nationalizations and extra taxes on profits rendered property rights at risk. Wage demands exceeded productivity rates while political business cycle affected public expenses and public debt soared. In such conditions, financial repression acted as a mechanism for keeping alive inefficient and problematic enterprises instead of being the developmental factor of the previous period. In short, the political system failed in substituting the authoritarian framework of the post-war period with a new consensual one which would be equally conducive to economic development by guaranteeing long-term investment returns and macroeconomic stability. Pagoulatos (2003) describes more closely the intimate relation between the post-war political economy model for Greece‟s economic development and the prevailing financial structure. His argument rests on the perception of Greek economic development as triggered by unilateral government/Bank of Greece initiatives in the absence of the civil society, although the relations between political personnel and the economic oligarchy cannot be denied (Pagoulatos (2003:41)). However, this perception of the problem does not transcend Katseli‟s (1990) formulation to the degree that it recognizes the three major players in this game: the state, the banks and the entrepreneurial families. Besides, even if the civil society in Greece in the post-war period was very weak to express demands and formulate economic policy (Pagoulatos (2003:40)), the relations between the political and economic elite recognized also by Pagoulatos (2003:41) provide a justification for Thomadakis‟s (1995:105) assertion that government policies should be conceived as responses to social pressures. This means that government policies both reflect the prevalence of the interests of a particular social group or groups over others and they also produce the legitimation to act in this way30. However, Thomadakis‟s (1995:105) claim demands one modification and this has to do with the external constraints to domestic policy. To this respect we will agree with Pagoulatos (2003:39) that state‟s 30
For the role of “legitimation” in devising and implementing particular government policies see Thomadakis & Seremetis (1992) and on page 123 of this text.
120 developmental initiative in the 1950s and 1960s was strongly boosted by its role in the cold war setting to defend the Western political and economic structures through the urgent need for economic development. Be that as it may, the model championed by the Governor of the Bank of Greece for the period 1955 – 1967 Xenophon Zolotas, was based on the idea of mixing pricing stability with bank-financed industrialization the latter being assisted by the state. This was a rather eclectic view not completely identified either with the Keynesian or the neoclassical tradition. For example, the developmental state31 of the post-war period in Greece used banks as instruments of development along with a policy of administered low interest rates. However, neither of these policies can be uniquely identified with the Keynesian or neoclassical theoretical tradition (Pagoulatos (2003:29-30)) although, according to Zolotas, the problem that developing countries face was one of structural weaknesses rather than insufficient effective demand. In this sense, monetary stability was important for the additional reason that Greek economic development ought to be driven by an export oriented growth rather than increases in domestic consumption (Psalidopoulos (1990:52-53)). At the centre of the financial regime was the followed credit policy used at the same time for developmental reasons and for maintaining stability by means of quantitative controls on extended credit and special reserve requirements of banks with the Central Bank. Credit rationing was the means used to limit credit expansion whenever price stability was threatened by excessive liquidity. Through this policy, there was no need to raise interest rates so as to restraint monetary expansion (Pagoulatos (2003:32-33)). In this context, of particular importance was the Currency Committee established in January 1946 with the authority to decide on monetary, credit and foreign exchange policies (Pagoulatos (2003:48)). Although the initial intention was for a short-lived institution in order to control credit expansion and channel financial aid to productive uses (Kostis (1997:90)), in fact the Committee became a powerful mechanism of detailed control of the credit system until its abolishment in 1982 (Garganas & Tavlas (2001:48)). The Currency Committee consisted of the economic ministers, the Governor of the Bank of Greece and two foreigners, an American and a British citizen. However, from 1951 onwards its 31
A state is characterized as “developmental” to the degree that intervenes in the economy through its bureaucratic apparatus to prioritize industries for development and uses public financial institutions, indicative planning and other means, especially those denoting state control of finance to promote its industrial policy. This should be juxtaposed to the “predatory” state characterized by corruption and endemic rent-seeking and the “intermediate” state where corruption coexists with sectors of efficiency in the political economy structure (Pagoulatos (2003:15-17)).
121 synthesis changed and only Greek nationals participated in the committee. These included the ministers of coordination, finance, agriculture, commerce, industry and the Governor of the Bank of Greece. The Committee decided on the purposes for which bank credit could be extended, the sectors that should be granted preferential credit according to prescribed percentages, the rates of interest charged, the terms of loans, the procedures that should be followed by banks and the security that should be demanded depending on the type of loan (Halikias (1978:27-29)). Qualitative and quantitative controls32 along with administered interest rates played the double role described above: 1) The achievement of monetary stability for fear of early post-war hyperinflation. 2) The direction of credit to chosen sectors along with credit rationing for firms in less-priority sectors. However, the latter resulted in a double paradox. At first the co-existence of few large oligopolies and many small firms (Ellis et. al. (1964:173-175)) the first comprising the “official” subsidized sector and the latter, more or less, the “unofficial” sector based on retained earnings for its financing or on curb markets. These economic conditions favoured the oligopolistic profits of large firms which were effectively subsidized by the government not only through preferential credit but also through various means of protection against external competition but without adequate attention to efficiency issues. Secondly, the overindebtness of favoured firms that obtained loans at preferential rates and relented them in rationed firms at higher rates thus becoming themselves “unofficial” financial intermediaries (Katseli (1990)). However, a dominant feature of the financial system was the oligopolistic structure of the Greek banking system predominated by the two major commercial banks the National Bank of Greece and the Commercial Bank of Greece (Psilos (1964:186)) (Kostis (1997:91)) and the thin or practically non-existent capital market. After the 1953-1955 stabilization that restored public confidence on the currency, a period of both monetary stability and increasing accumulation of savings in the form
32
Qualitative controls were based on an official distinction between “productive” and “unproductive” sectors and activities. Hence, preferential credit had to be offered to activities such as export trade, agriculture, manufacturing, mining and tourism while import and domestic trade and housing construction faced credit rationing. Hence, qualitative controls had the purpose of affecting the composition of assets (loans) of financial intermediaries while quantitative credit controls aimed at controlling the magnitude of credit expansion for certain loan categories. Given the high liquidity of commercial banks and the underdeveloped money and capital market, monetary policy instruments such as the discount rate or Open Market Operations could not be effective. Hence, reserve requirements and qualitative and quantitative credit controls were used as monetary policy instruments. (Halikias (1978:39-40,171,207-208)
122 of bank deposits started (Ellis et. al. (1964:50), Pagoulatos (2003:48-49)). This was the “era of emancipation” of commercial banks which indicated also the increase of their bargaining power in the Greek economy (Kostis (1997:93)). It is surprising that as early as mid-1960s, Psilos (1964:17) indicates that the problem of the Greek financial system is not the inadequacy of savings but the inefficient mechanism for the channeling of excess liquidity into productive investment. Such inefficiencies were related to the reluctance of large family-owned firms to go public or the inability of small firms to access the capital market, the inadequacies of Greek corporate law to protect shareholders‟ interests and the lack of competition in the banking industry that resulted in the paradox of excess supply of savings coupled with high cost of capital (Psilos (1964:246-251))33. These features that were related to capital market underdevelopment also provided the justification for state intervention to channel these funds to preferential uses for the sake of development through a complex system of rules and controls. Besides, as Pagoulatos (2003:11) indicates, in developing economies with oligopolistic banking systems, market determined credit allocation would favour import trade at the expense of more productive and developmental activities because of the higher profit rates of the former. Courakis (1981) reports that there were two major means of state intervention on the link between surplus and deficit units: 1) Controls on commercial banks concerning the required reserve ratios with the Central Bank, reserve/rebate ratios on bank credits and credit ratios on bank liabilities for specific sectors‟ financing, lending limits for unfavoured sectors, interest rate ceilings on lending and deposit rates and prescribed terms on loans supplied and deposits accepted. 2) Controls on special credit institutions – such as the Postal Savings Bank, the Agricultural Bank, the Development Banks, the Mortgage Banks and the Consignations and Loans Fund – concerning the permitted range of their business and the structure of their balance sheets. Nevertheless, the need for financial development remained a task resulting from the weaknesses of the Greek financial system during the whole period under consideration. A pressing need, in this direction, was to break the oligopolistic structure of banking persisting during the whole post-war period (Psilos (1964:186), Katseli (1990)). At first, banking oligopolies were favoured by the Bank of Greece to 33
High cost of capital took the form of additional fees in excess of official interest rates charged by bank oligopolies. Hence, loan rates to small handicraft firms exceeded the official ones (Halikias (1978:230-231)).
123 maintain the stability of the Greek banking system (Pagoulatos (2003:76))34 and additionally, industrial family-ran oligopolies reinforced each-other (Pagoulatos (2003:73)) and thus contributed to financial underdevelopment given the eagerness of banks to finance these firms and the reluctance of the latter to resort to the capital market (Pagoulatos (2003:70)). In a sense, one can assume the existence of a special relationship between the commercial banks and the large industrial firms (Halikias (1978:166)). On the other hand, it should be mentioned that the system of administered low interest rates had the undesired consequence of being a disincentive for firms and the government to seek funds in the capital market thus limiting the supply of financial assets as alternative (to bank deposits) placements of savings and hence, resulting in excessive liquidity of banks and underdeveloped capital market (Harissopoulos Committee (1979:6)), (Karatzas Committee (1987:22,66)) In this sense, financial repression also reinforced the oligopolistic structure of the banking system. In addition Psilos (1964:191-194) observes that the major commercial banks obstructed the development of the capital market either by opposing to the establishment of specialized institutions for long-term credit (such as the EDFO in the 1950s) or by demanding that competing institutions limit their operations to sectors unprofitable for commercial banks and by using their affiliated insurance companies to stifle competition in the insurance market. The issue of competition along with capital market development remained major problems in the Greek financial system even in the 80s as it is revealed in the Karatzas Committee (1987:34) report where it is related to the need for modernization of the Greek banking system in the context of economic stabilization and curbing of public deficits (Karatzas Committee (1987:11)). Indeed, as Katseli (1990) indicates, public deficits increased enormously during the crisis years. However, more important is the fact that the bulk of these expenditures covered consumption rather that investment needs of the public sector and functioned mostly as cushions of reactions within a political cycle framework. This happened especially when trade unions emerged also as interest groups after 1973 (Pagoulatos (2003:88)). This is probably the reason why Bosworth & Kollintzas (2001:168-169) identify labour market rigidities that permitted the rise in real wages above labour
34
However, Kostis (1997:98) indicates that the government, perceiving the negative effects of the concentration of the banking system which they themselves promoted, favoured the establishment of foreign banks‟ branches in Greece although domestic commercial banks sought to inhibit it.
124 productivity as a major factor for the productivity slowdown during the late 1970s and 1980s along with macroeconomic instability and financial regulation. On the other hand, Thomadakis & Seremetis (1992) seem to support the view of Katseli (1990) for the direction of public expenditures as they examined fiscal management during the decade of the 1980s in Greece under the theoretical notion of “fiscal regime”. The interesting point in this notion is that it embodies both the economic and political parameters of fiscal management relating the effectiveness of institutional arrangements concerning tax collection and public expenditure with the ability of the state to intervene in a developmental direction and without endangering financial stability. In this respect, a fiscal regime might become unsustainable either because of mere financial reasons35 or/and because of lack of “social legitimation” (Thomadakis & Seremetis (1992:206)). It might take the form of demands of vested interests or even the form of pessimistic expectations if the state loses its credibility as manager of public funds. For example, the chronic differential tax burden at the expense of salaries and pensioners as opposed to corporate business profits and properly income revealed the political/voting weight of the latter interest groups. Such differential tax treatment accommodated tax laxity and, in a sense, institutionalized tax evasion from income categories other than salaries or pensions such as rents, profits or self-employment incomes. This led to a fall in “tax morality” for all income categories as some groups found that tax evasion was indeed possible for them while others, being the permanent victims of the prevailing tax regime, sought every possible way to escape their fate (Thomadakis & Seremetis (1992:231-235)). On the other hand, on the expenditures side of the budget, the fact that the Greek state attributed to incomes‟ policy – and hence the transfer-payments component of its budget – a developmental role that it could not have (Thomadakis (1995:105)) along with its extensive use in a regressive manner for political-electoral reasons, undermined severely the credibility of the Greek state as a developmental state (Thomadakis (1995:110)). Despite that, Thomadakis (1993:367,370-371, 1995:119121) makes the point that the state has a role to play even in the new conditions of economic integration and increased capital mobility. This role must be attributed to 35
A rising deficit as proportion to GNP indicates a growing need for borrowing to finance it and a general diversion of resources and priorities that condition revenue collection and expenditure from public goods and services towards debt service. To the degree that future budget revenues are devoted at a growing proportion to service past debt obligations, new borrowing becomes more difficult as the creditworthiness of the state falls. (Thomadakis & Seremetis (1992:204-205,211,219-220)).
125 the importance of public investment for economic development, mainly through its effect on infrastructure and the subsequent favourable effects on private investment returns and volume, but also as a declared commitment of the state for long-term economic stability and growth creating an attractive environment for foreign capital investments36. However, this was not the case of the Greek experience during the 1980s and especially after 1984 as, in an environment of growing debt-service expenditures, public investment expenditure fell for the sake of increased transferred payments in the government budget indicating the substitution of income formation targeting some social groups in the form of pensions and social security contributions – or even investment incentives in the form of grants that are transformed to rentseeking income formation by particular groups (Thomadakis (1995:106,119)) – for capital formation that would have contributed to the structural change of the economy. The policy commitment towards developmental change degenerated to a policy of social subsidization (Thomadakis & Seremetis (1992:243,247,251-252)). On the other hand, both the defects of the credit policy followed and its underpinning financial structure were revealed (especially during the 70s and 80s) in two major problems stated by Halikias (1978): 1) The adverse effects of official interest rate policy on bank profitability that rendered qualitative and quantitative controls ineffective for both investment and monetary policy. The structure of interest rates – at least till 1966 when a system of banks‟ profits equalization from various types of loans was introduced – rendered long-term lending unprofitable for banks. In addition, banks were permitted to charge short-term loans with various fees in excess of the official interest rates thus increasing the effective return from these loans (Halikias (1978:52,168,185,187)). Furthermore, small-firms lending was effectively discouraged because of the high administration costs of such small amounts of loans, the lower official loan rates to handicrafts with respect to the manufacturing industry and lower creditworthiness of these firms (Halikias (1978:191-192)). Hence, the inconsistency of official interest rate policy with commercial banks‟ profit maximization gave a disincentive for banks to cooperate with the monetary authorities in the success of the preferential credit system. Qualitative credit controls concerning 36
Indeed, we can conjecture that public investment that increases aggregate productivity in the economy, also contributes to a regular repayment of public debt, less inflation and hence, increased macroeconomic stability. In addition, as Thomadakis (1993:371-372) indicates, the superiority of “investment discipline” versus “monetary discipline” to establish credibility and reputation is that the former, as opposed to the latter, rests on investment programmes that require continuity and cannot be reversed without a cost.
126 the allocation of credit to priority sectors failed because of the indirect financing of imports and trade as industrial enterprises transformed themselves to financiers of trade enterprises (Halikias (1978:232, 212)). In addition, qualitative and quantitative controls proved inefficient because of the excess liquidity of banks, their reluctance to cooperate with the authorities against their preference for short-term lending and the inadequate demand for long-term loans by industrial firms37. Consent of commercial banks with credit regulations would amount to maintaining excess idle funds and hence, to assume profits loss (Halikias (1978:220-221))38. Finally, the success of a system of extensive controls demands the operation of an effective mechanism of inspection of banking activities along with the uses of borrowed funds by their clients. However, such a detailed inspection mechanism is rather unlikely to operate efficiently in segregating “socially desirable” from “undesirable” lending (Halikias (1978:221-222)). 2) The ultimate failure of easy finance policy that leads to the overindebtness of firms, increasing risk, divergence of enterprises‟ earnings to unproductive activities such as real estate and less intention for reinvestment of retained earnings to more competitive productive structures. The favourable access of large industrial firms to bank finance along with their indirect financing of trade increased the indebtness of these firms along with the risks assumed both by these enterprises and their lending institutions. In addition, the Greek entrepreneurs were characterized by low propensity to save as they reinvested only a small proportion of their profits in the business. The most preferred placement for industrial profits was real estate that had the element of security – as opposed to the most risky industrial ventures – and also guaranteed high capital gains because of rising prices and the increasing volume of trading in the real estate market. For these reasons, industrial enterprises in Greece operated below the optimum size despite the intention of official financial policies to boost industrial investment (Halikias (1978: 195-204)). Courakis (1981) adds another adverse consequence of administered ratescredit controls system. This system is based on the calculation of apparent yields 39 of
37
Weak demand by firms to absorb the available funds for long-term fixed investment is attributed to the established oligopolistic “equilibria” in many industrial sectors along with the lack of entrepreneurship and skilled labour (Halikias (1978:215)). 38 In addition, as Kostis (1997:119, n.196:199-200) indicates, commercial banks faced in mid-1970s a policy of differential treatment on behalf of the Currency Committee that favoured the Bank of Greece and special credit institutions at the competitive disadvantage of commercial banks. 39 According to Courakis (1981), apparent yields on loans of any given type which abstract from default risk equal the ratio of the difference between the rate charged on the borrower minus the net
127 various categories of loans and disregards the actual expected returns and the costbenefits structure of banks‟ financing decisions. However, expected returns from loans might fall for given charged official rates as the default risk for every type of loan increases. In addition, ceilings on loan rates increase the emphasis given by banks on collateral requirements so as to limit their risk exposure and this discouragers small and new firms with limited collateral to undertake investment initiatives. More importantly, it discourages those firms that seek to pursue projects that are more risky but socially desirable to the degree that high collateral requirements renders such firms not eligible as prospective borrowers. Hence, government policy fails to favour exactly this kind of activity which its regulatory apparatus aimed at promoting. The picture is changing gradually from 1982 and especially from 1987 onwards when financial liberalization proper commenced also in the face of the 1992 milestone for European market integration (Karatzas Committee (1987:15)). The two major studies of the Greek Banking System, the Harissopoulos Committee (1979), and the Karatzas Committee (1987) reports indicate the policy change under the pressure of external factors mainly the developments because of the accession of Greece in the European Community in 1981 (Harissopoulos Committee (1979:1)). It is notable that the Harissopoulos Committee (1979:29-30) indicated that Greek economic development in the 60s and early 70s was not accompanied by an accommodating financial development so as for the anachronistic structure of the financial system to become an impediment to further growth. This structure would have come under greater pressure after the accession of Greece in the European Community and the related liberalization of the capital account and the harmonization of the Greek financial system with the European one. The proposals of the Harissopoulos Committee included: i) abolition of the diversification of lending rates according to loan types and gradual increase of both lending and deposit rates to market levels. In this context, abolition of indirect subsidization of manufacture, exports and agriculture through the interest rate policy. Subsidies should explicitly appear as entries in the government budget. ii) Abolition of the complex reserve-rebate system imposed on commercial banks. iii) Gradually, financing of budget deficits by resorting to money and capital markets. iv) Measures “contribution” or plus the net “subsidy” on this type of loan over one plus the corresponding reserve or minus the corresponding rebate ratio.
128 for the development of the money market, the foreign exchange market and the capital market.
v) Measures in order to curb oligopolistic conditions in banking. vi)
Liberalization of the funding sources for the special credit institutions including the issuing of their own securities. vii) Restructuring of the Postal Savings Bank, the Agricultural Bank and the National Mortgage Bank to face the new competitive environment. viii) Measures for the modernization of the three Development Banks. These included cutting administrative costs, a healthier portfolio and a greater role in the capital market for ETBA. Concerning the private banks, the Committee suggested the extension of their funding sources and the development of their lending activity to other sectors of the economy along with a more active role in the development of the capital market. (Harissopoulos Committee (1979:38-46)). On the other hand, the Karatzas Committee (1987) made suggestions for the reformation of the Greek financial system focusing on interest rates and credit rules, competition and bank portfolio management, bank accounts disclosure and supervision along with particular suggestions concerning agricultural credit, development banks and the capital market. i) Especially for the required changes concerning interest rates and credit rules, the Committee identifies three phases. The first phase should ensure the restoration of positive real deposit and lending rates along with the disentanglement of the credit system from the obligation to support social and development tasks, the latter being transferred to the government budget. The second phase should activate the market forces in the determination of deposit and lending rates except the long-term lending rates for handicraft and agriculture enterprises. Phase three should render the market the major determinant for interest rates and the allocation of resources with the abolition of various credit controls and compulsory reserves for industrial financing and the recourse of the government to the market in order to finance its deficit. It is in the sense of these phases, that both the Harissopoulos Committee (1979:38) and the Karatzas Committee (1987:11,25) stress the need for gradual liberalization in tandem with stabilization of the economy characterized by lower inflation rates and balance of payments deficits as necessary conditions for interest rates convergence at lower levels, and lower budget deficits that would contribute to the normal
functioning of money and capital markets
(Karatzas Committee (1987:25)) . ii) Competition in the Greek banking system ought to be fostered through the gradual increase in importance of the smaller banks rather than the curtailing of the power of the major banks. This is because a financial system
129 consisted of sizable institutions would have been in a better position to cope with international competition. In addition new innovative products such as leasing, credit factoring, forfeiting, venture capital services, loan securitization and syndicated loans techniques should be included in those offered by the banking system. In addition, portfolio management for commercial banks should distinguish between participation in companies that offer financial services – which should be further extended – and those in industrial and tourist companies. The latter should not exceed a certain limit and they should be handled by independent holding companies while participations that end up in more permanent relations between the banks and specific companies should be avoided (Karatzas Committee (1987:34-35,38-39)) iii) Adaption of uniform accounting principles and standards that would improve economic information disclosure for banks. In addition, a new supervisory system of banks by the Bank of Greece is proposed that includes the close monitoring of banks in terms of capital adequacy, liquidity and quality of assets (Karatzas Committee (1987:48-50)). iv) Suggestions for special credit institutions such as the Agricultural Bank of Greece and the three Development Banks. Concerning the latter, it is proposed that they should continue to offer financing for long-term investment projects but they should also extend their activities to include modern investment banking practices such as: participation in syndicated loans, underwriting of share and bond issues and participation in the restructuring of enterprises through mergers and acquisitions. Concerning the sources of their funds, the Committee proposed that Development Banks should have the right to accept time deposits and borrow directly from insurance companies and pension funds. They should ensure their access to the interbank, money and capital markets. They should also be allowed to extend loans for working capital on a more permanent basis and offer long-term financing to a wide range of activities including commerce, real estate and services. Finally, the gradual adaptation of Development Banks to a more liberalized environment called for the gradual abolition of the government subsidization of the banks‟ own bond issues (Karatzas Committee (1987:61-62)). v) The development of the capital market should be based on measures concerning both the supply and demand of securities and the organization of the Athens Stock Exchange. Financial instruments such as long-term government bonds, commercial paper, certificates of deposit, private bond issues underwritten by banks, long-term bond issues of banking institutions could increase the supply of alternative securities offered while measures concerning taxing
130 of interest income, institutional investors such as insurance companies and pension funds and foreign investors could boost demand (Karatzas Committee (1987:67-69)). Both studies indicate the crucial role of the Bank of Greece that should lead this operation freed from its obligation to monetize government deficits or to support the balance sheets of commercial banks (Harissopoulos Committee (1979:20-21,39), Karatzas Committee (1987:30)). The decision for financial liberalization came as an answer to both external and domestic factors. The major external constraints related to the European single market programme and the capital flow liberalization while the domestic determinant was the need for disinflation and the Bank of Greece determination towards this aim (Pagoulatos (2003:112-114). Besides, this was reflected in the Harissopoulos and Karatzas Committees‟ reports referred to above. Pagoulatos (2003:114, 159-160) stresses the “policy strength” of the Central Bank which is a feature different from its formal dependence on the government. Even if a Central Bank is institutionally dependent, it might have the control in policy areas where the government does not have the technical expertise to exert its influence (Pagoulatos (2003:120)). Hence, according to Pagoulatos (2003:160) the state-driven directed finance developmental process of the post-war period was followed by an equally government initiated financial liberalization process in which, on the one hand social groups pressures played a minor role and on the other hand, the contribution of the Bank of Greece was crucial. Specifically, the Central Bank had the capability in terms of its personnel, its own agenda of policy objectives that considered financial liberalization as necessary for effective monetary policy implementation towards disinflation, the determination and the ability to insulate policy from the demands of various groups pressures. In this context, the organizational weaknesses of different interest groups to express uniform demands along with the government‟s escape route to avoid pressures by invoking the external European factor or the Bank of Greece authority were crucial in the ultimate success of the financial liberalization policy (Pagoulatos (2003:159)). Furthermore, the outcome of financial liberalization was also a transformation of the state itself from a “developmental state” to a “stabilization state” in the sense of prioritizing macroeconomic stability over development so as for the former to be a pre-condition for the latter and not vice-versa, to the degree that the balance of power has turned against government intervention and in favour of globalized financial markets and institutional investors. (Pagoulatos (2003:203-205))
131 What the above analysis reveals is the central role of the type of financial development/underdevelopment
in
the
understanding
of
Greek
economic
development in the post-war years. It also indicates the crucial role of the two major players in this game: the state and commercial banks. It seems that the state took the initiative for economic and institutional development depending on the needs and the international environment that prevailed in each era. Hence, government intervention took the form of a financial regulation regime during the early 50s which was succeeded by a financial liberalization regime during the mid-80s. The problems of the former seemed to be the consistency by which the government was devoted to its task for economic and institutional development. They also had to do with the decisive role of the banking oligopolies of that era and the special relations they developed with their major clients again given the inability of the government to play a catalytic role in this nexus. What is left to consider is the role of specialized credit institutions and especially Development Banks in this process. These institutions, that were meant both to bridge the gap between affluent savings and investment demand as substitutes of capital market and to prepare the development of the latter, might have made the difference in the above political-economic nexus or, equally possible, might not have been able to overcome it.
2.5. Development Banks in Greece and Financial Sector Development
The history of development finance institutions in Greece commences practically with the establishment of EDFO (Economic Development Financing Organization) in 1954 on the basis of an agreement among the Greek government, the Bank of Greece and the US Operations Mission to Greece. EDFO pursued four main tasks: 1) to collect the credits extended by the American Mission for Aid (AMAG) and the Central Loan Committee (CLC) (1948-1954) immediately after the war for the reconstruction of the devastated economy, 2) to grant medium and long-term loans to specific sectors of the economy including industry, mines, navigation, agriculture, fisheries, transportation and tourism,3) to participate with preferred stocks in private and public enterprises and 4) to act as an intermediary between Greek firms and foreign suppliers of capital (Psilos (1964:221-222)). However, the pathology of the
132 preferential state – bank – particular families relationship revealed itself in EDFO‟s operation with the financing of high risk projects characterized by low efficiency guided by political rather than economic criteria (Psilos (1964:226-227))40. Furthermore, these loans were guaranteed by the two major commercial banks which acted as underwriters and distributors of them. However, high commission fees paid to the commercial banks further undermined EDFO‟s net income (Psilos (1964:228230), Psilos & Westebbe (1964))41. Finally, the contribution of EDFO to capital market development should be assessed negatively to the degree that it offered low cost lending to firms that would have otherwise sought funding through security issuing (Psilos (1964:230)). In 1960 another semi-public institution called Industrial Development Corporation (IDC) (1960-1964) was established with the participation of the Greek government, the National Bank of Greece, the Cosignation and Loan Fund, the Commercial Bank group and other small private investors. The aims of IDC included the establishment of private or public mining or industrial companies, the participation in existing companies in order to aid their modernization, the provision of technical and financial assistance to companies that contribute to industrial development and the training of technical personnel in order to promote the above objectives. However, IDC‟s operation was considered unsatisfactory as it had invested in only 13 small enterprises with a minor contribution in promoting economic development (Psilos (1964:231-232)). Halikias (1978:246) attributes the failure of IDC to actively involved in the risks of industrial investment to the fact that its board of directors consisted mainly of businessmen that did not believe in direct government involvement in industrial investment. Hence, IDC confined itself to the issuing of feasibility studies and information dissemination to domestic and foreign entrepreneurs for the conditions for investment in Greece. However, the main part of the history of Greek Development Banking started in the early 60s. However, it was marked even from its beginning by the confrontation between the Bank of Greece (as a government agency) and the commercial banking 40
Halikias (1978:244-245) has a different opinion on EDFO lending, stating that its lending activity was conservative with the aim to minimizing risks. However, both Psilos (1964) and Halikias (1978) refer to the same fact, that of financing already-existing large firms. Psilos (1964) regards this as a risky policy to the degree that lending was inadequately diversified to few large enterprises while Halikias (1978) stresses the reluctance to lend in new medium-sized enterprises as an element of conservatism. 41 Halikias (1978:245) has also a different view on the relation between EDFO and the commercial banks by indicating that EDFO competed with commercial banks for customers instead of acting supplementary to them in financing activities that carried risks that these banks could not assume.
133 duopoly. On the one hand, the initiative on behalf of the National Bank of Greece and the Commercial Bank of Greece, each one of them to launch its own development bank was met with discontent by the Bank of Greece that favoured their cooperation in the establishment of a powerful joint institution (Kostis (1997:n.152:193). On the other hand, the development bank that was under the direct control of the government, ETBA, was established in the midst of commercial banks reactions that claimed the control of long-term financing for themselves (Kostis (1997:99)). Nevertheless, according to Xanthakis (1995:177-178) the three Greek Development Banks, ETBA, ETEBA and Investment Bank, that were established during the period 1962-64 had as major objectives the facilitation of industrial development, the appraisal and support of investment and the development of the capital market. Development Banks obtained funds mainly by the Bank of Greece, their mother-commercial banks, the Postal-Savings Office and some external sources especially the World Bank and the European Investment Bank. In addition, foreign investors participated in the share capital of ETEBA and Investment Bank for a significant period of their operation42. After 1975, when the law allowed Development Banks to issue their own bonds, their financing from this source increased gradually. In mid-1980s bond issues constituted 64% of ETBA financing sources, while the corresponding percentages for ETEBA and Investment Bank were 69% and 42% respectively (Karatzas Committee (1987:59)). By the early 1990s over 90% of their funds were covered by bonds issuing and foreign borrowing. These developments increased the degree of their independence from government financing. Concerning the financing of economic activity there was a differentiation between the state-owned ETBA on the one hand, and ETEBA and Investment Bank that were controlled by commercial banks on the other. The first one financed mainly projects favoured or sponsored by the government thus placing greater emphasis on the social returns of these projects rather than their pure financial ones (Xanthakis (1995:179)). The case was different for the other two banks and especially for ETEBA which sought a balance between social and financial returns43. Of course ETEBA was effectively under the control of the state after June 1985 when foreign shareholders sold their shares to its state-controlled mother bank, the National Bank of Greece. In addition, the Commercial Bank Group that included Investment Bank came under public control after the restoration of 42 43
See below for the withdrawal of foreign shareholders (p. 132 of this text). See Section 5.1 of this paper on the history of ETEBA.
134 democracy in 1975 (Kostis (1997:118)). Nevertheless, none of them was a direct government agency as was ETBA. Furthermore, we presume that the participation of foreign shareholders for a significant period in their life and the “banking culture” that they inherited from their mother-institutions should have played a significant role in adapting private economic criteria of operation in contrast to ETBA. This is probably the reason why Xanthakis (1995:179) calls ETEBA and Investment Bank private development banks. We will adapt this characterization for ETEBA and Investment Bank for the rest of the paper. Be that as it may, ETBA developed a substantial activity in long-term financing amounting for about 64-70% of the total for all Development Banks. On the other hand, Development Banks and commercial banks found themselves competing each other in long-term financing as the latter were obliged by the Monetary Authorities to devote 15% of their funds to fix investment financing (Karatzas Committee (1987:60)). Furthermore, all three banks played a notable role in the development of the capital market by underwriting securities, offering their own portfolio of shares and their own securities for trading, establishing holding companies and offering fund management and advising services in mergers and takeovers (Xanthakis (1995:179-180)). However, their financial position deteriorated especially after 1983. Possible causes, according to Xanthakis (1995:180), can be found in the high cost of their financing especially after the abolition of the subsidization of their bond issues and their losses from loans extended to enterprises that turned to be problematic during the 1980s. In addition, the liberalization of the Greek financial system placed them at a competitive disadvantage with respect to commercial banks that enjoyed a lower cost of capital (Xanthakis (1995:207)). As we shall see in the following sections of this paper, Development Banks attempted to solve these problems by extending their activity to short-term and fee-income operations at the expense of long-term financing thus being transformed gradually to merchant banks. The Karatzas Committee (1987:60) gives an account of the operation of the three banks which can be considered positive on various grounds: 1) Development banks promoted economic development by extending long-term financing for manufacture, tourism and shipping thus promoting import-substitution and export growth. 2) They also aided capital market development through the establishment of mutual funds, portfolio companies and the management of their own portfolio of securities. 3) They helped in business development and management techniques
135 through the supply of equity capital, their participation in boards of directors of specific companies and their consulting services and also through the establishment of scientific methods of project appraisal and various studies on certain sectors of the Greek economy. On the other hand, Halikias (1978:246-247) makes a negative assessment of government development banking institutions such as EDFO, IDC and of course ETBA to the degree that they acted competitively rather than supplementary to the commercial banks concerning long-term financing. Their contribution to the supply of venture capital is minimal while their provision of loans mainly to large existing oligopolies hindered the development of competition in manufacture. Even their functions concerning the evaluation and implementation of projects are not considered satisfactory or their stance and operation more helpful to industrial development than that of commercial banks. Finally, in many cases, the vulnerability of their decisions to external political pressures should be considered a minus for their contribution in economic development. The general picture that we obtain from the above analysis is: i) the possibly positive role of Development Banks in financial development in Greece both indirectly through their lending activity and promotion of economic development and directly through specific measures. ii) The crucial role of the state in this contribution of Development Banks which can be separated into two phases: a first supportive one during financial repression years and a second negative one during the deregulation years. This observation makes the operation of Development Banks subject not only to criteria such as management quality of pure economic efficiency but also on the constraints imposed on them by the government and the pursued economic policy in each case. In this context, Psalidopoulos‟s (1990:20,75) remark concerning the consistency of the implemented economic policy in Greece with dominating economic doctrines makes us wonder about the identification of each period with a consistent programme of financial repression or liberalization as a means to promoting economic development or as a means to obtaining short-term political goals. This can be seen in the Greek case either as a degeneration of financial repression policies to policies aiming at financing short-sighted government consumption – instead for long-term government investment – or in the case of financial liberalization as a means to defending ideological prejudices in favour of free markets when the international environment favours them at the expense of long-
136 term planning of structural adjustments that would not downgrade economic development as a policy goal. In any case, if the above results hold then, the above historical-political economy context of the operation of Development Banks could be seen, we argue, as the canvas on which financial sector development in Greece depicts itself. The ups and downs in the financial characteristics of the Banks should indicate their great dependence on the existing financial regime and on government policy priorities. The structural brake after 1982 but especially after 1986-87 in financial policies should be reflected predominantly in Development Banks financial statements as the micropictures of the Greek financial sector development. The birth and operation of the Banks during the 1960s and 1970s and their changing nature during the 1980s and 1990s should be closely related to the incentives given in each period by the government and the existing institutional structure. Then, the institutional transformation of the Greek financial system as reflected in the related transformation of the nature of Development Banks can be established using as a theoretical tool the political-economy model described in Section 2 and the empirical data of Development Banks‟ financial statements. This endeavour is the subject of the remaining part of the paper.
2.5.1. ETEBA
2.5.1.1 The years of Economic Growth 1963 - 1973 ETEBA was established on 13th November 1963 by the National Bank of Greece and a number of foreign shareholders. The latter included Chase International Investment Corporation, Manufacturers Hanover International Banking Co., Hambros Bank Ltd, Deutsche Bank AG, Banca di Credito Finanziario (Mediobanca) S.p.A., Crédit Lyonnais, Banque Nationale pour le Commerce et l‟Industrie, Crédit Commerial de France, Banque Lambert and Compagnie Financière et Industrielle Confinindus SA. In 1965, ETEBA‟s capital increased and four new foreign shareholders were added to the old ones: Crédit Suisse, International Finance Corporation, Nordfinantz-Bank Zurich and Svenska Handelsbanken.
137 ETEBA indicated the scope of its affairs to include both the long term financing of the Greek industry – in a role complementary to that played by the existing commercial banks – and the development of the capital market in the Greek economy. In addition, the Bank aimed at playing a distinctive role to the modernization of the Greek industry by financing joint ventures by Greek and foreign firms that would mean transfer of know-how and modern management. Furthermore, concerning the financing sources of the Bank itself and its activities, the possibility of accepting time deposits and of extending its operation to fee-income banking activities were also included in its Charter. However, the Bank indicated in its Annual Report of 1964 as a major problem that it encountered, the non-existent framework for the operation of Investment Banks in Greece. In addition it conditioned its operation on the pressing needs of the Greek economy during that era. As the Bank mentions, the situation of the economy and especially of manufacturing in 1964 was characterized by significant structural and quantitative changes that can be traced back to the post war period. There was a wide spread transition from large handicraft to small and middle industrial units in the context of an increased growth of production. However, the industrial units were mainly labourintensive and focused on consumption goods production. The inadequacy of own capital funds for investment in capital equipment reflected their low productivity. On the other hand, the small size of the market and the existence of protective tariffs contributed both to the low competitiveness of the industry and the small size of its units. Finally, these industrial units were both least specialized and concentrated around Athens and Piraeus because of the proximity of the labour market in this area and the inadequate infrastructure and transportation facilities away from Attica. On the other hand, there was a tendency to overcome these problems as the increased demand for mechanization of production and the rising capital/labour ratio indicates. However, the lack of specialized workers and the family and individual owner structure of Greek enterprises was an additional institutional impediment for both the increasing size of industry and the need for enhanced productivity by incorporating new technology. Furthermore, the need for modern management techniques and professional technical and administrative staff was deemed crucial for the development of the Greek industry. Another problem was the underdevelopment of the Stock Exchange that did not permit it to play a role in funding investment while the attraction of foreign capital
138 in the form of direct investment was deemed necessary. Besides, encouragement of equity investment in industry would also have an institutional gain for the Greek economy as far as it would activate the capital market. The double problem of Greek firms was the inadequacy of retained earnings to finance new ventures and the use of short-term bank borrowing to cover long-term capital requirements. It is notable that ETEBA pointed out these problems even on the first year of its operation and proposed measures for their alleviation. At first, it indicated that the establishment of Development Banks would create a healthier environment in the Greek Banking system by distinguishing the role of traditional commercial banks from that of institutions that have as their special purpose to finance long term investment. However, it also considered its operation as a private DFC along with the public Hellenic Bank for Industrial Development (ETBA) as an active institution not only for financing purposes but also for institutional proposals. Hence, it envisaged the need for a future development of the capital market in Greece, the establishment of new forms of financing of industry as equity participations, and the restoration of a rational relationship between short-term and long-term interest rates. Especially, concerning the capital market, ETEBA aimed at its development by underwriting and distributing issues of shares and bonds and by placing in the market its own investments in securities when the respective firms have reached a level of maturity. This means, that the Bank had a market orientation on its decision making concerning its loan activity especially that backed up by equity participations. In this respect, we can see the interrelation between the issue of industrial development and that of financial development in the thinking of the Bank as early as 1964. During the period from 1962 to 1974 the role of the capital market remained limited while firms borrowed their funds mainly by banks. There was also a significant role of foreign capital either in direct investments especially in industries concerning energy, or as a supplement to local savings and to the import of advanced technology. ETEBA during these years played an active role to the development process not only by extending loans but also by participating in the share capital of firms seeking financing. In this way it succeeded a “fair bargain” with entrepreneurs, as the latter obtained finance at lower interest rates against the participation of the Bank to the potential profits. It also extended loans in foreign exchange guaranteed by the government – mainly coming from the International Bank for Reconstruction and Development and the European Investment Bank – along with transferring the foreign
139 exchange risk to its clients. In general, the forms of financing extending to its clients that the Bank used were the following: i) loans that included payment of interest plus the participation in profits. ii) Participation in share capital without voting rights up to a specific period, converted to ordinary shares or repurchased by the existing shareholders. iii) Loans convertible to shares. iv) Acceleration of the repayment of the loan if the cash generation of the borrower exceeded a specific level. v) Long-term loans with foreign exchange clause. Furthermore, the Bank proposed a number of measures that should be taken in order to facilitate capital market development. These included: tax-exemption of dividend revenue under given conditions, extension of tax-exemption of capital gains also to banks and insurance companies, tax-exemption in firms‟ capitalizing their revenues, reduction of charges and transaction costs of capital market operations, establishment of investment companies and of a Capital Market Committee along with a uniform accounting system (Annual Report 1965). The domestic financing of the Bank was made mainly by loans extended by the Central Bank of Greece and the National Bank of Greece. The Bank played also an active role in facilitating mergers, especially in the metal industry, so as to increase the size and competitiveness of industrial units, while following a policy of decentralization of industrial activity by financing the set up of factories in the new industrial zones outside Attica. It is notable that as early as 1966, the Bank tried to diversify its loans by financing a variety of sectors such as chemicals, paper, building materials, metal, textile, food and even tourism enterprises. Furthermore, it did not abandon the goal for an active role in developing the capital market. In this respect, it held a growing portfolio of bonds and shares with the intention of their future channeling to the Stock Exchange. This eventually happened in 1971. Furthermore, concerning the legislation matters, it prepared drafts for the establishment of closed and open end investment companies in order to give an opportunity to the small investor, pension funds and Greeks of diaspora to place their savings with the minimum risk and generally to contribute to the capital market development. The rationale, as expressed by the Bank (Annual Report 1968) was that the acquisition of shares of firms by investment companies would increase the confidence sentiment of the public and would stabilize price fluctuations in the Stock Exchange. These companies would also be a new source of funds directed to the industry in the form of equity capital. In this respect, it established the Diethniki management company and the Delos Mutual Fund in 1972 that entered the market
140 early in 1973. Also it floated its own preferred non-voting shares (one-third of its total share capital) on the Stock Market in the same year in an attempt to obtain additional share capital by exploiting the savings of the general public. Concerning this endeavour to attract local savings ETEBA indicated (Annual Report 1972) that for its entrance in the capital market to be successful the Bank should have maintained a reasonable profitability ratio along with a balanced debt/equity ratio. An important point is that even from 1967 the ETEBA recognized the need for a special technical and management support of Greek firms and hence, it cooperated with the international consulting firm Arthur D. Little in establishing the Arthur D. Little Hellas SA. This became in 1969 the joint-stock company Arthur D. LittleHellas Consultants SA with the participation of both Arthur D. Little and ETEBA.
2.5.1.2. The Period of Crisis and Stagnation 1974 – 1987 Despite the quantitatively astonishing results of the Greek industry in the previous period, its development was based on a rather short-sighted model with weaknesses being revealed in its technological and organizational structure. These shortcomings became more evident when the economy faced the great oil shocks of 1973 and 1978-1979 along with the stagflation period that followed. The industry had to cope with the increased demand of workers to participate in the division of the GDP – especially after the dictatorship years – the increased international instability, both in terms of demand and in exchange rate fluctuations, and the need for controlled prices because of the rising inflation that confined their profitability and competence to self-finance their operations. The immediate result of all these was the emergence of firms that had economic viability problems, the so-called “provlimatikes”. Investment rates were falling especially because of the inability of Greek firms to respond to the changing international environment, while prices and unemployment increased. It is notable that a large part of financing which extended during this period had to do mainly with the modernization of existing capital equipment rather than with new productive plants. Another important sum of funds was extended, especially from 1984 onwards, for the reconstruction of “provlimatikes” through the relevant organization established by the state, the “OAE” (Organization for Business
141 Restructuring). Hence, a usual practice during this period was the rescheduling of firms‟ debt to the bank along with their reorganization so as to render them viable. Such measures included the conversion of a part of the outstanding unserviced debt to share participation of the Bank in the relevant firms and the extension of new loans along with management and structural reorganization. Generally, the Bank participated in three kinds of firms: i) firms in the financial sector that complemented its activities. Such firms were the Bank of Macedonia and Thrace, the insurance company “Insurance ETEBA”, the FrancoGreek Bank of International Trade and Navigation, the ΔΓΔΦ – a firm for international portfolio investments. ii) Firms that promoted the development aims of the Bank such as the ΔΛΔΜΒΔ – a firm that would undertake big development projects in the chemicals and metal sector – the exporting firm HEDCO, the MEBIOP SA. iii) Firms called “provlimatikes” in order to help them on the course of their restructuring. Despite the adverse environment in the real economy the Bank did not abandon its developmental role. In this context, ETEBA recognized the importance, not only of the financial viability of the projects it financed, but also of their economic rate of return concerning the development of the entire economy. Hence, from 1974 onwards, it initiated the assessment of these projects concerning their contribution to a number of indicators such as: technological improvements, additional exports, imports substitution, creation of new jobs, strengthening of provincial industry, and effect on agricultural incomes (Annual Report 1974). In addition, the Bank undertook a number of case development studies that included: i)
the possibility of the
establishment of a petrochemical industry in Greece. ii) The study for tourism development in the Mediterranean countries. iii) The implications of the accession of Greece in the EEC (in cooperation with ETBA and IOBE). iv) The possibility of exports in the Middle East and for Greece to become the trade link between Europe and that part of the world. v) A study for the exploitation of quartz mineral deposits in northern Greece and the production of oil coke. vi) Case study for the initiation in the Greek market of the form of leasing and the institution of Mutual funds based on real estate (Amoibaia Ktimatika Meridia). vii) Studies concerning the exploitation of lignite as a substitute of oil and the recycling of by-products of aluminum and tires industries. Furthermore, ETEBA took on initiatives in the support of problematic firms by approving loans on the modernization of their capital equipment and rescheduling
142 outstanding debts of firms that were deemed to be financially viable. In addition, the Bank proposed and implemented policies such as conversion of part of outstanding loans to share participation and new loans subject to organizational restructuring of the borrowers (Annual Reports 1983, 1984). During this period, the Bank extended its sources of external funds by including to its suppliers of loans the German Kreditanstalt für Wiederaufbau and the US Bank of Exports-Imports. Furthermore, the Greek Post Savings institution was added to its domestic lenders. It also floated in 1976 its first bond issue to the public which would be a major source of finance for the Bank‟s activities during the following years. An important point to make is that ETEBA found that its profits coming from its long term loans were diminishing during this period while those coming from the management of its portfolio started to play an increasing role in sustaining its profitability. Hence, it is not surprising, that even in 1978 the Bank complained about the policy of below market rates on long term loans that could not be matched by the increased cost of borrowed funds. It was considered that government subsidies on interest rates were not sufficient to alleviate the problem that was aggravated by the depressed economic activity (Annual Report 1978). Hence, the Bank supported a more liberalized financial system as early as in 1979, in the relevant Annual Report, in the face of the accession of the country as a full member in the EEC. The Bank‟s demands echoed the international discussion on the financial repression model and its adverse effects both on the viability of the financial system and the efficiency of investments. On the same footing, and because of the depressed activity in industry, the Bank sought to extend its loans to a wider range of activities such as navigation, commerce and construction.
2.5.1.3. The Transformation into a Merchant Bank 1987 – 2001 However, the financial system in Greece entered a period of liberalization only after 1987 with the publication of the relevant resolutions of the Bank of Greece that concerned: i) the liberalization of interest rates for loans extended to industry for fixed assets, ii) the ability of DFCs to determine freely the interest rate and the terms under which they would issue their bonds. Although the preservation of certain restrictions
143 on the kinds of loans extended by banks was not conducive to a complete liberalization of interest rates, the above resolutions initiated a new era in the relations between financial institutions and firms that would be apparent in the changing nature of ETEBA during the last 13 years of its life. From 1986 onwards the Greek government maintained a stabilization program aiming at the reduction of the inflation rate, the diminution of public debt and the confinement of public expenditure along with the entailing crowding effects of its financing that kept interest rates at high levels. These endeavours were accompanied by the resolutions of the Central Bank concerning the liberalization of the financial system. In this new environment, ETEBA sought its new role in the context of an internationally integrated financial system with falling barriers to capital movements across countries and market determined interest rates. Hence, in 1989 (Annual Report 1989) the Bank declared its intention to transform itself from a traditional Development Bank into an Investment Bank. Now its operation involved activities such as underwriting of new share and bond floats to the Stock Exchange, consulting concerning mergers, acquisitions and international entrepreneurial cooperation, consulting in institutional investors for portfolio management, creation of special mutual funds and establishment of venture capitals. On the same footing, the Bank decreased gradually the proportion of long-term loans in favour of participation in share capital of the firms seeking finance from it. It is characteristic that although in the previous period long term loans comprised about 90% - 95% of total approvals, in 1990 they comprised only 47% of them. On the other hand, share participation increased from a low 5% - 10% to the substantial 53% of total approvals (Annual Report 1990). Hence, the Bank changed the form of long-term finance of firms. An even more important development was the ability of the Bank to offer short-term loans from 1991 onwards. The importance of this change was that shortterm loans were extended not to finance investment in capital equipment but working capital. Maybe this was the crucial feature that changed the whole character of the bank shifting it away from the traditional DFC model. This is apparent from the evolution of the ETEBA financing activity where approvals for long-term loans exhibited a sharp decline reaching 37% of total loans in 1992 compared to 65% in 1991 (Annual Report 1992). On the other hand, short-term loans reached the high level of 63% as opposed to 35% of total loans in 1991. For example, open accounts
144 increased only within one year by about 288% in current prices. In this context the Bank rearranged its policy concerning share participation in enterprises. The previous interest on maintaining the viability of “provlimatikes” was now abolished. ETEBA liquidated shares of firms when there was an opportunity to obtain profit from this operation and did not participate from 1992 onwards to any firm that was not listed on the Stock Exchange. This was a prudent financial decision not only because it could enhance the credibility of its portfolio but also because it made it possible for the Bank to assess readily a firm‟s value according to the price fluctuation of these shares on the Stock Exchange. As far as ETEBA was a private Development Bank, it was interested in its profitability along with its social role concerning the financing of industrial investment. However, the Bank could not play its social role in the first place without the aid of the State. Since, in the new financial environment interest rates were liberalized and since the State stopped subsidizing bank bonds and even taxed them from 1993 onwards, the Bank could no longer play its role in long term financing. It is worth noticing, that ETEBA tried to maintain a balance between foreign and domestic borrowing so as not to be extremely exposed into foreign exchange risk. It also tried to be self-financed by the regular floating of its bonds. But these sources of finance became extremely difficult after 1993 under the competition of government bonds and Treasury Bills that remained untaxed. Hence, ETEBA confined its long-term loans only to those that were directly financed by the European Investment Bank. The result was a very low proportion of long term loans relative to the total – about 18% – comparing it to 82% of short-term ones (Annual Report 1993). The transformation of ETEBA to a semi-commercial bank with special investment activities was further facilitated by the 554/3/1995 Resolution of the Committee for Monetary and Credit Issues of the Bank of Greece that allowed ETEBA to: i) accept all kinds of deposits, ii) extend credit for working capital to all kinds of enterprises, iii) raise capital from the interbank market (Annual Report 1994). This resolution gave the Bank the opportunity to decrease its dependence on bond financing that had become rather expensive and increase its liabilities in deposits. On the asset side of the Bank‟s balance sheet, the new era was characterized by increasing activity in consulting, mergers/acquisitions, portfolio management. In this context, two major highlights were investment banking activity in countries of Northeastern Europe and its participation in the privatization program of the Greek
145 Government for the Public Enterprises the so called DEKO. The Bank extended its operation in countries such as Bulgaria, Romania, Cyprus, Egypt, Albania and Yugoslavia. Especially in Bulgaria and Romania it established two investment companies the ETEBA Bulgaria AD and the ETEBA Romania SA respectively. Concerning its consulting activities to the Greek Government, it participated as underwriter to the share floating of OTE, EYDAP, DEH, ΔΥΑΘ, ΟΠΑΠ etc. In addition it established two offshore venture capital companies the ETEBA Greek Fund and ETEBA Balkan Fund later renamed as NBG Greek Fund and NBG Balkan Fund. The Bank extended its consulting services in project financing concerning the major projects of the Greek government such as the new Airport, the Rio-Antirio bridge, the Ymitos Avenue etc. It also became investment advisor of pension funds such as ΤΔΑΓΥ and ΤΑΑΣ. The general characteristic of this later period in the history of ETEBA was the changing focus of the Bank operation from loan financing to various investment banking activity including an active management of its portfolio during the Stock Exchange boom in 1999. The cost for this transformation of the bank was the diminution of its net profits before tax (in current prices) by 26% in 2000 and 3% in 2001 (Annual Reports 2000, 2001). The great exposure of ETEBA in Stock Exchange activity, reflected in its income from both dividends and capital gains/losses from trading securities made its financial results dependent on the negative course of the Stock Exchange index during the last two years of the life of the Bank 2000 and 2001. ETEBA was absorbed by the National Bank of Greece at the end of 2002.
2.5.2 Investment Bank
2.5.2.1. The Period of Expectations: 1962 – 1975 Investment Bank was established in December 1962 with major shareholders the Commercial Bank of Greece and the Ionian and Popular Bank of Greece. However, during the period under examination, a host of other institutions also participated in the capital of the Bank. These included the Bank of America and Barclays Bank International Ltd. Minor shareholdings with participation ranging from 1.57% to 0.07% were possessed by the Commercial Bank of the Near East Ltd.,
146 Banque Nationale de Paris, Algemene Bank Nederland N.V., Banca Nazionale del Lavoro, Dresdner Bank AG, Société Générale pour Favoriser le Développement du Commerce et de l‟Industrie en France SA, G. & C. Kreglinger SA, Banque de l‟Union Européenne, Samuel Montagu & Co Ltd, the “Phoenix” Greek General Insurance Co SA, the “Ionian” Insurance Co SA and General Insurance of Greece Co Ltd. The purpose of the establishment of the Bank, was to provide long-term loans in firms engaged in industry, tourism and shipping and supporting these enterprises in managerial and technical aspects. In addition, the possibility of joint-ventures between Greek and foreign firms was also included in the purposes of the institution. The Bank provided loans both for the modernization and expansion of existing firms and for the establishment of new ones with particular development significance for the Greek economy. The main form of financing was long-term loans. However, in addition to them, short-term loans to cover particular working capital requirements could accompany the long term development loans. In some cases, the Bank participated in the equity capital of funded firms as an alternative form of financing. Furthermore, it included in its scope of operations activities that would promote capital market development such as promotion and underwriting of new issues of shares and bonds for both public and private firms in the open market. The main sources of funds for the first period of the operation of the Investment Bank were, apart from its equity capital, facilities from the Commercial Bank of Greece, the Ionian and Popular Bank of Greece and the Bank of Greece. However, the Bank was considering the possibility of issuing a domestic debenture loan of the order of 100 million Drs. as early as 1968 in order to diversify its sources of funds. This loan was finally issued in July 1969 as a ten-year debenture loan and was considered by the Investment Bank both as an additional form of its financing and as an activity that helped the development of the capital market. In addition, Investment Bank obtained three loans from foreign sources. The first and second ones were loans of 5 million Dollars each, granted in 1968 and 1971 respectively by the foreign institutions that participated in the capital of the Bank, namely the Bank of America, the Commercial Bank of the Near East Ltd., Banque Nationale de Paris, Algemene Bank Nederland N.V., Banca Nazionale del Lavoro, Dresdner Bank AG, Société Générale SA, Banque de l‟Union Européenne and Banque de Bruxelles. The third loan, also of 5 million Dollars was extended to the Bank in 1971 by the National
147 Bank of North America. However, the shortcoming of the above foreign borrowing was the exposure of the Bank to exchange rate fluctuations after 1971. On the other hand, the management of the Bank, as early as 1963, expressed in the relevant Annual Report its reservations for the efficiency of the prevailing financial structure of the economy and the predominance of the Monetary Committee with its restrictions on the operation of banks in general and investment banks in particular. Investment Bank disagreed with “economic planning in the financing field of the economy” and believed that the reasons of restrictive monetary policy that prevailed in the 1950s were now missing and hence, quantitative and qualitative credit controls inhibited rather than helped the economic development of the country. Furthermore, such policies depressed the profitable prospects of banking institutions and their ability to use their funds in more efficient ways. These observations echoed the continued interest of the Bank to measures that would revive the capital market so as to form an environment conducive to operations such as equity participation in funded enterprises and the issuing of shares and bonds by both firms and the Bank itself. The poor performance of the capital market in Greece was attributed by the Bank (Annual Report 1967) to the small size of the producing units, the inadequacy of the corporate law, the absence of effective tax incentives and the lack of available institutional means to attract savings in productive investments. However, the Bank did not seem to take any particular initiative towards alleviating these obstacles except some recommendations to the government to facilitate foreign purchases of securities in the Greek capital market and to enact the appropriate legislative measures for the operation of financial corporations (for example unit trusts) (Annual Report 1964). However, an important initiative of the Bank concerning the institutional development of the Greek financial system was the foundation on April 2nd 1972 of the first Mutual Fund Management Company in Greece, named Hellenic Mutual Fund Management Company. This was done in association with Barclays Bank International and Merrill Lynch and should be credited to the Investment Bank as an important institutional step to the development of the financial system. The idea was to increase the number and range of listings in the Athens Stock Exchange by investing part of the portfolio of the Fund in unlisted shares which would be subsequently introduced to the stock exchange by the Mutual Fund. The second aim of the establishment of the Fund was to attract savings from small investors throughout the country. Another innovation of the Bank was the opening of a special office for dealings in unquoted shares in 1973.
148 The aim was to establish a parallel market so as to serve as a clearing-house for those holding such shares. Finally, in 1974 Investment Bank entered the share underwriting business by underwriting the first public share issue of Radio-Athinai SA in association with the Hellenic Mutual Fund Management Company. The financing activity of the Bank in the form of loans was continuously growing during this first period of operation. Sectors to which funds were provided included engineering industry, electrical appliances, construction materials, automobile components, paper and printing products, fertilizers, pharmaceuticals, plastics and canning, cotton textiles and silk industries, tobacco industries and oil. Furthermore, sectors such as shipping and tourism – especially hotel enterprises – were also granted loans. The Bank preferred to extend loans of small and medium size so as to minimize the related risks of repayment and default by the borrowers. In addition, it followed some stringent criteria of selecting prospective clients such as the ability of the borrower to service the loan, the ability and experience of management, the financial and technical planning of the project. Concerning the economic returns of the project, an additional criterion was its contribution to the Greek economy in the form of employment and export amelioration. The final requirement that the Bank demanded to be fulfilled by its borrowers in order to finance a project was their own financial participation in it by at least 30% of the total cost. Furthermore, loans granted were secured through appropriate real estate collateral or guarantees offered by third parties. Hence, the Bank did not suffer losses from defaulting borrowers during this period as reported in the Follow-up Report of 1975. In short, Investment Bank granted 659 loans during the period 1963 – 1975 amounting to 4350 million Drs. Of this amount, 691 million Drs were repaid while 678 million were not yet drawn and 2981 million were outstanding by mid-1975. Loans granted increased by 482.89 % during the first two years and by 541.73% between 1965 – 1970. The related figure for the period 1970 – 1973 was 183.36%. In addition to extending long-term loans, the Bank participated in the equity capital of various industries as an alternative form of financing. Its portfolio, by the end of 1974, included firms such as Eleusis Shipyards SA, Greek Industry for Sacks & Plastic Products Ltd, Hellenic General Enterprises Co SA, Phosphoric Fertilizers Industry Ltd and others. Besides, in 1974, the Bank sponsored a joint venture with Del Monte Corporation and the IFC for the establishment of a canned food industry in Greece named Hellenic Food Industries SA. This was the first successful activity of
149 the Bank in the field of international joint ventures in an attempt to attract foreign investment capital in Greece. In addition, it participated in a joint venture with Crown Paints (Hellas) SA, a subsidiary of Reed International Ltd for the erection of a paint factory in Greece.
2.5.2.2. Investment Bank 1975 – 1985: Crisis and Reorganization
The second period of the operation of Investment Bank was marked by the adverse developments in the real economy due to the two oil shocks of the 1970s and the growing proportion of problematic enterprises in the Greek economy during the 1980s. It is notable that loan repayments in arrears concerning industrial loans as a percentage of total repayments in arrears amounted to 36.7% in 1976, 38.3% in 1977 and 51.8% in 1978 (Annual Report 1978) thus, exhibiting a persistence increase. These percentages fell between 1979 and 1981 from 47.8% to 38.6% but remained substantial and increased subsequently till the mid-1980s indicating the enduring problem of financial viability that the borrowers of the Bank faced. In general, the financing activity of Investment Bank was adversely affected by the conditions of stagflation in the economy that hit especially major companies that were affiliated with the Bank such as the Eleusis Shipyards. Furthermore, the Bank remarked in late 1970s the distorted development of the Greek industry during the previous years concerning their low rate of return along with their high entrepreneurial risk as compared to other economic activities such as real estate, construction and import trade. These shortcomings, according to the Bank‟s view, along with the increased international competitive environment and the diminishing expectations of entrepreneurs called for a reorganization of industrial policy. Otherwise, the effects would be negative both for the Greek economy and Bank‟s clients on the one hand, and the Bank‟s performance on the other (Annual Report 1978). These developments led the Bank to mention in 1981 the significant decline in its business along with an increase in bad loans that affected negatively the quality of its portfolio. They also compelled the Bank to regard its transformation into a merchant bank or banque d‟ affaires (Annual Report 1981) as necessary in order to overcome the double problem of unprofitable long-term financing and the increased cost of borrowed funds.
150 Concerning the financial cost of operation of Investment Bank, the latter observed that its profit margin diminished from 2.65% in 1979 to 2.01% in 1980 (Annual Report 1979). The problem was attributed by the Bank to the existing financial system of quantitative and qualitative controls of credit along with the policy of administratively set interest rates. From this respect, the difficulty to obtain funds at the domestic market at reasonable rates was deemed crucial for the financial viability of Investment Bank. On the other hand, the Bank managed to obtain two loans from the European Investment Bank in October 1981 and April 1982 at the amount of 620 million Drs. each. Its borrowing from the European Investment Bank continued during this period comprising additional loans in 1983 and 1984 of 1 million and 1.5 million Drs. respectively. Besides, in an attempt to diversify its domestic sources of funds the Bank floated in 1981 a bond issue of the amount of 500 million Drs. while it obtained a long-term loan from the Postal Savings. Despite the relative stagnation of its financing activity, the Bank undertook initiatives in other banking activities which had a particular institutional importance for financial development. Hence, in 1979, Investment Bank organized the first syndicated loan in Drs. at the amount of 700 million Drs. extended to Halkis Cement company. Two further loans of this kind, extended to Aspropyrgos Refineries and Achaia Paper Company, they were organized in 1982. Furthermore, the Bank, in association with US Leasing International, Barclays Bank and Banque Nationale de Paris proceeded to the establishment of a leasing company in order to accommodate the demand for capital equipment through this new form of financing. As early as of 1980 the Bank orientated its activity to merchant banking operations such as brokerage in the domestic interbank market while in 1981 it considered the possibility to extend its operation to activities such as medium-term financing of exports through factoring, mergers and acquisitions, consulting services to firms and public organizations. In general, the Bank entered a reorganization phase during the 1980s concerning not only the orientation of its activities but also its internal organization such as the modernization of its functioning in terms of internal management of operation and the recruitment of specialized personnel. Furthermore, it attempted to differentiate its revenue sources by introducing innovative products in the area of merchant banking and by attracting low interest bearing deposits in an endeavour to improve its profit margins (Annual Report 1985). To achieve this end the Bank hoped also in the removal of the restrictions imposed by the financial system
151
2.5.2.3. The Merchant Banking Transformation that never realized: 1986 – 1997 During the first years of this period, the Bank was still plagued by the problems encountered in the crisis years. The Asset side of its Balance Sheet suffered from the remaining bad loans of the previous period while the Receipts side of its Income Statements exhibited, even at current prices, losses rather than profits for most of the period 1986 – 1992. The Bank attributed this result to two main reasons: i) The administratively set low interest rate of these loans that could not be rescheduled upwards despite the change in the expected returns of the funded projects and ii) the suspension of interest due to loans that rendered unprofitable during the crisis in the real economy. These loans were extended during the period 1970 – 1980 and made up 11.9% of the total outstanding loans in 1986 (Annual Report 1986). However, it is interesting to see how the percentage of non-interest bearing loans with respect to total outstanding loans evolved during the subsequent years. According to the relevant Annual Reports of the Bank this percentage reached the level of 15.5% in 1987 and increased further to 18.2% in 1989, 33.6% in 1990, 36.1 % in 1991 but decreased at the level of 28.4% in 1992. iii) The forced securitization of the part of outstanding bad loans through the acquisition by the Bank of shares of the borrowed enterprise in place of the lent capital due. This was the case of problematic enterprises such as ΑΓΔΤ Heraklis SA, Kavala Plastics SA, Pournaras SA etc. which however had the effect of burdening the bank with assets with diminishing returns. iv) The low-return participation of the Bank in enterprises within the Emporiki Bank Group and the loans extended to clients of Emporiki Bank (Annual Report 1991). The main source of funds, during this period, were the long-term loans extended by the Bank of Greece, domestic commercial banks, the Postal Savings institution and the European Investment Bank. On the other hand, Investment Bank‟s bonds offered to the public represented 49.2% of total long-term borrowed funds in 1986 but increased to 55.1% in 1987 and followed a rising trend till 1989 (Annual Report 1989). However, the change in the financial environment towards its liberalization during the late 1980s raised new problems for Investment Bank, this time affecting its liabilities. The policy of long-term funding of development banks
152 through the offering of their own bonds was supported by the state through the subsidization of these bond issues. Starting from 1988 this subsidy fell from 4.5% to 3.25% (Annual Report 1988) with the perspective of its full abolition in the future. The Bank stressed the dangers emanating from this development by describing the disharmony between the attempted by the state full liberalization of the financial system and the preservation of the old state of affairs for development banks that rendered them less competitive than their commercial counterparts. Commercial banks faced a lower cost of funds and a greater variety of opportunities to invest them while development banks were still plagued with the low return long-term loans and they depended on the government for their sources of funds either directly – through the loans of the Bank of Greece – or indirectly through the subsidization of their bonds. As far as Investment Bank was concerned, it seemed that, at least until 1992, it never managed to overcome the problem of the rising cost of its funds as bond subsidization decreased and the old low-interest loans from commercial banks and the European Investment Bank were diminishing. Despite these problems, the Bank never abandoned the endeavour to modernize and extend its operation to more profitable activities to the degree that this was permitted by the existing framework for development banks. It continued its feeincome activity as a manager in the field of syndicated loans concerning the financing of enterprises such as Athinaiki Brewery, EBO SA and others. It also participated as consultant and/or underwriter in the share floating on the Athens Stock Exchange of Petzetakis SA, Alouminion Attikis SA, Geniki Commercial and Industry SA, Rokas SA, BIOSOL SA, Radio-Athinai SA, 3Epsilon, Medical Center of Athens and others. It offered its services as consultant for the floating of Greek state bonds or their syndicated offer. Economic consultant services were offered also for important developmental public works such as the Rio-Antiorio bridge, the Acheloos project (in association with Morgan Grenfell & Co Ltd). It also participated in the mergers/acquisitions of Delta SA, Chipita International SA, Biolex SA, Petzetakis SA, Keranis SA, Bianca SA. However, all this activity seemed to come to an end in 1992 when the Bank admitted that its operation in investment banking was anemic. There are no Annual Reports available for the period 1993 – 1996. Hence we cannot assess the course of the Bank during these years. However, from the Annual Report of 1997 we are informed that the Bank stopped its operation in 1995 while there were thoughts for a revival of the Bank in specialized fields such as
153 privatizations and mergers/acquisitions. In addition, Xanthakis (1995:195) reports that the accumulated losses of the Bank during the 1990s indicated the need to stop its operation and to be absorbed by its mother-banks.
2.5.3. ETBA
2.5.3.1. The Period of High Growth: 1964 – 1975 The Hellenic Industrial Development Bank (ETBA) was established on 16th September 1964 with L.D. 4366, by the merger of three institutions: the Economic Development Financing Organization (OHOA), the Industrial Development Corporation (OBA) and the Tourist Credit Organization. Until 1973, ETBA was a Public Enterprise. However, by the L.D. 1369 of 1973, the Bank was transformed into a joint stock company with only one shareholder, the Greek government. The laws of 1964 and 1973 described the purpose of the establishment of ETBA, that being to promote large and medium scale industry, mining, metallurgy, shipbuilding and tourism by providing loan and equity financing. Towards accomplishing its developmental purpose ETBA was also meant to offer technical and financial assistance to already existing companies in order to modernize their operations and to encourage the inflow of foreign capital. Finally, it also had an institutional mission to accomplish by contributing to the development of the capital market. However, the legal framework of the Bank‟s operation also stressed that, although the Bank would operate as a private enterprise, its financing activity would take place within the framework defined by the development program of the government. In this context, the Annual Report of 1975 indicated that ETBA had also meant to undertake activities that, although unprofitable from a financial point of view, they were, nevertheless, vital for the development of the country. The above indicates that ETBA was closely related to the Greek state, a fact that resulted, on the one hand, to a far larger scale of operation with respect to the other two Development Banks and on the other hand, a much greater dependence of the Bank on the decisions and the policy of the government. ETBA played, from the beginning of its operation, a leading role in long-term financing of both private and public enterprises. As the Annual Report of 1967
154 informs us, the Bank handled 42% of total long-term financing in the Greek economy concerning manufacturing and mining and about 40% of total financing of enterprises operating in tourism. Furthermore, starting in 1968, ETBA applied preferential interest rates to export industries envisioning the opportunities arising from the proximity of the country with Middle-East and Africa. On the other hand, it maintained a particular concern to the decentralization of industry by increasing the approval of loans to provincial firms. Such loans increased by 360% between 1966 and 1968. It is characteristic that in 1972, loans granted to the general Athens area were 32.7% of total loans extended, while the relevant proportion for the Macedonia and Thrace district was 42.7%. Finally it approved loans for shipbuilding which increased from 84 million Drs in 1966 to 2137 million Drs. in 1969. On the other hand, its activity in equity investments in industrial enterprises was also substantial as it consisted of 1/3 of the total funds of the Bank in 1967. Some of these enterprises were wholly owned by the Bank such as the Nitrogenous Fertilizers Industry SA, Metal Constructions of Greece SA, Hellenic Marble SA, Hellenic Tanneries SA. In firms, such as the Aluminium de Grèce SA, LYWANA Hellas SA, Gypsum-Hellas SA, Lavreotiki SA, ETANAL SA, Viohalco-Aluminium SA, Piraiki-Patraiki Cotton Mfg. Co. SA, Greek Exports SA, Hellenic Automobile Manufacturing Co SA, Steyr-Daimpler-Puch Hellas, Greek Company of Industrial and Metallurgy Investments it participated in the equity capital. It is notable that the Bank stated in its Annual Report of 1967 that its aim was to pass on the ownership of its shares in these firms to the general public in due course so as to help the development of the capital market. Hence, for example, in 1972, the Bank sold its share participation in Lywana Hellas and Textile Mills “Ilios Ten Cate” SA. The Bank sought to promote foreign investments in Greece by opening an office in New York in 1963 and also an office in Cologne, Germany in 1967 and by publishing guides and pamphlets for investment legislation, taxation, and fiscal and other incentives for foreign investors. This policy yielded its results in 1968 with the agreement between ETBA and Kredittanstalt für Wiederaubau for a loan of 6250 dollars directed to shipbuilding. In 1972 a number of agreements were completed between Greek and German firms for the establishment of new enterprises ranging from vegetable canneries to automatic polishing machines. Furthermore, four loans by the European Investment Bank were extended in 1975.
155 An important part of its operations was the derivation of techno-economic studies concerning the survey of certain industrial sectors or referring to general economic issues related to industrial policy. Such studies included: i) feasibility studies for meat packing units in Northern Greece, ii) a study for a new town gas plant in Athens-Piraeus, iii) studies for industrial complexes in Macedonia and Thrace to exploit their forests, iv) study for the establishment of water desalination plants in the Greek islands. v) The establishment of the General Company of Studies, Research and Exploitation SA in order to elaborate feasibility studies for the exploitation of the underground mineral wealth of the country. vi) Studies on the shipyard industry in Greece and many others. In the field of general economic surveys the Bank published in 1975 a study called “Anatomy of the Market Conditions of Greek Industry” that included a detailed survey of 110 industrial subsectors examined with respect to the possibilities of their development. A unique function of ETBA that distinguished it from the other Development Banks was the industrial estates programme. The purpose of this plan was to select and acquire land portions throughout the country and implement the relevant infrastructure work so as to render them proper for industrial estates. This programme included areas in Thessaloniki, Volos, Patras, Herakion in Crete, Hania, Kavalas etc. An important initiative towards the development of the capital market was the set up by the Bank of the Hellenic Investment Company SA in 1972 whose shares were listed on the Athens Stock Exchange during the following year. The new company aimed at accommodating the listing of shares of enterprises funded by ETBA. It also initiated a cooperation with foreign financial firms such as Bankers Trust Co N.Y. and Merrill Lynch, Pierce, Fenner and Smith N.Y.. In the same year ETBA also undertook – together with other banks – the underwriting of two bond loans floated by the Aluminium de Grèce.
2.5.3.2. ETBA: The Crisis Years 1976 – 1986 Year 1976 was a crucial for ETBA. At this year‟s Annual Report the Bank expressed the need to reconsider its role in the Greek economy after its internal reorganization during the years that followed the fall of the dictatorship in 1974 and
156 the pressure imposed in the economy by international events such as the oil crisis of 1973 and the prospective accession of Greece in the European Community. The Bank described in detail the evolution of Greek industrialization during the 1960s and focused on three major shortcomings in this process: i) the prevalence of small scale industries that employed labour-intensive production methods which would have rendered them uncompetitive in the new international conditions. ii) The low degree of specialization and standardization of Greek industry that increased their cost of production. iii) The insufficient degree of vertical integration and the dependence of industrial units on imported semi-finished products and raw materials. The common cause of all these seemed to be the protective policy measures that directed industry to inefficient and non-competitive production methods which put their exporting activity under the new competitive international environment at risk. In this context the Bank reoriented its role in the Greek economy given that its imprudent activity, especially during the dictatorship years, had rendered it a promoter of the short-run political goals of the military regime rather than a developmental institution (A. Report 1974). The Bank acknowledged that the entrepreneurial sentiment of uncertainty was a crucial factor that restrained investment so it considered as one of its primary goals to establish favourable conditions for entrepreneurship by contributing to economic infrastructure works – the industrial areas programme included – and by providing technical assistance to firms. In this context, the Bank considered the role of Development Banks as those banking institutions that specialize in long-term financing, to be the crucial one. However, for each project examined, the criterion of competitiveness of the said investment was predominant for ETBA. Other criteria that should be taken into account included the high ratio of value added, utilization of domestic raw materials, comparative advantage, industrial decentralization, export orientation, employment criterion, improvement of managerial skills and protection of the environment. Furthermore, the Bank, during its evaluation process, placed more emphasis on the importance of the proposed project for economic development than to the collaterals provided by the enterprise. It is notable, that ETBA acknowledged its responsibility for the delays observed concerning the development of the capital market. The Bank aimed at undertaking initiatives towards the underwriting of securities‟ issues of both newly established and old existing firms that sought to improve their capital structure. ETBA had already underwritten the loan to Piraiki-Patraiki and also channeled to the market
157 various issues of banking debentures. Furthermore, the Bank would continue its policy of equity participation which could take three forms: i) participation to improve the capital structure of borrowed firms, ii) equity participation in the context of rescheduling of overhang debt of troubled firms and iii) equity participation to support the Greek side of joint ventures with foreign firms. Then a policy of recycling its portfolio of equities through the capital market would revive the latter. ETBA‟s main source of capital from its establishment in 1964 was the Central Bank. However, the Bank understood the need to gain more independence in its financing sources and hence, aimed at increasing the proportion of its own banking debentures. However, note that ETBA acknowledged the burden of risks that it assumed with respect to other Development Banks and therefore, it considered its preferential treatment concerning the cost of its capital as necessary. The funds acquired by the Bank of Greece as a proportion of total capital sources fell from 53% to 48.9% between 1976 and 1977 while the same percentages for bank bonds were 6.9% and 12% respectively. Bank bonds continued to rise in subsequent years reaching the level of 14.31% in 1979 (Annual Report 1979) and 17.9% in 1980 with a fall of Bank of Greece financing to 39.4%. The respective figures for 1982 were 32.2% for bond financing and 24.4% for Bank of Greece funds, while for 1984 bond financing rose to 48.1% and Bank of Greece funds fell to 9.9%. On the other hand, foreign borrowing increased from 2.6% in 1975 to 16.4% in 1980 and 26.1% in 1984 consisting of loans raised by the European Investment Bank and by the Euromarket. (Annual Report 1980). In addition, ETBA succeeded to place its first bond issue at the Tokyo capital market on favourable terms in 1982. In the context of the above developments, ETBA continued its long-term financing activity through loans or equity participation with the cooperation, in many cases, of foreign organizations. Examples of this activity were: i) the industry of asbestos fibres in Kozani with MABE SA (financed through a bond-loan convertible into shares), ii) industry of Ammonia Production with Greek Ammonia Industry SA, iii) Greek Electronics Industry SA with equity participation by ETBA (55%), iv) the Greek Arms Industry SA with equity participation 30% by ETBA and 70% by the Greek government, v) the Hellenic Steel SA (participation of 14%), vi) the spinning mills Aegeon SA (12% participation), vii) Neorion-Shipyards Syros SA (both equity participation and loan extended), viii) METBA Aegean Metallurgical Industries SA. However, part of the investments the Bank made through equity participation and/or
158 long-term loans proved to be unprofitable or the respective enterprises were categorized as problematic. Hence, the Bank initiated a programme of assistance and reorganization of these firms. These included, Hellenic Exports SA, GEMEE SA, the Nitrate Fertilizer Plant, Steyer Hellas, Thermis SA, Chandris –Cables SA, Deras Leather Industry, Piraiki-Patraiki SA, Skalistiris Group, Pyrkal SA, Hellenic Steel SA, Hellenic Shipyards SA and others. In 1982, the Bank estimated the number of employees in problematic firms to have reached the level of 3722 persons. This made it necessary for the Bank to find ways to reactivate these firms through new loans, conversion of matured liabilities or rescheduling of debts along with their reorganization. Starting from 1983 the Bank cooperated with the Organization for Business Restructuring (OAE) established by the Law 1386/1983. Concerning the loans approved, it is notable that these increased at current prices by 210% between 1975 and 1977 of which those channeled to industry and mining increased by 275%. The figure at current prices between 1978 and 1981 was only 13.7% in industry but 208% in shipping. However, starting from 1982, the Bank provided not only long-term capital for fixed assets but also the necessary start-up working capital for the first months of the operation of a project. Total loans continued to rise in subsequent years exhibiting a change of 25.4% between 1983 and 1984, 19% in 1985. The greater portion of loans went to industrial and workshop units. For example, by the end of 1985 the portfolio of the Bank was comprised of four kinds of loans: those to industry and workshops (70.5%), to shipping (6.4%), to tourism (18.7%) and miscellaneous loans (4.4%) (Annual Report 1985). The industrial areas and Workshop-Industry centers programme became a continuing concern for the Bank. Hence, as reported in 1978, the number of industries installed in these areas rose to 148 from 42 that were at place in 1977. These firms increased to 192 in 1981 while 4800 enterprises were yet expected to locate. The impact for employment was substantial with the creation of 11500 jobs and the expectation of providing additional 250000 jobs in the future (Annual Report 1981). Furthermore, in 1979, the Bank established a subsidiary company named Industrial Areas-ETBA SA which in 1980 took over all functions concerning the designing and construction of projects in the industrial areas. The amounts of funds disposed by the Bank to the development of industrial areas rose at current prices from 160 million Drs. in 1975 to 1280 million Drs. in 1980 (Annual Report 1979) and to 10807 million Drs in 1984 (Annual Report 1984). The sources of financing of these projects were
159 the Bank‟s own funds, the proceeds from the sale of industrial sites, the public investment programme and loans from the European Investment Bank and the European Regional Development Fund. A basic element of its activity was the implementation of various studies and research concerning the possibilities of Greek industry. These included: i) study on the marble industry, on the construction of buses and on telecommunication material, ii) feasibility study on semi synthetic penicillin, on the use of solar energy, on the development of silk industry, iii) market research on fish processing industries, meat canning and fruits and vegetables industry, iv) study on use of emery from Naxos, v) estimates of operating costs of new oil storage facilities, v) study in cooperation with ETEBA and the soviet firm TSVETMETPROMEXPORT for the construction of an Alumina plant, vi) a study for Maritime Industrial Areas (NA.VI.PE.). More encompassing studies included a study implemented in cooperation with IOBE on the conditions of industry in Greece as compared to the corresponding sectors in the European Community. In addition, the Bank founded in 1980 a special Technical Assistance Company staffed with financial and technical experts so as to consult small and medium size business on matters such as internal organization, production and market conditions. Concerning the development of the capital market, the Bank channeled the shares of Greek Portfolio Investment SA to the Stock Exchange in 1978. However, the Bank justified its poor performance in this field by the adverse conditions in the economy that also affected the capital market and made it difficult for it to recycle its portfolio in the market without loss. This means that many of its equity participations were locked into its portfolio yielding low returns which reduced further its financing capacity but also impeded its endeavor to revive the capital market (Annual Report 1979). However, the main contribution of ETBA in capital market development was the operation of its affiliated company, the Hellenic Portfolio Investment Company which attracted new shareholders, 14 insurance funds, thus enabling ETBA to reduce its equity participation to it.
2.5.3.3. The Transformation of a Public Developmental Agency to a Private Universal Bank: 1987 – 2002
160 The late 1980s, especially from 1987 onwards were important years for ETBA in terms of the nature of its operation as was also the case for the other two Development Banks. It is characteristic that in the Annual Report of 1987, the Bank remarked a slowdown of the process of raising funds from the domestic bond market because of the competition faced by the government‟s Treasury Bills. The latter offered higher interest rates than those permitted for the bank‟s bonds and hence, ETBA‟s funds through bonds‟ flotation fell to 22549 million Drs compared to 49328 million in 1986. This was certainly a turning point for the nature of the Bank as far as it indicated a gradual withdrawal of the support of the state to the Development Bank model prevailing in the previous decades. ETBA seemed to felt this change so as to demand from the government to segregate its role as a competitive investment banking institution from its role as a manager of government‟s programmes within the Public Investment Programme. The Bank stated that the original need for long-term financing in the Greek Economy that determined its establishment in 1964 was now satisfied by a variety of institutions. Hence, there was no reason for ETBA to be tied in this operation which, in many cases, was unprofitable. In the new environment of financial liberalization and integration of money and capital markets within the European Community in 1992, the Bank sought a new role as a modern investment bank by including in its operations activities such as counseling, underwriting, promotion of mergers and acquisitions, factoring, leasing and venture capital. The aim of the Bank was not to abandon its previous role but to set it on a new competitive basis. In fact, what ETBA wanted was a new compromise between the traditional Development Bank model and the modern Merchant Bank model both operating at the same time and within the same entity. However, this would prove difficult in the years to come. Indeed, in its Annual Report for 1989, the Bank raised again the problem of government‟s interest firms such as Greek Coastal Shipping Company, Porcel and others that were financially unviable and in fact worsened the portfolio of ETBA. Furthermore, it proposed passing on its subsidiary manufacturing companies to the private sector or their liquidation in an attempt towards a healthier investment portfolio. In 1990, nineteen such firms went into liquidation and seven of them went bankrupt. Finally, in 1994, the Bank published a business plan in which it indicated its determination to follow a conservative financial policy that would minimize the risks that it would assume in the future along with the full liquidation of its problematic portfolio. On the basis of this plan and the Law 2359/1995, the Bank underwent a
161 restructuring process towards its new role in the context of the modernization of the Greek banking system. Finally, in 1998, ETBA in cooperation with ABN-AMRO – the latter acting as consultant – defined its strategy towards the three branches of its operation: commercial banking, investment banking and development banking. In 1999, ETBAbank was admitted at the Athens Stock Exchange after a public subscription that took place on 17th December 1999. Hence, the government was no longer the only shareholder of the Bank as its share contracted to 65.56%. The process of privatization of the Bank continued in the subsequent years until its absorption by the Piraeus Bank. Nevertheless, the Bank continued its industrial estates programme along with its long-term financing activity. A novelty however, was the new proposal of ETBA to establish “technopolises” that is special industrial estates for manufacturing plants that will use technologically advanced production processes with the least environmental impact (Annual Report 1989). Furthermore, it initiated a programme within the context of government‟s Regional Development Plan raising funds from the EEC Structural Funds. In the context of this programme ETBA implemented the relevant feasibility studies such as the exploitation of lignite deposits, the exploitation of geothermal field at Nea Kessani in Xanthi, a study for the identification of investment opportunities in the area of water supply and drainage, a pre-feasibility study into the Area Heating of Megalopolis. The Bank also participated in other European Community programmes such as INTERREG (inter-regional development), VALOREN (conservation of energy), ENVIREG (protection of the environment) (Annual Report 1992) and JEV (Joint European Venture) for encouraging joint European ventures in SMEs (Annual Report 1998). In ETBA‟s development projects we should include its financing for the modernization of existing industries such as Nitrogenous Fertilizers Industry SA (AEBAL), Hellenic Alumina SA, NA.VI.PE. It also triggered an investment project concerning spa tourism in N. Apollonia and Icaria. As far as the technical aid to domestic enterprises was concerned, the Bank participated in the PRISMA programme that aimed at the improvement of the quality and standardization of produced products and the RETEX programme for the modernization of enterprises. Extended loans increased, at current prices, by 28% between 1986 and 1987, while for industrial estates total expenditure in 1987 reached the level of 16131 million Drs at current prices. However, the financing of this activity became more
162 difficult in the early 1990s both because of the 25% reduction on the interest rate subsidy on Bank‟s bonds in 1990 and its complete abolition in 1991 along with their taxation – as opposed to State‟s securities – and the inability to readjust the interest rates charged on its loans that refer to the 1/3 of its portfolio (Annual Report 1990). Loans, continued to rise at current prices but at lower rates. Hence, the rate of change of loans approved between 1991 and 1992 was 20.7% while between 1992 and 1993 was only 9.5%. This figure for 1994 is 3.3% while in 1995 we have for the first time a negative change of – 6.2% in the extended loans which continued in the next years so as to become a negative change of – 24.4% between 1996 and 1997. However, starting from 1998 onwards loans increased to reach the level of 55% upward change between 1998 and 1999. This trend lasted until 2000 while in 2001 new approved loans fell again. However, the criteria under which these loans were now contracted were entirely different from those prevailing in the past as profitability of the proposed projects was the determining one. Despite the adverse conditions in the bond market, ETBA‟s bonds remained the main source of funds being the 60.4% of total in 1987 and 64.8% in 1988. However, this percentage fell in 1989 to 59.9% with a rise of funds raised from abroad from 20.6% in 1988 to 27.6% in 1989. Foreign funds consisted of loans by the European Investment Bank and credits by international capital markets – especially the German and Japanese markets. Part of the foreign exchange risk was assumed by the Bank of Greece. In addition, ETBA sought new sources of funds and in this context, proposed in 1990 to the Bank of Greece that Investment Banks should be permitted to accept time deposits in Drs. and foreign exchange and to increase the maximum limit for raising capital on the interbank market to up to 50% of the bank‟s equity capital. These amendments were accepted and implemented in 1991 along with the issuance of new one-year “6,9,12” bank bonds that could compete Treasury Bills on the grounds of their early redemption attractive terms. Furthermore, in the same year the establishment of a secondary market for bank bonds and the renewal of old non-taxable bonds with an interest payment option strengthened the liquidity position of the Bank. However, bank bonds fell continuously as a percentage of total sources of funds constituting the 51.5% in 1992 and the 38.5% in 1993 with the parallel increase of own funds (share capital, reserves and provisions) from 12.5% in 1992 to 27.5% in 1993. In 1996, bonds consisted only the 7.8% of total capital sources.
163 In an attempt to promote its new role in the financially liberalized environment as a merchant or a universal bank, ETBA established in 1988 the ETBA Leasing SA while upgrading the role of its old company Hellenic Investment Company SA. These firms along with the ETBA Bank and the Hellenic Export-Import Bank SA, founded in 1989, would be parts of the ETBA Group. ETBA Insurance Brokers SA was added to the Group in 1991 so as to act as brokers for the Bank‟s insurance-related portfolio. In addition, the Bank launched a new Capital Market Service in order to provide consultancy services to public and private firms concerning the floating and underwriting of new share and bond issues on the Athens Stock Exchange, and to help the restructuring of enterprises through mergers and acquisitions. Such services were provided to firms such as Natural Gas (DEPA SA)
(a public corporation), EKO-
Chemicals SA, Hellenic Shipyards SA, HELEXPO, Petzetakis SA, Macedonia Plastics SA, Kavala Plastics SA, E.D. Mouzakis SA, OP. Darig & Co SA, the Bank of Central Greece, SANYO HELLAS SA, Public Petroleum Corporation (DEP), Hellenic Sugar Industry, OTE and others. Furthermore, the Bank established a Privatization Committee in 1990 to help the privatization programme of its subsidiaries. These included Hellenic Marble SA, Porcel SA, Nafsi Sa, Elvior SA, Helenic Shipyards SA, Shipyards of Greece SA, Thraki SA, Filiates Textiles SA, Akti Mirinis SA, GEMEE SA, Hellenic Asbestos SA and others. Furthermore, ETBA along with the Agricultural Bank of Greece were appointed in 1990 as intermediaries and financial advisors on behalf of Greece for the provision of economic assistance to 6 countries of the Central and Eastern Europe within the PHARE Programme. The services that the Bank would provide included the assessment of investment programmes and the prospective companies, the determination of the preliminary steps towards the establishment of joint-ventures and the provision of the related technical assistance. In the context of its international operations we should include its participation in the MENTOR Programme for the establishment of international business center in Romania. Besides, in 1992 ETBA set up its own Dealing Room that became a precious link between the Bank, the interbank market and the REPOS and Swaps market. In 1993, the Bank played a significant role to the development of the fixed income bond market by underwriting for the first time on its own or with other institutions, the issue of bonds of international organizations such as EBRD, EIB IFC and the World Bank. In 1994 ETBA participated in two new firms in the context of its transformation in the new financial environment: ETBA-Natwest Mutual Fund
164 Management (in cooperation with National Westminster Bank) and DANUBE Fund (Venture Capital). In short, by the end of 2001, the Bank was completely transformed to a modern universal bank with separate branches in corporate banking, retail banking, investment banking and treasury services. The history of the Bank as a separate entity ends in 2002 with its absorption by the Piraeus Bank.
2.6. ETBA, ETEBA and Investment Bank: Serial Trend Analysis The above discussion in Section 5, gave a short overview of the history of each of the three Greek Development Banks focusing on their effort to promote economic and financial development and the gradual change of the direction of their operations subject to the constraints imposed by the existing government policies. Section 6 aims at supplementing this qualitative analysis with the examination of the available quantitative data. Using financial data as these are reported in Balance Sheets and Profit and Loss Accounts of firms in order to describe and assess the efficiency of their operation is a usual practice in banking history. For example, and as far as development banking is concerned, studies such as Murinde & Kariisa-Kasa (1997), Singh, Arora & Anand (1991), Jain (1989) use data from financial statements in order to assess the performance of the related institutions. However, using the same Accounts to describe macroeconomic institutional developments is, we argue, a novelty of our study. In accordance with our theoretical framework for institutional development, we seek to discern patterns and trends in the accounting measures that would signify major turning points in the evolution of the Greek financial system. In this sense, serial trend analysis of major Balance Sheet and Income accounts might reveal the phases which characterized the operation of Banks as instruments of the prevailing in each period financial regime. In addition, financial ratios analysis might give a meaningful comparative picture of the performance of the three Banks that would also indicate their dependence on the financial regime and their ability to transform themselves as this regime underwent a process of change. We base the validity of this approach on the peculiar nature of Development Banks as hybrid institutions with both private economic – hence, microeconomic profitability – goals
165 and social welfare – that is macroeconomic – goals related to the promotion of government economic and institutional development policies in LDCs. However, we are aware of the risks entailed in such an operation. Hence, we are not intending to derive macroeconomic results from microeconomic data. We only aim at obtaining macroeconomic historical indicators of the structural breaks in financial development in Greece using the tools of business history for specific firms with the peculiar characteristic of being firms with idiosyncratic macroeconomic influence such as was the case for the Development Banks.
2.6.1. Income, Expenses and Net Profits
The gross income of Development Banks was divided into two major sources44. The first was income in the form mainly of interest and dividends. Interest relates directly to the credit operation of the Banks in the form of loans extended to enterprises and is the usual major source of revenue of banking institutions in general. It also includes interest income from held securities, especially corporate and government bonds. On the other hand, dividends relate to the portfolio of Banks comprising shares of funded enterprises. In this category we also include revenue in the form of commission fees that relates to banking operations of these institutions. The second source is capital gains from securities in the Banks‟ portfolios of either private or public origin and other income from miscellaneous sources.
44
See the Appendix for a detailed description of the data used.
166
Figure 1a: ETEBA: Gross Income and Its Components (Constant 1982 Prices)
16000,00
14000,00
12000,00
10000,00
Gross Income 8000,00
Capital Gains from Sold Securities & Other Income
6000,00
Interest, Dividends & other Banking Revenue
4000,00
2000,00
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
0,00
Source: ETEBA Annual Reports
Figures 1a, above and1b and 1c below depict both the evolution and division of the Banks‟ gross income during their operation. However, data for the capital gains source is available only for ETEBA for the whole period while it appears as a separate entry in Investment Bank‟s Income Statements from 1991 onwards and in ETBA‟s accounts as of 1993. This component of ETEBA‟s gross income seems to be present even from the very first years of its operation but especially after 1971. Capital gains reveal an active operation of the Bank in trading securities even in the context of a thin capital market as the period of 1972 – 1985 reveals. On average, revenue from capital gains reaches the amount of 131.01 million Drs. at constant 1982 prices during this period45. Such an activity grows after the deregulation of 1986-87. The period 1986 – 1998 the average figure of this source of revenues is 509.99 million Drs. at constant 1982 prices while for the period of 1999 – 2001 of the capital market boom and burst reaches the level of 1838.17 million Drs. On the other hand, interest revenue remains considerable during the whole life of the Bank while exhibiting four
45
Average values have been calculated using Microsoft Excel or Eviews 3.1 that returns the mean of a sample .
167 discerning patterns. It is continuously growing during the period 1964 – 1983 with an average level of 1946.01 million Drs at constant 1982 prices. Then, it reveals a fluctuation for the period 1984 – 1992 with average 4326.76 million Drs at constant prices. The downturn comes during the period 1993 – 1996 where interest income falls from 3844.63 constant million Drs. in 1993 to 1527.46 million Drs. in 1996. The final major fluctuation is observed during the period 1997 – 2001. Interest revenues reach the peak of 5613.25 constant million Drs. in 2000 while falling to 2576.18 million Drs in 2001 with an average figure of 3586.25 million Drs. for this period. Four points should be mentioned here. First, it seems that the interest component drives the evolution of total gross income for the whole period 1964 – 2001 which means that it remained the main income resource for the Bank during its life. The correlation coefficient46 between the data for interest revenue and gross revenue for the whole period is about 96%47. Secondly, total gross income fluctuates during the period 1984 – 1992. This fluctuation reflects the problems in the real economy encountered during this period with a bulk of firms becoming “problematic” after the burst of the two oil crises of 1973 and 1978-79 and the new competitive international
environment
without
the
Bretton
Woods
system
guarantees.
Furthermore, both components exhibit a decline during the period 1993 – 1996 although this effect seems more pronounced for the interest component. Interest earnings in 1996 fell by about 60.27% with respect to their value in 1993 while capital gains fell by about 28.26%. Finally, both components rise sharply after 1997 reaching their peak in year 2000 for interest income and in 1999 for capital gains. Interest income rises in 2000 by about 187.33% with respect to 1997 while the same figure for capital gains in 1999 with respect to 1997 is 721.31%. The last two trends exhibit possibly the reorganization and reorientation of the Bank and its activities in the face of the changing financial environment.
46
This is Pearson correlation coefficient calculated using Microsoft Excel according to the formula
47
We use a t-test to test the significance of this correlation coefficient
under the
null hypothesis of no correlation, where is the sample correlation coefficient and are the degrees of freedom (d.f.) for the test (Keller, Warrack & Bartel (1988 : 611-612)). The critical for 30 d.f. at 0.05 level of significance one-tail test is 1.697. Since computed critical the computed correlation coefficient is significant at the 0.05 level and the null hypothesis of no correlation can be rejected.
168 Figure 1b indicates the evolution of gross revenue at constant 1982 prices for Investment Bank. In this case, however, all income depicted relates to interest revenue and fee income since there is no data on capital gains from securities trading except for the short periods 1991 – 1992 and 1996 – 1997. Furthermore, the data for Investment Bank is rather incomplete since no data is available for the year 1975 and the period 1993 – 1995. This is the reason for the sharp breaks in Figure 1b. Despite these data problems, Figure 1b exhibits three major patterns in the evolution of gross income of Investment Bank. Gross revenue rises at constant prices during the period 1963 – 1980 reaching the peak of 1879.74 million Drs. The second period that we can discern is between 1981 – 1992 where we observe a fluctuation Figure 1b: Investment Bank: Gross Income and Its Components (Constant 1982 Prices)
4500,00
4000,00
3500,00
3000,00
2500,00
Gross Income
2000,00
Capital Gains from Sold Securities & Other Income
1500,00
Interest, Dividends & other Banking Revenue
1000,00
500,00
0,00
Source: Investment Bank Annual Reports
of gross income when the average value for this period is 1476.99 million Drs. at constant 1982 prices. Finally, the last trend exhibits itself during the period 1996 – 1997 with an insignificant rise of gross revenue from 17.98 (of which 16.69 million Drs are interest income and 1.29 million Drs. are capital gains) in 1996 to 51.50 million Drs in 1997 at constant 1982 prices. However, although data is not available for the period 1993 – 1995, the low value obtained for the year 1996 (17.98 million
169 Drs.) with respect to that of the year 1992 (1373.35 million Drs.) indicates a fall of revenue during these years. Two points should be mentioned. First, Investment Bank‟s gross revenue presents a fluctuation for roughly the same period 1981 – 1992 as that of ETEBA. So we can imagine that the same reasons, namely, the adverse conditions in the real economy, are responsible for the similar trend in both Banks‟ gross income. Secondly, although data is missing, it seems that it must have been a sharp decline of revenue somewhere between the years 1993 – 1995 that was kept low as the data for 1996 and 1997 reveals. Again, one could speak of a prolonged reorganization phase in the operation of the Bank after 1995. Figure 1c depicts the evolution of gross income for the period 1964 – 2002 for ETBA, the third Development Bank operated in the Greek economy. Again, separate data for capital gains from securities trading is not available until 1992. What we observe for gross income is a continuously rising trend until 1995 with fluctuations especially for the crisis years of 1973 – 1980 and the period of 1990 – 1995. On the contrary, the second trend between the years 1996 – 2002 is falling. Initially, the decline is sharp from 25015.38 million Drs at constant 1982 prices in 1995 to 7942.80 million Drs in 1998. The short recovery with a peak of 10047.55 million Drs in 2000 for interest income or 11716.50 million Drs. for gross income in 1999 is not capable to reverse the trend which establishes itself with a further fall till 2002. Surprisingly, the data for ETBA exhibits a completely different pattern than that for the other two Development Banks. First, gross income rises without its fluctuations, because of the abrupt changes in the real economy during the 1970s and 1980s, to affect the general pattern. Secondly, the Bank seems to have been only superficially affected by the developments in the financial sector and the capital market development during the late 1990s. Indeed, considering the capital gains/other income component of gross income we face abrupt fluctuations between positive and negative values (capital losses from securities trading and other losses) for the period 1993 – 1998 and only a short-lived recovery of this source of revenue for 1999 that is followed by downward fluctuations until 2002. The highest figure for 1999 is 2458.24 millions of constant 1982 Drs. while the average value of capital gains for the period
170
Figure 1c: ETBA: Gross Income and Its Components (Constant 1982 Prices)
60000
50000
40000
Gross Income 30000
Capital Gains from Sold Securities & Other Income Interest, Dividends & other Banking Revenue
20000
10000
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
0
Source: ETBA Annual Reports 1993 – 2002 is only 218.67 million Drs. with the impressive standard deviation48 of 1325.78. However, a distinctive characteristic of ETBA with respect to ETEBA and Investment Bank should be stressed. The fact that ETBA was a state owned Bank – and not just one aided by state funds – might be an explanation for its different behavior described by the two stated observations. A second cluster of Figures obtained by the available data of Profit and Loss Accounts of the Banks refers to financial and personnel expenses. Charges for payroll and social security contributions should be a rather stable element of total operating costs not necessarily reflecting any major breaks in the life of the Banks. On the other hand, financial charges are important for our study as far as they represent a component of costs directly related to the level of operation of each firm and hence, to the fluctuations of its financial status during the years under examination. Figure 2a presents financial and personnel charges for ETEBA at constant 1982 prices. Payroll charges present a rather smooth picture during the whole period, 48
Standard deviations were calculated using Microsoft Excel or Eviews 3.1 according to
171 as expected, rising only slowly through the years. However, the evolution of financial charges seems to be almost identical with that observed for gross income in Figure 1a. Indeed the correlation coefficient between the two sets of data is about 97%49. The picture is not any different for Investment Bank. The data for financial and payroll charges is presented in Figure 2b. Again, the breaks in the data make the assessment difficult but an overall picture can be obtained. A mean value of 15.92 million Drs at constant 1982 prices for the period 1963 – 1974 (standard deviation 6.91) becomes an average 88.59 million Drs (standard deviation 34.85) during the period 1976 – 1992. The corresponding figures for ETEBA are 49.68 million Drs. average personnel charges for 1963 – 1974 (standard deviation 31.02) and 203.38 million Drs. on average for the period 1976 – 1992 (standard deviation 36.31). Figure 2a: ETEBA: Financial and Payroll Expenses (Constant 1982 Prices) 6000,00
5000,00
4000,00
3000,00
2000,00
Financial Charges Personnel Payroll & Soc. Charges
1000,00
0,00
Source: ETEBA Annual Reports Finally, during the years 1996 – 1997 payroll expenses are kept low and decreasing from 25.91 million Drs in 1996 to 20.28 million Drs. at constant 1982 prices in 1997. Besides, the similar picture between the two banks concerning payroll expenses is also revealed by the correlation between these costs and gross income as an indicator 49
Using the t-test described above we obtain for 30 d.f. one-tail test at 0.05 level of significance. Hence, the computed correlation coefficient is significant at this level of significance.
172
Figure 2b: Investment Bank: Financial and Payroll Expenses (Constant 1982 Prices)
2500,00
2000,00
1500,00
Financial Charges Personnel Payroll & Soc. Charges
1000,00
500,00
0,00
Source: Investment Bank Annual Reports
of the fluctuations in the level of their operation. This correlation coefficient is about 80% for Investment Bank (period 1963 – 1992) and 81% for ETEBA50. On the other hand, the figure for financial charges is again similar to that of total turnover exhibited in Figure 1b. The general pattern of trends, especially the fluctuation during the period 1981 – 1992 and the reorganization from 1995 are also present in this Figure. To establish these observations note that the correlation coefficient between total gross income and financial charges for the period 1963 – 1992 is about 98%51. Figure 2c presents the same kinds of data for the state owned ETBA. Payroll expenses are again the less fluctuating part of operating costs with a mean value of 863.18 million Drs. for the whole period 1975 – 2002. However its standard deviation of 122.93 far exceeds that of 78.14 for ETEBA which exhibits an average payroll figure of 239.04 for the period 1975 – 2001 indicating a larger and much more
50
Note that both correlation coefficients are significant at the 0.05 level of significance since: a) For ETEBA for 30 d.f. and b) for Investment Bank we have for 28 d.f.. 51 This figure is again significant at the 0.05 level of significance since for 28 d.f.
173
Figure 2c: ETBA: Financial and Payroll Expenses (Constant 1982 Prices)
35000
30000
25000
20000
Financial Charges 15000
Personnel Payroll & Soc. Charges
10000
5000
0
Source: ETBA Annual Reports fluctuating cost for the state-owned bank.. On the contrary, financial charges follow the trend of operating income. However, total income and financial charges are less closely correlated compared to the same data for the other two Banks since their correlation coefficient is about 91%. Note that the correlation coefficient for the subperiod 1989 – 1995 falls to 32%52. Figures 3a,b,c depict the evolution of net profits at constant 1982 prices for ETEBA, Investment Bank and ETBA respectively. Each graph exhibits a completely different picture indicating the major differences in the financial operation and management of each Bank. The only Bank that seems to be sustainably profitable is ETEBA as Figure 3a indicates. Net profits fluctuate but remain positive during the period 1970 – 1997 with an average profit of 506.94 million Drs while they reach high levels during the next period 1998 – 2001 with an average profit of 1884.37 million Drs. Although net profits fall after a peak in 1999 they remain high presenting an increase of the order of 186.66% between 2001 and 1997. Furthermore, the major 52
Note that the correlation coefficient for the whole period is significant at the 0.05 level since for 30 d.f.. On the contrary, the computed correlation coefficient of 32% for the subperiod 1989 – 1995 is not statistically significant since for 5 d.f. at 0.05 level of significance one-tail test.
174 downturn of net profits occurs between the years 1984 – 1989 with an average value of 346.02 million Drs or a fall of about 60% in 1989 with respect to 1984.
Figure 3a: ETEBA: Net Profits (Constant 1982 Prices)
3000,00
2500,00
2000,00
1500,00
Net Profits
1000,00
500,00
0,00
Source: ETEBA Annual Reports The picture is completely different for Investment Bank. Net profits fluctuate initially only at positive values for the years 1965 – 1984 with a mean value of 60.22 Figure 3b:Investment Bank: Net Profits (Constant 1982 Prices) 600,00
500,00
400,00
300,00
200,00
100,00
0,00
-100,00
-200,00
-300,00
-400,00
Source: Investment Bank Annual Reports
Net Profits
175
million Drs. However, for the period 1985 – 1992 this fluctuation occurs almost entirely in negative values with mean – 125.42 million Drs. Excluding the years 1993 – 1995 for which we have no data, net profits become again positive and at a much higher level during the period 1996 – 1997 with an average value of 348.94 million Drs. Figure 3c gives a rather surprising picture for ETBA. It is surprising since we Figure 3c: ETBA: Net Profits (Constant 1982 Prices) 10000
5000
0
-5000
-10000
Net Profits
-15000
-20000
-25000
Source: ETBA Annual Reports have seen in Figure1c a continuous rise of gross income until 1995 and a fall thereafter. Of course, the less intensive correlation of the evolution of gross income with that of financial charges especially during the period 1989 – 1995 casts doubts on whether financial charges were the crucial component of costs that determined the profitability of the Bank. Indeed, ETBA‟s net profits exhibit three discerning patterns. There is a positive fluctuation of net profits until 1989 with mean value 347.35 million Drs. However, for the next period 1990 – 1997 net profits become negative with mean value – 12482.74. The last period 1998 – 2002 net profits become positive again (except in 2001) with mean value 1995.91. Hence, although gross income was rising until 1995, net profits were initially positive at very low levels and then highly negative. On the contrary, the continuous fall in gross income after 1996 was
176 followed initially by negative and then by positive net profits with the exception of a negative figure for 2001. The next series of figures completes the examination of the Profit and Loss Accounts of the Banks by comparing net profits with distributed dividends. In this case, we are trying to examine whether the Banks followed a consistent dividend payout policy given the existing level of net profits for each year of operation. Figure 4a depicts net profits and distributed dividends for ETEBA. As we can Figure 4a:ETEBA: Net Profits and Dividends (Constant 1982 Prices)
3000,00
2500,00
2000,00
1500,00
Net Profits Dividend
1000,00
500,00
0,00
Source: ETEBA Annual Reports see, the Bank started to distribute dividends out of its profits from the year 1967 onwards without any break in this policy. It is visually obvious that ETEBA followed a stable dividend payout policy. Statistically, dividends are on average the 46% of net profits for each year with a standard deviation of only 0.13. What this might mean is that the Bank valued its external testimony to the markets highly as a trustful financial institution for which shareholder interest mattered. Of course, its sustainable profitability helped its financial managers to fulfill such a task. The picture is completely different for Investment Bank. A first observation of Figure 4b indicates that, whenever there were positive net profits, the Bank distributed dividends with the exception of the years 1976, 1987, 1989, 1996 and 1997. Furthermore, there is no a stable dividend payout policy. In some years such as in the
177 period of 1966 – 1974 distributed dividends are extremely high with respect to net profits. In this period, dividends reach the average level of 60% of net profits with standard deviation of 0.27. On the other hand, for the period 1979 – 1985 dividends constitute on average 66% of net profits with 1.50 standard deviation. Figure 4b: Investment Bank: Net Profits and Dividends (Constant 1982 Prices)
600,00
500,00
400,00
300,00
200,00
Net Profits
100,00
Dividend
0,00
-100,00
-200,00
-300,00
-400,00
Source: Investment Bank Annual Reports It is notable that for the whole period 1966 – 1997 dividend payout ratio is about 37% with a large standard deviation of 0.80. This inconsistent dividend payout policy indicates the reduced interest of the Bank to signal a sound financial management in capital markets. Indeed, extreme levels of distributed dividends reflect inadequate retained earnings that could be used for the expansion of the operation especially in the favourable environment of Greek economic development during the 1960s. On the other hand, an unstable payout policy even in the reorganization years of the late 1990s would give, as we remarked, the wrong signal to investors when the capital market in Greece was living its rising trend. Picture 4c depicts only the level of net profits since data for distributed dividends is nonexistent. However, this happens because ETBA was a state owned bank. Hence, no comment can be made for this Bank concerning its dividend payout policy.
178
Figure 4c: ETBA: Net Profits and Dividends (Constant 1982 Prices)
10000
5000
0
-5000
Net Profits Dividend
-10000
-15000
-20000
-25000
Source: ETBA Annual Reports
We will conclude this section by providing summary statistics such as means, medians, standard deviations, and range of values (minimum and maximum) for the three main variables we have examined, namely, gross income, financial charges and net profits. The statistics have been calculated using the econometric program EVIEWS Ver. 3.1 and they cover the three main periods that we have identified in our analysis in section 5: the period of high growth till the mid-1970s, the crisis period between mid-1970s and mid-1980s and the financial liberalization period afterwards. The rationale for this exercise is to link our data analysis with the context of historical developments and their effect on the performance of the three Banks in a comparative way. Table 6.1.1 presents the summary statistics for Gross Income at deflated prices as an indicator of the total turnover of the Banks. A first observation is that for both ETEBA and ETBA, gross income increases on average as we move from the mid1960s to the 1990s. On the contrary, for Investment Bank, total turnover decreases on average during the liberalization era. The same observation holds according to the medians for the respective periods. Furthermore, the variability of these average values seems to increase for ETEBA and ETBA while it decreases for Investment
179 Bank for the period of crisis 1976 – 1986. Another interesting observation is that the standard deviation of gross income around its mean almost doubles during the financial liberalization period with respect to the previous period for ETEBA and ETBA and almost triples for Investment Bank indicating a large variability of revenue for that period. Hence, the deregulation of the financial system seemed to have affected the stability of the income inflow of Investment Bank more than it had done so for the other two Banks ETBA and ETEBA. The dispersion of revenue around its Table 6.1.1: Gross Income: Summary Statistics53 ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1967-
1975-
1987-
1974
1986
2001
1974
1986
1997
1974
1986
2002
830.11
3803.72 4394.48 313.00 1489.62 1092.67 3751.14 9300.52
13850.07
Median 511.82
4056.78 4541.17 177.35 1535.08 1307.86 4413.50 9321.01
15305.78
Std.
774.86
894.25
1502.08 3187.81
5621.74
Min
48.65
2434.71 2027.14 4.43
1624.06 4505.54
5447.52
Max
2058.30 4891.88 7331.53 996.88 1879.74 1951.86 5372.49 14801.45 25015.38
Mean
1499.39 323.28 226.20
689.94
Dev. 1148.87 17.98
Source: Own Calculations
average value increases more slowly for ETEBA (by about 68%) than for ETBA (76%) between the periods 1975 – 1986 and 1987 – 2001-02 although mean gross income rises by about 15.53% and 48.92% respectively. Table 6.1.2 presents the same statistics for the financial cost of operation. The trends in average and median values are similar to those described for the evolution of gross income among the three periods. Again, standard deviations increase as average values rise, but in this case, the effect of rising borrowing costs is similarly enormous to all three Banks especially in the last period. The rate of increase of the standard deviation of financial charges between the periods 1975 – 1986 and 1987 – 2002 is about 64% for ETEBA, 295% for Investment Bank and 185% for ETBA given an 53
Summary statistics have been calculated using Eviews 3.1 according to the formulas
sample means and
for sample standard deviations.
for
180 average increase in financial cost of about 8% for ETEBA, a fall of 19% for Investment Bank and a rise of 101% for ETBA. Hence, the deregulation period increased the variability of their total borrowing costs thus raising the riskiness of their operation. Inspection of Table 6.1.3 reveals that average net profits for ETEBA seem unaffected, in their rising trend, between periods of high growth, stagnation and financial liberalization. On the contrary, Investment Bank, during the phase of its reorganization exhibits a falling trend in mean profits. Futhermore, ETBA‟s net profits also fall as we move along the three periods so as to present losses on
Table 6.1.2: Financial Charges: Summary Statistics ETEBA
Mean
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1967-
1975-
1987-
1974
1986
2001
1974
1986
1997
1974
1986
2002
480.12
2572.43 2774.85 194.30 1194.34 964.32
1765.35 7089.65
14265.32
1214.23 1084.93 1976.22 7333.57
13221.67
Median 266.76
2565.61 2947.81 68.41
Std.
504.04
682.33
Min
0.00
1581.57 727.36
Max
1357.86 3523.68 4804.00 725.00 1467.47 1915.55 2947.43 12591.77 28992.57
1118.26 251.75 167.45
660.95
1112.53 3339.19
9521.66
0.32
344.97
2629.66
Dev. 0.60
964.89
2986.89
Source: Own Calculations average during the period 1987 – 2002. For both ETBA and Investment Bank, the riskiness of their operation increases along with the fall in their average profits as the evolution of standards deviations indicate. On the other hand, we need to stress the rising risk during the deregulation period even for the most financially successful bank, ETEBA, which exhibits, along with an average increase in net profits by about 81% between 1975 – 1986 and 1987 – 2001, an enormous rise in their variability by about 274%. For the sake of comparison, the same figures for the periods 1964 – 1974 and 1975 – 1986 were 258% (net profits increase) and 39% (variability increase) respectively.
181 Table 6.1.3: Net Profits: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1967-
1975-
1987-
1974
1986
2001
1974
1986
1997
1974
1986
2002
145.84
521.86
946.54
67.63
9.20
-13.52
534.36
322.72
-5615.87
Median 89.94
485.83
811.53
50.10
20.45
-47.08
427.00
168.22
-3711.68
Std.
127.57
177.77
665.52
64.35
74.47
264.52
520.50
587.78
7819.66
Min
16.58
250.83
241.79
-23.22
-194.09 -295.58 0.00
15.25
-21299.9
Max
387.88
874.36
2569.03
201.59 98.03
Mean
Dev.
522.15
1330.91 2168.75
4340.59
Source: Own Calculations
2.6.2. Earning Assets: Loans and Placements in Securities Now, we will turn our attention to the data provided by the Balance Sheets of the three Banks. At first, it is interesting to see how long-term and medium-term loans evolved during the period under examination. This is a crucial figure as far as it indicates the transformation of the Banks from traditional long-term financing institutions under financial repression regimes to merchant or investment banks under the new liberalized market conditions. However, data are not available beyond 1991 when, because of the new Accounting standards, long-term financing data were no longer recorded separately in the Balance Sheets. Figure 5a provides the evolution of long and medium term loans for ETEBA. It is clear that long-term financing increases steadily until 1977, fluctuates at high levels during the period 1978 – 1981 and then decreases initially smoothly but quite sharply after 1984 with a small recovery between 1988 – 1989. The conclusions that can be drawn from this picture are the following. ETEBA tried to support its clients during the oil crisis years of the 1970s by increasing or maintaining its financing at high levels. As can be seen from the data, the peak of 23127.10 million Drs in 1977 is followed by an average magnitude of long-term loans of 22926.17 million Drs for the period 1978 – 1981 with minimal fluctuation.
182
Figure 5a: ETEBA: Long Term and Medium Term Loans (Constant 1982 Prices) 25000,00
20000,00
15000,00
10000,00
Long and Medium Term Loans
5000,00
0,00
Source: ETEBA Annual Reports However, the falling pattern during the 1980s could possibly be the result of two compounding factors. First, the continuous existence of the troubled firms called “problimatikes” during the 1980s that made further long-term loans to them financially unsustainable. Secondly, the financial deregulation wave during the mid1980s onwards that opened new and more profitable opportunities for the Bank‟s operation. The examination of placements in securities later in this paper might establish this result. For the moment, note that long and medium term loans fell by about 11.1% during the period 1982 – 1984 but by 29.38% between 1984 – 1987 and by 22.63% during the years 1987 – 1991 including the short recovery of the late 1980s. Figure 5b depicts the same data for the Investment Bank. Ignoring the rupture in data for the year 1975, it is obvious that long-term loans increase until 1976 and then follow a falling trend without any sign of recovery through 1990. In this case, it seems that the turbulent times in the real economy during the 1970s and 1980s were the main cause of such a steady fall in long-term financing during this period. Investment Bank appears to be completely driven by the adverse events in the real economy without the ability to react to them at least as far as long term financing of enterprises is concerned . After reaching the peak of 12777.85 million Drs in 1976,
183
Figure 5b: Investment Bank: Long Term and Medium Term Loans (Constant 1982 Prices)
14000,00
12000,00
10000,00
8000,00
Long and Medium Term Loans
6000,00
4000,00
2000,00
0,00
Source: Investment Bank Annual Reports long and medium term loans fell by 21.61% between the years 1977 – 1981 and by the impressing 73.96% during the period 1981 – 1992. However, it is interesting that
Figure 5c: ETBA: Long Term and Medium Term Loans (Constant 1982 Prices) 120000,00
100000,00
80000,00
60000,00 Long and Medium Term Loans 40000,00
20000,00
Source: ETBA Annual Reports
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
0,00
184 both for ETEBA and Investment Bank the time of inflection seems to be the years 1976-77 where long-term financing stops to be increasing and in the case of Investment Bank it also decreases thereafter. However, the data for ETBA depicted in Figure 5c provides again a trend in long term financing that contradicts that of the two private banks. The pattern is rising for the whole period until 1992 although long term loans fall during the period 1974 – 1977 so as to decrease in 1977 by about 23.12% with respect to the 1973 figure. Then long term financing is rising again from 1978 onwards initially smoothly, by about 11.60% during the period 1978 – 1986, and then more sharply by 39.43% for the period 1987 – 1992. The data indicates two things. First, ETBA followed a policy of continuing financing of Greek firms throughout the whole period of diminishing and even negative growth rates for the Greek economy in the 1970s and 1980s. Furthermore, there seems to be no substitution of alternative banking activity for that of long term financing even after the deregulation of the mid-1980s. In short, ETBA appears to be unaffected, from the point of view of its long-term financing activity given the developments in both the real and the financial sector. The second interesting figure in the Balance Sheets of the three Banks is that which is related to their placements in securities as an important element of their assets. Given the available data in the financial statements, we can distinguish between investment in shares and investment in bonds (public and private) and mutual funds. The importance of this kind of data is twofold. First, they indicate, although indirectly, to what degree Development Banks contributed to the development of the capital market by becoming a buyer of securities from both the government and the firms they financed. Secondly, it gives a picture of how they were affected by financial deregulation to the degree that such an operation – along with the trading of these securities – increases in time as liberalization of the financial markets goes on. Figure 6a depicts these developments for ETEBA. It is clear that total investment in securities fluctuates during the period 1972 – 1986 around a mean value of 4204.63 million Drs while the same value for the period 1987 – 1997 is 6297.89 million Drs. Then, placements in securities increase at a growing rate to reach the peak of 24978.58 million Drs at constant 1982 prices in 1999 while remaining at the high level of 20829.86 in the last year of operation.
185 On the other hand, the synthesis of securities held is also interesting. Placements in shares remain the main part of the portfolio of securities during the Figure 6a:ETEBA: Investments in Securities (Constant 1982 Prices) 60000,00
50000,00
40000,00
30000,00
Total Investments in Securities Investments in Bonds, Treasury Bonds & Mutual Funds Investments in Shares
20000,00
10000,00
0,00
Source: ETEBA Annual Reports period 1970 – 1995 with an average 77% of total portfolio comprised of shares (standard deviation 0.17). On the contrary, for the period 1964 – 1969 shares comprise on average only the 32% of the total portfolio (standard deviation 0.16) while for the period 1996 – 2001 they comprise 34% of the total placements in securities (standard deviation 0.07). Indeed, it is surprising that the Bank‟s managers selected to place their funds in the riskier shares during the era of crisis and decreasing growth while choosing the safer placement in bond-like investments during the more favourable periods for the economy. Total investment in securities and its composition for Investment Bank are depicted in Figure 6b. We can discern two phases. The first covers the period 1964 – 1978 where placements in shares and bonds increase reaching the peak of 1971.66 million Drs at constant 1982 prices. However, from 1979 onwards and till 1992 and 1996 – 1997 there is a clear decreasing trend in securities‟ holdings. The synthesis of the portfolio is also interesting with share holdings predominating during the whole period. Indeed, the proportion of shares in the portfolio of securities is on average 90% with standard deviation 0.19.
186
Figure 6b:Investment Bank: Investments in Securities (Constant 1982 Prices) 4500,00 4000,00 3500,00 3000,00
Total Investments in Securities
2500,00
Investments in Bonds, Treasury Bonds & Mutual Funds
2000,00
Investments in Shares
1500,00 1000,00 500,00 0,00
Source: Investment Bank Annual Reports
The case for ETBA is depicted in Figure 6c below. Concerning the total level of securities held, these remain at high levels during the whole period although they exhibit a further substantial rise between the years 1993 – 1995 and 1999 – 2000 and then fall. For the previous period 1965 – 1992 the average level of total securities reaches the amount of 17087.07 million constant Drs. The lowest value is observed in the year 1981 at 11700.81 million Drs. while the highest is exhibited in the year 1992 at
187
Figure 6c: ETBA: Investments in Securities (Constant 1982 Prices) 180000,00 160000,00 140000,00 120000,00 Total Investments in Securities 100000,00 Investments in Bonds, Treasury Bonds & Mutual Funds
80000,00
Investments in Shares
60000,00 40000,00 20000,00 0,00
Source: ETBA Annual Reports
30940.85 million Drs. Nevertheless, the highest value of securities holdings is obtained in the year 1995 which is a figure of 80227.56 million constant Drs while for the last period 1999 – 2002 the average value is 40146.23 million Drs. On the other hand, the composition of the portfolio seems to change after 1992. Indeed, during the period 1965 – 1992 the proportion of shares in the total is on average 93% with standard deviation 0.09. On the contrary for the period 1993 – 2002 the share of equity holdings falls to 29% with standard deviation 0.12. Now we will turn to a series of figures that compare the evolution of long-term financing and of securities holdings for each Bank. In fact, these two kinds of assets, loans and securities, constituted the main elements in the Asset side of their Balance Sheets and as such they disserve a closer examination. On the other hand, the evolution of the composition of assets between loans and securities obtains a particular importance in our study as far as it indicates the changing nature of these Banks. Since loans here refer to long and medium term financing which are characteristic of the traditional development banking activity, their possible substitution intertemporarily by securities holdings in the business affairs of these Banks indicate a form of institutional transformation towards market-oriented
188 merchant and investment banking activity. It is interesting then to see, whether this is supported by the data and, if this is case, when this happens. Figure 7a depicts the parallel evolution of long term financing and securities Figure 7a: ETEBA: Loans and Placements in Securities (Constant 1982 Prices) 30000,00
25000,00
20000,00
15000,00
10000,00
Long and Medium Term Loans Total Investments in Securities
5000,00
0,00
Source: ETEBA Annual Reports
holdings for ETEBA. Although data is not available beyond 1991 for long-term loans, it is safe to assume that this kind of activity would continue its falling trend during the period 1992 onwards. On the other hand, placements in securities exhibit a rising trend not only from 1998 onwards but also during the period 1986 – 1997. Hence, it seems that, at least in the case of ETEBA there is a clear substitution of long-term financing activity through the traditional form of loans by indirect financing of industry through share or bond holdings. The fact that this change happened especially from 1986 onwards when financial market deregulation accelerated in the Greek economy indicates that the Bank perceived the new era beginning in the financial system quite early. Furthermore, as capital market grew substantially during the 1990s, the Bank increased such activity in unprecedented levels as the growth of it by 153.47% between the years 1997 – 2001 indicates. The picture for Investment Bank that Figure 7b illustrates, indicates that this Bank‟s operation reflects to a lesser degree the developments in the financial sector
189
Figure 7b:Investment Bank: Loans and Placements in Securities (Constant 1982 Prices)
14000,00
12000,00
10000,00
8000,00
Long and Medium Term Loans 6000,00
Total Investments in Securities
4000,00
2000,00
0,00
Source: Investment Bank Annual Reports
than it is the case for ETEBA. Although long term financing decreases steadily even from the mid-1970s, securities‟ holdings also decrease as of 1979. Hence, no substitution between the two kinds of assets can be established for this period at least as far as their long run trend indicates. Hence, it seems that Investment Bank could not follow the example of ETEBA concerning the exploitation of the new opportunities of the financial market deregulation during the 1990s. Again, the picture is confusing for ETBA. As Figure 7c indicates both placements in securities and long term loans exhibit a rising trend until the early 1990s. On the other hand, securities holdings fluctuate wildly after their peak in 1995 while our data does not permit us to establish the trend for long and medium term loans. Hence, at least as far as our data permits us to conclude we cannot establish any substitution effect. The continuing long-term financing operation can be attributed to the state-owned nature of the Bank. However, despite this, financial deregulation seemed to affect temporarily the Bank‟s operation concerning the increase of its securities‟ holdings. Note their increase between 1992 – 1995 and 1999 – 2000. However, this effect was not sustainable as the downturn intervals of the years 1996 – 1998 and 2001 – 2002 indicate.
190
Figure 7c:ETBA: Loans and Placements in Securities (Constant 1982 Prices) 120000,00
100000,00
80000,00
60000,00
40000,00
Long and Medium Term Loans Total Investments in Securities
20000,00
0,00
Source: ETBA Annual Reports
Setting the previous serial trend analysis in the context of the periodization of Section 5 permits the extraction of a clear comparative picture for the three Banks given by Table 6.2.1 below. Consistent with the negative effect of financial liberalization on the long-term financing operation of private development banks we observe that the average magnitude of long-term loans decreased from 1987 onwards. Furthermore, to the degree that mean and median values are almost identical for this period indicates that decreased mean values are not guided by any low-value outliers. The picture is different for ETBA which observes its long-term loans to rise on average even during the deregulation period 1987 – 1993. The rupture between the behaviour of private and public banks on the one hand, and between the prederegulation and after-deregulation period for ETEBA and Investment Bank are confirmed.
191 Table 6.2.1: Long-term Loans: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1965-
1975-
1987-
1974
1986
1991
1974
1986
1992
1974
1986
1993
8330.50
20916.90 13130.60 3694.63
10202.45 5274.69 50059.66 65719.35 96553.49
Median 5297.00
21978.78 13741.11 2069.25
10016.26 5524.75 47200.85 66690.55 101178.7
Std.
8059.25
2668.97
1697.89
1816.78 19806.01 3848.37
Min
53.33
14914.18 10631.31 73.36
7622.95
2607.66 28359.68 58839.77 75257.23
Max
19817.21 23314.10 14494.39 10417.57 12777.85 7273.80 76534.98 71325.38 104931.4
Mean
1640.42
3577.98
11450.15
Dev.
Source: Own Calculations
However, the other aspect of financial liberalization and its effect on Banks‟ operation is the average evolution of securities‟ holdings during the three periods. As depicted in Table 6.2.2 below, placements in shares and bonds rise on average for all
Table 6.2.2: Placements in Securities: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1965-
1975-
1987-
1974
1986
2001
1974
1986
1997
1974
1986
2002
1808.71 4318.20 9809.95
632.34
1227.72 564.84 13662.50 16198.30 36197.08
Median 1207.35 4528.59 6451.19
737.06
1235.91 453.04 12672.06 16229.15 27892.42
Std.
332.42
421.08
239.22 2132.58
0.00
632.31
339.10 12328.06 11700.81 14419.74
Mean
1353.20 505.75
6603.57
2957.96
21157.23
Dev. Min
245.07
3507.89 4673.99
Max
4126.91 4831.09 24978.58 1047.43 1971.66 915.77 18939.26 20766.73 80227.56 Source: Own Calculations
three Banks before the deregulation era but only for ETEBA and ETBA during the deregulation period. Again mean and median values are quite close in most cases. However, the variability of this source of income differs between the two first and the two last periods. Standard deviations rise between 1975 – 1986 and 1987 – 2002 by about 1206% for ETEBA, 615% for ETBA and falls by 43% for Investment Bank
192 with respect to a fall of 62% for ETEBA, a rise of 27% for Investment Bank and of 39% for ETBA between the periods 1964 – 1974 and 1975 – 1986. Hence, although we have already seen by the serial trend analysis that from 1987 onwards securities‟ holdings reached high levels (at least for
ETEBA and ETBA), their increased
variability also indicates the decreased stability of this source of income as opposed to the previous financial repression period. This also means, that during the period 1987 – 2002 holding securities means more active trading in securities and exploiting the opportunities for capital gains than was the case in the previous periods where securities were held as a form of financing, supplementary to that of long-term loans.
2.6.3. The Liability Side: Own and Borrowed Funds The two sets of figures that we will present below concern the Liability side of the Balance Sheets of Banks. Important elements in this respect are the evolution of share capital, reserves and provisions on the one hand and the composition of borrowed funds on the other hand. The first set of data will give us a picture of how the own capital requirements of Banks evolved within the context of the developments in the real economy and the financial sector. The second indicates the dependence of Banks on local and foreign borrowing. Figure 8a: ETEBA: Share Capital, Reserves and Provisions (Constant 1982 Prices) 7000,00 6000,00 5000,00 4000,00 3000,00
Capital and Reserves Provisions
2000,00 1000,00 0,00
Source: ETEBA Annual Reports
193 Figure 8a gives the available data for share capital, reserves and provisions against bad debts for ETEBA. There is a continuously rising trend for both capital and provisions during the period 1964 – 1993. Concerning the share capital and reserves this is important as far as it indicates a continuous concern of the Bank to keep its credit risk low by raising its own funds including its capital base and retained earnings. On the other hand, keeping provisions for bad debts increasing in the long run can be understood as a response by ETEBA to the increasing risks of default on its loans during the 1970s and 1980s. Note that during the whole period 1973 – 1990 provisions for bad debts exhibit an almost steady increase. The situation changes for the period 1993 – 2001, a development that should reflect the reorientation of the activity of the Bank away from its traditional long-term financing operation. Finally, the increase of capital/reserves in the late 1990s should be related to the new risks that merchant banking operation entailed. Figure 8b depicts a different picture for Investment Bank. Ignoring the break in the data for the year 1974, it appears that during the period 1977 – 1991 the Bank‟s capital and reserves follow a decreasing pattern so as to exhibit in 1992 a negative figure of -201.37 million Drs. which continues in 1996 – 1997 with the negative values of -326,48 and -133.78 million Drs. in constant 1982 prices. This astonishing picture, along with persisting negative profits that we show in Figure 3b Figure 8b: Investment Bank: Share Capital, Reserves and Provisions (Constant 1982 Prices) 2000,00
1500,00
1000,00 Capital and Reserves 500,00
0,00
-500,00
Source: Investment Bank Annual Reports
Provisions
194 between the mid-1980s and mid-1990s can only be explained as a prolonged period of reorganization of the Bank during these turbulent times for the Greek economy. On the other hand, provisions for bad debts rise steadily until 1980 reaching the amount of 915.92 million Drs. Subsequently, they remain at an average value of 872.87 million Drs during the period 1981 – 1985 and follow a decreasing pattern with short fluctuations till 1997. In short, the evolution of both capital and provisions of the Bank during the 1980s and 1990s seems to justify our position that Investment Bank was unable to manage successfully the changing environment in both the real and the financial sector. Figure 8c exhibits the same kind of data for ETBA.
Both capital and
provisions seems to fluctuate though the first at a much larger magnitude. Share capital and reserves, after reaching a peak of 36893.18 million Drs in 1973 they follow a decreasing path until 1984 when they fall to 14793.46 million Drs. The short fluctuation during the period 1985 – 1991 is followed by further large fluctuations between 1992 and 2001. Figure 8c: ETBA: Share Capital, Reserves and Provisions (Constant 1982 Prices) 50000,00 45000,00 40000,00 35000,00 30000,00 25000,00
Capital and Reserves
20000,00
Provisions
15000,00 10000,00 5000,00 0,00
Source: ETBA Annual Reports
This fluctuating tendency during the 1990s was the result of falling profits that resulted in large losses during the period 1990 – 1997 absorbed by bank capital along with increases of share capital to add on banks own funds. On the other hand, the falling trend during the 1970s seems to indicate that the Bank did not pay the adequate care for its capital adequacy in the adverse economic situation of that era.
195 The same holds for its provisions for bad debts, although we need to acknowledge that the latter remained relatively high with an average of 4586.94 million Drs. for the period 1971 – 1985 when many Greek firms were rendered insolvent. The data for the source of borrowed funds refers to long and medium term borrowing plus bond issues of banks. Besides inspecting how internal and external borrowing evolved for each Bank, we will seek to find if any sort of correlation between this data and those concerning long-term financing that we saw before in Figures 5a,b,c exists. Furthermore, the data is available only till 1993, except for the case of Investment Bank for which the data exist till 1992. Figure 9a indicates the path of borrowed funds for ETEBA. As it can be seen, total long and medium term borrowed funds follow a pattern similar to that encountered for long-term financing. Bond issues are not reported separately for ETEBA. They rise till 1977, they fluctuate during the period 1978 – 1986 and then they decrease. Indeed, the correlation coefficient between the two series of data is about 94%54. This indicates that, to the degree that the Bank moved its business away from long-term financing it also decreased its dependence on long and medium term borrowing either from local or from foreign sources. So, the path of long and medium term borrowing and especially its decline during the mid-1980s onwards, indicates the gradual transformation of the Bank from
Figure 9a: ETEBA: Local and Foreign Borrowed Funds (Constant 1982 Prices) 60000,00 50000,00 40000,00 30000,00
Total Borrowed Funds
20000,00
Foreign Borrowed Funds
10000,00
Local Borrowed Funds
0,00
Source: ETEBA Annual Reports
54
Since test then this value is statistically significant.
for 26 d.f. at 0.05 level of significance one-tail
196
traditional development bank to a modern merchant bank. Furthermore, in the composition of its total borrowed funds, local borrowing predominates on average constituting 76% of the total funds (standard deviation 0.15). Foreign borrowing exceeds local one only in 1981 where the related figures are 12154.87 million Drs and 12083.77 million Drs at constant 1982 prices respectively. More generally, the composition of borrowing between local and foreign sources before and after 1981 are as in Table 6.3.1 below. The fact that the Bank either preferred or had easier access to domestic rather than
Table 6.3.1: ETEBA: Average Composition of Borrowed Funds Period
Foreign
Domestic
Borrowing
Borrowing
1965 – 1979
21%
79%
1980 – 1993
26%
74%
Source: Own Calculations
foreign sources to fund its long-term loans, exposed itself and its clients to a reduced degree to the risks following the collapse of the Bretton Woods system and the abrupt fluctuations of exchange rates that followed. Figure 9b presents the same kind of data for Investment Bank. In this case, the correlation coefficient between total borrowed funds and long term financing plus bond issues from 1981 onwards reaches the level of 99% for the period 1963 – 1974 and 98% between the years 1976 – 199155. So there is an even closer relationship between the Bank‟s development banking operation and this borrowed source of funds. Concerning, the composition between domestic and foreign sources, the latter never exceeded the former and in some cases they became even zero as in years 1969 – 1970 and 1976 – 1979. In general, the composition of borrowed funds in the two periods for which we have data is as in Table 6.3.2 below.
55
Both computed correlation coefficients are statistically significant since for the period 1963 -1974 we have for 10 d.f. at 0.05 level of significance and for period 1976 – 1991 we have for 14 d.f. at 0.05 level of significance one-tail test.
197
Figure 9b:Investment Bank: Local and Foreign Borrowed Funds (Constant 1982 Prices) 30000,00 25000,00 20000,00 Total Borrowed Funds
15000,00
Foreign Borrowed Funds
10000,00
Local Borrowed Funds
5000,00 0,00
Source: Investment Bank Annual Reports
Table 6.3.2: Investment Bank: Average Composition of Borrowed Funds Period
Foreign
Domestic
Borrowing
Borrowing
1963 – 1974
6%
94%
1976 – 1992
10%
90%
Source: Own Calculations The overall picture is similar to that of ETEBA with domestic borrowing to predominate throughout the period although in this case at a greater percentage. Figure 9c: ETBA: Local and Foreign Borrowed Funds (Constant 1982 Prices) 350000,00 300000,00 250000,00 200000,00
Total Borrowed Funds
150000,00
Foreign Borrowed Funds Local Borrowed Funds
100000,00 50000,00 0,00
Source: ETBA Annual Reports
198 Figure 9c gives a different picture for ETBA which is also expected as far as its long-term financing pattern was also different from that of the other two Banks. However, the correlation between total borrowed funds and long-term financing is not at all clear. In fact, we can distinguish three periods. During the first period 1965 – 1972 the correlation coefficient is as high as 99.8%. For the last period 1987 – 1991 the correlation coefficient is about 99%. The interesting point is that for the intermediate period 1974 – 1986 the correlation coefficient is only 65.4%56. Concerning the composition of borrowed funds, the data for ETBA exhibit a similar pattern with the other two banks as we move on from 1974 onwards. As it can be seen from Table 6.3.3 below foreign borrowed funds as percentage of total increase gradually so as in Table 6.3.3: ETBA: Average Composition of Borrowed Funds Period Foreign Domestic Borrowing
Borrowing
1965 – 1972
15%
85%
1974 – 1984 1985 – 1993
16% 30%
84% 70%
Source: Own Calculations the last period 1985 – 1993 to reach the level of 30% of total borrowed funds which include in their domestic component Bank‟s bond issues from 1975 onwards. Tables 6.3.4, 6.3.5 and 6.3.6 present the summary statistics for share capital, provisions and (long and medium term) borrowed funds respectively. Share capital and retained profits rise unambiguously on average for ETEBA. This is not the case for ETBA that exhibits a fall in its capital (in real terms) during 1975 – 1986. On the other hand, the data for Investment Bank reveals a fall in both average and median value for the last period which indicates the effects of the negative values for the years 1992, 1996, 1997. If the adequacy of capital and reserves is the ultimate indicator of the solvency situation of a Bank then their fall indicates that ETBA and Investment Bank faced problems in covering their liabilities during the respective periods. 56
All correlation coefficients are statistically significant at the 0.05 level of significance. For the period 1965 – 1972 for 6 d.f. For the period 1987 – 1991 we have for 3 d.f. Finally, for period 1974 – 1986 for 11 d.f.
199 The results for provisions against losses are almost identical for all banks. As Table 6.3.5 indicates, provisions rise on average during the second period but fall in the third period It is not surprising that the most successful Bank in financial terms exhibits a falling trend of provisions along with a falling trend in long term loans and
Table 6.3.4: Share Capital & Reserves: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1965-
1975-
1987-
1974
1986
2001
1974
1986
1997
1974
1986
2002
Mean
2054.34 3734.43 4479.60 902.33
1056.26 236.71
35397.76 19843.01 22608.33
Median
1929.04 3751.53 4483.79 899.97
1042.53 227.76
35848.98 19120.94 19142.21
Std.
542.72
1045.50 285.97
316.87
439.34
2104.01
Min
1226.07 2690.06 2833.11 335.57
606.68
-326.48 29780.43 14113.79 8019.03
Max
2961.91 4665.74 6622.25 1462.46 1644.92 752.52
622.06
4668.57
11468.20
Dev.
36893.18 28745.96 43621.39
Source: Own Calculations
a rising trend of net profits. To put it differently, it is surprising that the most troubled Banks see their provisions for losses to fall even when their falling or negative profits indicate the unhealthiness of their portfolio. This is an observation that would call for further examination by the aid of financial indicators such as the recovery of loans as
Table 6.3.5: Provisions: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1965-
1975-
1987-
1974
1986
2001
1974
1986
1997
1974
1986
2002
400.22
1816.48 1287.36
103.28 818.24
310.99
3533.06 4329.85
1598.87
Median 270.82
1887.75 273.98
46.48
871.32
427.07
2796.29 4415.33
1306.14
Std.
392.14
430.64
125.09 107.34
239.15
1132.66 1140.28
1041.50
Min
0.20
1230.55 181.70
0.00
2.60
2514.17 2443.19
309.99
Max
1037.75 2335.74 3138.35
561.72
5189.20 5951.44
3967.66
Mean
1218.67
Dev.
Source: Own Calculations
614.51
348.77 915.92
200 a ratio of total loans extended. However, because of lack of data such an exercise is not possible to be carried forward by this study. Finally, Table 6.3.6 gives a picture of the evolution of average long term borrowed funds plus bond issues which is similar for the two private banks but differs for ETBA which exhibits a continuously rising trend at average value in all periods. As we have already mentioned above, borrowed funds follow the trend of long-term
Table 6.3.6: Borrowed Funds: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1965-
1975-
1987-
1974
1986
1993
1974
1986
1992
1974
1986
1993
8730.12
25216.52 17589.00 3613.41 9914.67
5252.18 26074.60 74940.36
134952.5
Median 5388.24
25433.72 16189.23 2163.34 9196.32
5018.60 19156.94 71430.60
141157.0
Std.
8546.18
1403.46
1547.67 21154.65 20563.77
16331.33
Min
0.00
21686.76 11972.34 16.58
3490.78 4542.97
107833.1
Max
21674.82 26896.06 23651.92 9838.62 12033.45 7231.53 56391.91 113455.40 148962.4
Mean
4052.38
3555.43 1552.49
Dev. 8024.35
52766.47
Source: Own Calculations
loans and hence, they rise until the mid-1980s and then fall except for ETBA. However, it is interesting that, at least for ETEBA and Investment Bank the relatively high level of average borrowed funds during the period 1975 – 1986 is accompanied by a relatively low standard deviation around this mean. This indicates that the Banks maintained total borrowings at high levels during the whole crisis period in an attempt to cover the increased demand for loans mainly for reconstruction and reorganization of firms.
2.7. ETBA, ETEBA and Investment Bank: Financial Indices Although the analysis of Section 6 was useful in determining the major trends in the operation of the three Banks, it was an examination of data in absolute and not relative terms. Ratio analysis has the advantage of conditioning the previous absolute
201 figures on the scale of operation of each Bank thus making their comparison more meaningful. This kind of analysis we will attempt in this section. According to the literature, (Ledgerwood (1999), Koch (1995), Murinde & Kariisa-Kasa (1997), Jain (1989), Singh, Arora & Anand (1991)) the financial performance of the three Banks can be obtained by the examination of various financial indicators. These ratios include profitability measures such as Net Interest Margins (NIM), Net and Gross Profit Margins (NPM and GPM), Return on Total Assets (ROTA), Return on Earning Assets (ROEA) and Return on Equity (ROE). We can also obtain solvency indicators such as the Average Cost of Debt (ACD), Loss Ratios (LR) and Debt/Equity Ratios (DE).
2.7.1. Profitability Ratios The first measure of performance that we will calculate is the Net Interest Margin (NIM) (Koch (1995:116)) which equals the difference between Interest Revenue and Interest Expense over Earning Assets.
NIM
Interest Re venue InterestEx pense EarningAssets
This is a ratio that indicates the net interest return as a percentage of available assets. We have calculated this ratio for all three Banks for the whole period of operation by extracting the financial charges from interest income. As earning assets in the denominator we have included the amount of long and medium term loans till 199192 and subsequently the amount of long and short-term loans. As seen in Figure 10 below, and excluding the outliers for the years 1964-65 for ETEBA, the Net Interest Margin for all three Banks varies almost around the same level till 1990. Afterwards, there is a great divergence of the course of this indicator with the one pertaining to the data of ETEBA following a rising trend until 1996 and then a subsequent fall. On the contrary, Net Interest Margins for ETBA and Investment Bank fall after 1990 and 1991 respectively and reach even negative values, although in the case of ETBA the ratio rises again to positive values after
202
Figure 10: Net Interest Margin 1,2 1 0,8 0,6
ETEBA Net Interest Margin (NIM)
0,4
Investment Bank Net Interest Margin ETBA Net Interest Margin
0,2 0 -0,2
Source: Own Calculations
1996. The small range of fluctuation of the level of the ratio until the late 1980s can be attributed to the fact that it refers to long-term financing on concessional rates while the ratio after 1990 pertains to short-term loans and generally is affected by the deregulation on the loan activity of Banks. Table 7.1.1 gives a clearer picture for the evolution of the ratio. Observe that the indicator rises in median terms for ETEBA. We use the median to avoid the
Table 7.1.1: Net Interest Margins: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1967-
1975-
1987-
1974
1986
2001
1974
1986
1992
1974
1986
2002
0.16
0.05
0.09
0.04
0.03
0.02
0.03
0.03
0.01
Median 0.05
0.06
0.10
0.05
0.03
0.03
0.04
0.03
0.04
Std.
0.28
0.02
0.05
0.01
0.01
0.04
0.01
0.02
0.06
Min
0.03
0.03
0.02
0.02
0.00
-0.04
0.00
0.02
-0.09
Max
0.97
0.08
0.17
0.06
0.04
0.07
0.05
0.09
0.11
Mean
Dev.
Source: Own Calculations
203 outlier effect of the very large initial value of the ratio. However, on average, the Net Interest Margin falls for ETBA at least in the last period and for Investment Bank during the whole period of operation. The Net Interest Margin is a measure of profitability exclusively focused on the financial aspect of earnings and expenses over the related assets and hence, on the kinds of operation that are characteristic of a banking institution. Given this measure of performance, ETEBA sees its margin to rise over time while ETBA and Investment Bank exhibit a rather falling trend on average. Furthermore, the Net Interest Margin reaches the average level of 9% for ETEBA during the deregulation period while for the same era ETBA exhibits even negative values with an average of only 1%. Taking into account all sources of revenues and assets, Return on Total Assets (ROTA) (Singh, Arora & Anand (1991))57 is calculated by adding net profits58 and financial expenses and then dividing the result by the sum of capital and reserves plus total borrowings59.
ROTA
Net Pr ofits FinancialE xpenses NetWorth Debt
As can be seen from Figure 11 below, Return on Total Assets follows a rising trend for ETEBA from a low value of 1%-2% in 1964-65 to a high of 21%-22% during the period 1991-1993. The rising trend is even more pronounced for Investment Bank whose indicator starting from negative rates of return for the two first years of its operation reaches the level of 20% for the year 1990 and even the levels of 42% for 1991 and 35% for 1992. However, if we do not take into account these extreme figures during the early 1990s the return on Bank‟s total assets – in accounting terms – is quite similar to that of ETEBA. The picture is different for ETBA. The Bank is witnessing a rising return – with short fluctuations – till 1987 with figures starting from 3% and reaching the level of 11%. However, afterwards and till 1993, the trend is falling as the return on total assets decreases from 11% to 3%.
57
Singh et. al. (1991) calculate this ratio under the heading “Return on Investment (ROI)” In our case net profits are before tax profits 59 However note that in our case “Debt” pertains only to long term debt plus bond issues. 58
204 Figure 11: Returns on Total Assets 0,5
0,4
0,3
ETEBA Return on Total Assets (ROTA)
0,2
Investment Bank Return on Total Assets ETBA Return on Total Assets
0,1
0
-0,1
Source: Own Calculations
However, taking the average figures for the three subperiods gives a more meaningful picture. Hence, according to Table 7.1.2 below, ETEBA sees its average return to rise with small standard deviation between the periods. However, the same picture – of rising average returns – we obtain for Investment Bank, although in this case the variability of this ratio, especially for the last period is much larger than that of ETEBA. In addition, observe the stability of average ROTA at 8% for ETBA during the last two periods with small standard deviation.
Table 7.1.2: Return on Total Assets: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1967-
1975-
1987-
1974
1986
1993
1974
1986
1992
1974
1986
1993
0.05
0.11
0.18
0.03
0.11
0.24
0.04
0.08
0.08
Median 0.05
0.11
0.17
0.04
0.13
0.19
0.03
0.09
0.09
Std.
0.02
0.02
0.03
0.04
0.03
0.12
0.02
0.02
0.03
Min
0.01
0.08
0.15
-0.06
0.07
0.13
0.03
0.04
0.03
Max
0.07
0.13
0.22
0.08
0.14
0.42
0.08
0.11
0.11
Mean
Dev.
Source: Own Calculations
205
However, the general picture that we obtain from this measure of performance is that the returns on the Banks‟ assets – irrespectively of the net profitability of the Banks themselves when the various costs were deducted – were quite high and positive for all the three of them. Is the previous picture maintained if we focus on the return as a percentage of total earning assets only? We introduce this ratio both to correct for possible biases in ROTA as “Debt” in its denominator pertains only to long term debt and to cover a more extended period in the operation of the banks. Return on Earning Assets (ROEA) is calculated by dividing the sum of net profits and financial charges by total earning assets, that is the sum of long and medium term loans till 1991-92 or of long and short term loans afterwards plus total investment in securities. In addition, this measure, because of the availability of data, covers the whole period of operation of the three Banks.
ROEA
Net Pr ofits FinancialE xpenses TotalEarni ngAssets
Figure 12 gives the evolution of this ratio. The picture is quite interesting, especially for the period not captured by the ROTA measure. ETEBA‟s return on earning assets rises, more or less steadily until 1994 from a figure of 4% in 1965 to 33% in 1994. But subsequently this return falls to the level of 14% in 1996 and 1999 and to only 9% in 2001. On the other hand, Investment Bank sees its ROEA to rise up to the level of 39% in 1991 and even 52% in 1997 – excluding the extreme value for 1996. ETBA exhibits a less clear pattern with a return on earning assets that rises with fluctuations until 1987 when it reaches the level of 14%. Then, after a steady fall that also includes negative values for the years 1996 and 1997, this rate of return stabilizes to the level of 4%-6% during the last two years of operation. Table 7.1.3 gives the summary of these movements. The rise on average returns for ETEBA is steady and unambiguous as the identical mean and median values indicate. However, the variability of the ratio rises also. This effect is even more notable for Investment Bank with a standard deviation of 0.41 for the period 1987 – 1997. On the other hand, ETBA exhibits similar average and mean rates of
206
Figure 12: Returns on Earning Assets 1,6 1,4 1,2 ETEBA Return on Earning Assets (ROEA)
1 0,8 0,6
Investment Bank Return on Earning Assets
0,4
ETBA Return on Earning Assets
0,2 0 -0,2 -0,4
Source: Own Calculations return for the two last periods although the variability of the last period‟s returns is much greater. Indeed, the standard deviations and their increase during the period of deregulation is the most interesting element of these summary statistics as they indicate the much riskier nature of these returns in the liberalized market for all the three Banks.
Table 7.1.3: Return on Earning Assets: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1967-
1975-
1987-
1974
1986
2001
1974
1986
1997
1974
1986
2002
0.06
0.13
0.19
0.01
0.11
0.42
0.03
0.09
0.09
Median 0.06
0.12
0.18
0.04
0.12
0.28
0.03
0.10
0.10
Std.
0.01
0.04
0.06
0.11
0.03
0.45
0.005
0.04
0.11
Min
0.04
0.08
0.09
-0.31
0.07
0.12
0.03
0.04
-0.17
Max
0.09
0.20
0.33
0.08
0.13
1.46
0.04
0.15
0.41
Mean
Dev.
Source: Own Calculations
207 The previously calculated ratio Return on Total Assets, pooled the return that goes to debt holders with that pertaining to equity holders. On the contrary, to obtain a measure of profitability from the point of view of the owners of the Bank, the Return on Equity (ROE) (Murinde & Kariisa-Kasa (1997), Singh, Arora & Anand (1991))60 is the ratio of net profits over share capital and reserves (net worth).
ROE
Net Pr ofits NetWorth
As Figure 13 indicates, return on equity for ETEBA fluctuates for most of the period of operation between 10% and 20%, although initial values are quite lower between 1% and 8% for the period 1964 – 1971. However, the great difference is made during the last years of operation 1998 – 2001 when return on equity fluctuates between 28% and 43%. Fluctuation is even greater for Investment Bank reaching the minimums of -367% in 1991, -160% in 1996 and -131% in 1997 and the maximum of 147% in 1992. Excluding these extreme values the minimum is obtained in 1990 (49%) and the maximum in 1972 (15%). Figure 13: Returns on Equity 2
1
0 ETEBA Return on Equity (ROE) Investment Bank Return on Equity ETBA Return on Equity
-1
-2
-3
-4
Source: Own Calculations Table 7.1.4 indicates that Return on Equity rises for ETEBA both on average and in median values but falls for the other two Banks reaching negative values for
60
Singh et. al. (1991) calculate this ratio under the heading “Return on owners‟ Investment (ROOI)”
208 the period 1987 – 2002. It is notable that ETEBA manages to offer a return on its equity holders as high as 14% on average even in the crisis years 1975 – 1986 while the other two Banks see their rates of return diminish to levels of 2% or lower. Once again, the large variability of either ETEBA‟s positive or ETBA and Investment Bank‟s negative average rates of return for 1987 – 2002 indicates the increasingly
Table 7.1.4: Return on Equity: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1967-
1975-
1987-
1974
1986
2001
1974
1986
1997
1974
1986
2002
0.06
0.14
0.20
0.06
0.004
-0.72
0.02
0.02
-0.47
Median 0.05
0.14
0.18
0.06
0.02
-0.32
0.01
0.01
-0.21
Std.
0.04
0.03
0.10
0.07
0.09
1.51
0.02
0.02
0.66
Min
0.01
0.08
0.08
-0.07
-0.24
-3.67
0.00
0.00
-1.93
Max
0.13
0.20
0.43
0.15
0.11
1.47
0.04
0.08
0.10
Mean
Dev.
Source: Own Calculations
risky environment in which the banks operated, a risk bore predominantly by their shareholders as this measure indicates. Other interesting measures of performance are the Net Profit Margin and the Gross Profit Margin (Jain (1989))61. To calculate this indicator we first obtained the average cost of debt (ACD) by dividing financial charges by total borrowed funds. Then, subtracting from the average cost of debt the Return on Earning Assets (ROEA) (net profits plus financial charges over loans and securities held) we obtained the average Net Profit Spread or Net Profit Margin (NPM) in percentage terms. On the other hand, Gross Profit Margin is obtained by adding to the latter the operating
61
Jain (1989) calculates the ratio Net Profit Margin as the Gross Profit Margin minus the Operating Expenses ratio or while Gross Profit Margin is obtained by subtracting the Average Cost of Debt by the Average Return on the Loan Portfolio. However, since we do not have data on the rates of return on loan portfolios, in our paper we will obtain indirectly the Gross Profit Margin using Jain‟s (1989) relationship as but we will calculate the Net Profit Margin as the difference between the Return on Earning Assets (ROEA) and the Average Cost of Debt (ACD). We think that our approach follows the spirit of Jain‟s (1989) definitions to the degree that the ROEA does not include operating expenses and hence, qualifies for a measure of a profit margin net of such administrative expenses.
209 expenses ratio (OER) which in our case is the ratio of personnel charges over earning assets. Hence, the two margins were calculated as follows:
NPM ROEA ACD GPM NPM OER
As can be seen form Figure 14 below, ETEBA was the only Bank that Figure 14: Gross Profit Margins 0,4 0,3 0,2 0,1 0
ETEBA Gross Profit Margin (GPM) Investment Bank Gross Profit Margin
-0,1 -0,2
ETBA Gross Profit Margin
-0,3
Source: Own Calculations
maintained positive gross profit margin for the whole period of its operation. However, this margin decreased from 4% in 1965 to 1% in 1968 and remained to this level for most of the period until 1979. Then ETEBA exhibits a rising trend in its gross profit margin that reaches the level of 8% in 1986 while from 1987 onwards gross profit margin falls and remains close to 3%. On the other hand, Investment Bank‟s gross profit margin is positive only during the period 1965 – 1974 and for 1992 while it remains close to zero until 1989 with fluctuations. Subsequently, it follows a falling trend until 1992 when it reaches again a positive value. The situation is even more blurred for ETBA that exhibits quite large fluctuations. It has positive margins for the years 1975 of 1%, 1992 27% and for the period 1982 – 1989 that fluctuates between 1% and 5%.
210 The above described picture is evident by inspection of Table 7.1.5 below. ETEBA maintains its average positive gross profit margin for the three subperiods with small variability while Investment Bank exhibits persistently negative average values with much larger variation except in the interim period. ETBA‟s positive average margin for the last period is accompanied by very large standard deviation. The immediate result is that ETEBA‟s gross profitability was both financially superior and more stable than that of the other two Banks.
Table 7.1.5: Gross Profit Margin: Summary Statistics ETEBA
Investment Bank
ETBA
1965-
1975-
1987-
1963-
1976-
1987-
1967-
1975-
1987-
1974
1986
1993
1974
1986
1992
1972
1986
1993
0.02
0.03
0.03
-0.01
-0.01
-0.02
-0.01
0.01
0.02
Median 0.01
0.03
0.03
0.01
-0.01
-0.02
-0.01
0.01
0.01
Std.
0.01
0.02
0.01
0.08
0.007
0.03
0.005
0.02
0.12
Min
0.01
0.01
0.01
-0.25
-0.02
-0.06
-0.01
-0.01
-0.10
Max
0.04
0.08
0.05
0.03
0.00
0.02
0.00
0.05
0.27
Mean
Dev.
Source: Own Calculations
Figure 15:Net Profit Margins 0,3
0,2
0,1
0 ETEBA Net Profit Margin (NPM) -0,1
Investment Bank Net Profit Margin
-0,2
ETBA Net Profit Margin
-0,3
-0,4
Source: Own Calculations
211
The serial trend picture is similar for the Net Profit Margins as Figure 15 and Table 7.1.6 below reveal. Of course, the inclusion of personnel expenses as the only operating expenses pertaining to administration cost is an underestimation of the latter. However, to the degree that we are interested in the comparison of the three Banks, this comparative picture is not affected by this bias in our calculation. Note
Table 7.1.6: Net Profit Margin: Summary Statistics ETEBA
Investment Bank
ETBA
1965-
1975-
1987-
1963-
1976-
1987-
1967-
1975-
1987-
1974
1986
1993
1974
1986
1992
1974
1986
1993
0.01
0.03
0.02
-0.02
-0.02
-0.05
-0.01
-0.0008
0.01
Median 0.01
0.02
0.02
0.01
-0.01
-0.03
-0.01
-0.005
0.01
Std.
0.005
0.02
0.01
0.10
0.008
0.03
0.006
0.02
0.12
Min
0.00
0.00
0.00
-0.34
-0.03
-0.09
-0.02
-0.02
-0.11
Max
0.01
0.07
0.04
0.02
-0.01
-0.02
0.00
0.04
0.25
Mean
Dev.
Source: Own Calculations
also that once more, the stability of these margins is much higher for ETEBA than for the other two Banks that exhibit relatively high standard deviations around the mean values.
2.7.2 Solvency Ratios
Another interesting ratio is the Loss Ratio (LR) (Ledgerwood (1999:211))62 which is calculated by dividing the amount of accumulated Provisions for losses over total earning assets. In this case, we have included in the earning assets, not only the extended loans but also total investment in securities. This ratio reflects the proportion of losses that the Bank expects – as a real or precautionary measure – that they might need to be written off as a proportion of all earning assets. In this sense, it gives us an 62
Ledgerwood (1999:211) calculates this ratio as: Loan Loss Reserve Ratio (LLRR) = loan loss reserves for the period over portfolio outstanding for the period. Murinde & Kariisa-Kasa (1997) calculate a similar measure: COTL = net charge-offs over total loans and leases.
212 indication of the riskiness of the portfolio of the Bank according to the perception of its management.
LR
Pr ovisions TotalEarni ngAssets
As can be seen for Figure 16 below, the evolution of this ratio differs among the three Banks. It is true that both for ETEBA and Investment Bank, the Loss Ratio rises until the mid-1980s and fluctuates between 1985 and 1992-93. However, during Figure 16: Loss Ratios 0,18 0,16 0,14 0,12 0,1 0,08 0,06
ETEBA Loss Ratio (LR) Investment Bank Loss Ratio ETBA Loss Ratio
0,04 0,02 0
Source: Own Calculations
this last period, ETEBA maintains a much higher ratio than Investment Bank. The ratio for ETEBA falls during the 1990s. The picture is different for ETBA whose Loss Ratio surprisingly falls during the 1980s despite the burden of problematic enterprises that constituted a substantial proportion of its portfolio. Finally, throughout the decade of the 1990s the Loss Ratio for ETBA does not exhibit any persisting rising or falling pattern. Despite the particular pattern for ETBA, it seems that the Banks made substantial provisions for losses emanating from the long-term loans extended until the late 1980s while the period of financial liberalization – especially from the early
213 1990s onwards – was deemed by some of them as safer at least as far as their provisions for losses are concerned. Table 7.2.1 gives a clearer period by period picture. Loss Ratio increases on average in the case of ETEBA by about 133% between the two first periods and remains stable on average between the second and the third period. On the other hand, although Investment Bank increases its ratio by 250% in the crisis years its ratio of provisions over earning assets falls on average by 14% in the last period. Finally, ETBA is the only Bank whose ratio falls consistently on average during the whole period, initially by 17% during 1965 – 1974 and 1975 – 1986 and subsequently by 60% when moving on in the liberalization era. Solvency was certainly a problem for all Banks during the crisis years when they all maintained high ratios of about 5%-7% on average. Furthermore, solvency seems to have preoccupied ETEBA‟s management
Table 7.2.1: Loss Ratio: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1965-
1975-
1987-
1974
1986
2001
1974
1986
1997
1974
1986
2002
0.03
0.07
0.07
0.02
0.07
0.06
0.06
0.05
0.02
Median 0.04
0.07
0.02
0.02
0.07
0.06
0.06
0.06
0.01
Std.
0.02
0.03
0.07
0.01
0.02
0.04
0.01
0.01
0.01
Min
0.00
0.04
0.01
0.00
0.05
0.01
0.04
0.03
0.00
Max
0.05
0.12
0.17
0.03
0.09
0.11
0.07
0.07
0.05
Mean
Dev.
Source: Own Calculations
during the liberalization era as expected because of the higher risk in its operation that justified average ratios of about 7% similar to those of the crisis years. The puzzling issue, however, is the reverse trend of loss ratios for ETBA especially during the deregulation period with average value of only 2% and very small variability although the same ratio is fairly stable to 6%-5% during the two previous periods. An indirect measure of the degree to which the Banks could service their obligations is the average cost of debt. We have seen this measure when calculating the net and gross profit margins. However, a separate examination of this ratio is
214 interesting especially in terms of the comparison of the cost of debt from various sources between Banks and between periods. The Average Cost of Debt (ACD) (Jain (1989)) is obtained by dividing the financial charges by the total borrowed funds. However, in our case the variable “debt” includes only long term borrowing plus bond issues while the numerator pertains to total financial expenses. Hence, this measure is an approximation of the average cost of debt.
ACD
FinancialE xpenses Debt
Figure 17 below gives the evolution of the average cost of debt through time. Figure 17: Average Cost of Debt
0,6
0,5
0,4
ETEBA Average Cost of Debt (ACD)
0,3
Investment Bank Average Cost of Debt ETBA Average Cost of Debt
0,2
0,1
0
Source: Own Calculations Average cost of debt rises through time for all three Banks although in different magnitudes. ETEBA‟s cost of debt rises from a low 3%-4% in 1965 – 1966 to 25% in 1993. Investment Bank‟s ratio falls initially to 1% until 1966 and then rises persistently to reach the level of 26% in 1990 not considering the extreme values of 48% and 41% for the two last years for which we have data. On the other hand, for
215 ETBA the cost of debt rises from 4% in 1967 – 1971 to 14% in 1990 to reach the level of 16% - 18% in the period 1991 – 1993. Indeed, as Table 7.2.2 indicates, average cost of debt rises on average for all three banks. However, ETBA maintains a relatively low average cost of 14% during 1987 – 1993 while for the other two banks the relevant cost is much higher especially for Investment Bank. Deregulation, indeed, made the cost of external financing for development banks almost prohibitive with respect to previous periods. This effect is
Table 7.2.2: Average Cost of Debt: Summary Statistics ETEBA
Investment Bank
ETBA
1965-
1975-
1987-
1963-
1976-
1987-
1967-
1975-
1987-
1974
1986
1993
1974
1986
1992
1974
1986
1993
0.05
0.10
0.20
0.04
0.12
0.27
0.04
0.09
0.14
Median 0.05
0.11
0.18
0.04
0.14
0.23
0.04
0.10
0.14
Std.
0.01
0.02
0.04
0.02
0.03
0.14
0.005
0.02
0.03
Min
0.03
0.07
0.16
0.01
0.08
0.15
0.04
0.06
0.11
Max
0.06
0.13
0.25
0.07
0.15
0.48
0.05
0.12
0.18
Mean
Dev.
Source: Own Calculations
reflected in the rise of this cost by 100% on average for ETEBA but by 125% for Investment Bank and by 56% on average for the state-owned ETBA. If a rising cost of debt indicates a deterioration of the borrowing conditions for each Bank, then at least Investment Bank and ETEBA, the private banks, should have faced difficulties in meeting their debt obligations especially in the last period of their operation. The case was different for ETBA which had the support of the government at the same time when borrowing conditions for the private banks were deteriorating. The final indicator that we will examine is the usual debt/equity ratio which indicates the degree of leverage of the Banks.
216 Given the previous analysis that indicates the difficulty of the Banks to obtain external finance at favourable terms, we expect this ratio to fall through time as we move to the liberalization era and debt to substitute for capital and retained earnings. To calculate this ratio we have included in the numerator only long-term borrowing plus bond issues which are available until the early 1990s in the financial statements while denominator is consisted of equity capital and reserves (net worth). The patterns that we obtain are again differing between the two private banks and ETBA.
Figure 18: Debt/Equity Ratios 70 60 50 40 30 ETEBA Leverage (DE) Investment Bank Leverage ETBA Leverage
20 10 0 -10 -20 -30
Source: Own Calculations
As Figure 18 indicates, leverage for ETEBA and Investment Bank is much higher than that for ETBA until 1987-88. Subsequently, the debt/equity ratio falls for ETEBA, fluctuates wildly for Investment Bank and almost stabilizes for ETBA. Of course, ETBA was less dependent to borrowed funds than the private banks as far as the state – its only shareholder – provided it with the needed amounts of money necessary to implement its developmental role. Its privileged relation to the government helped it maintain a much lower leverage than the other two banks at least until the late 1980s. On the other hand, the almost similar pattern of debt/equity ratios for ETEBA and Investment Bank until 1987-88 indicates the dependence of
217 their leverage ratios to their long-term financing activity before financial deregulation. The picture is less clear for the early 1990s when ETEBA‟s ratio falls while that for Investment Bank overshoots greatly and then falls. However, we can attribute the latter to the reorganization phase that Investment Bank entered in the 1990s. However, inspecting the median values given in Table 7.2.3 below we observe that only for ETEBA debt/equity ratios rise between 1964 – 1974 and 1975 – 1986 and then fall as was expected. Leverage rises persistently for ETBA and rather stabilizes at high levels for Investment Bank. As far as ETBA is concerned this finding can be justified by the continuing long-term financing activity of this Bank until 1993. In addition, the back-up of the state as a lender of last resort and an ultimate guarantor made it unnecessary for the Bank to increase its equity with respect to its debt as a sign of more sound operation during the deregulation era.
Table 7.2.3: Debt Equity Ratio: Summary Statistics ETEBA
Investment Bank
ETBA
1964-
1975-
1987-
1963-
1976-
1987-
1965-
1974-
1987-
1974
1986
1993
1974
1986
1991
1972
1986
1993
3.66
6.90
4.78
3.54
9.84
20.53
0.63
3.96
7.39
Median 2.83
6.72
3.32
2.41
9.84
10.62
0.41
3.53
6.70
Std.
3.25
1.04
2.19
3.22
1.95
23.86
0.56
1.87
1.30
Min
0.00
5.40
2.71
0.05
7.17
7.53
0.13
1.84
6.15
Max
8.73
8.54
8.35
9.41
13.26
63.14
1.64
6.82
9.52
Mean
Dev.
Source: Own Calculations
2.8. Economic Development and the Changing Nature of the Banks
Development Banks were supposed to play a crucial role to the economic development of the country at least till the mid-1980s. Subsequently, they were meant to follow the process of both economic and financial development. The rate of growth of GDP during the years under examination might be useful as an indicator of the path
218 of economic development. The evolution of the rate of change of GDP for the period 1965 – 2001 is represented in Figure 19 below. As seen from this Figure, Greek economic development passed through three phases. There was a persistent high rate of growth until 1973, followed by large fluctuations involving also negative rates until 1993, while the last phase starting in 1994 exhibits the return of the economy to positive but mediocre rates of growth – probably justifiable for an economy much more
developed
than
that
of
the
1960s.
Figure 19: Real GDP Rate of Change
GDP Rate of Change % (Constant 1982 Prices)
15,0
10,0
5,0
0,0
GDP Rate of Change %
-5,0
-10,0
-15,0
Source: Own Calculations
Table 8.1 below gives the summary statistics for GDP growth under the three period classification which was characteristic for the operation of development banks in the Greek economy. Both in terms of means and in terms of medians, the respective rates of growth follow a downward trend as we move through the three periods. In addition, this lowering of average rates becomes more stable as it can be observed by the diminishing standard deviations. Furthermore, the range of values also decreases as we move from the mid-1960s to the mid-1980s and then to late-1990s. One might argue that this is not the right discrimination of periods of economic development in Greece as it can be seen by the time series trends in Figure 19 above. However, our intention is not to discern the respective patterns of growth in
219 the Greek economy but to examine the latter in relation to the patterns of change in development banking operation in the country.
Table 8.1: Real GDP Growth Rate: Summary Statistics 1965-
1975-
1987-
1974
1986
2001
7.71
2.73
2.55
Median 8.95
4.15
3.30
Std.
6.57
4.67
2.71
Min
-9.70
-3.90
-2.80
Max
13.20
9.60
7.20
Mean
Dev.
Source: Own Calculations
Hence, an interesting exercise would be to see, in comparative terms, the path followed by the GDP growth rate on the one hand, and the rate of change of crucial financial data for the three Banks. We think that in this data we should include the evolution of net profits, loans and securities holdings all in terms of their respective rate of change. This exercise cannot take the form of any correlation between this data since this would lead to inconsistent results as far as there is no reason for any direct and year by year relation between GDP growth and the above statistical data obtained by the Banks‟ Balance Sheets. Nevertheless, it is interesting to see whether the three phases described above for the Greek economic development have any correspondence to the Banks‟ net profits and their two main indicators of their operations. In addition, possible overshooting of the securities component during the years of financial deregulation – overshooting compared to the evolution of the rate of growth of GDP – might also be an indirect indicator of the effect of financial development on the operation of the Banks. Given this double task, both serial trend and statistical analysis will prove to be useful. Figure 20a presents GDP growth rates and net profits for ETEBA. As it can be viewed from this Figure, the rate of change of ETEBA‟s net profits is almost entirely
220
Figure 20a: Changes in ETEBA Net Profits and GDP 250
200
150
100
Rate of Change of Net Profits % (Constant 1982 Prices)
50
GDP Rate of Change % (Constant 1982 Prices)
0
-50
-100
Source: ETEBA Annual Reports & Own Calculations
positive until 1973 with the exception of a slightly negative figure ( - 4.96%) for the year 1968 and a larger – 36.55% for the second year of operation 1965. This picture contradicts the subsequent continuous fluctuation between positive and negative values during the period 1974 – 1997 which is followed by positive rates of growth of net profits for the period 1998 – 1999 and subsequently negative rates in 2000 - 2001. Hence, the pattern of ETEBA‟s rate of change of net profits conforms to that of GDP growth for the pre-1974 period and also to some degree to the period 1974 – 1994. However for the period after 1994 and especially for the last years of operation of the Bank, the factor of economic development seems to play a less important role to the evolution of net profits. Probably this can be attributed to a rising importance of the second factor that affected the operation of the Bank after the mid-1980s, that of financial sector development. At least to this influence we can attribute the large positive growth of profits in the stock market boom in 1998 – 1999 and the subsequent negative percentage rate of profits change in the burst of the early 2000. These observations are reaffirmed by the summary statistics of Table 8.2 below. Indeed, although ETEBA‟s change in net profits follows the downward trend in growth rates of the economy during the period of crisis 1975 – 1986, this does not happen from 1987 onwards when the Bank exhibits an increase in the average and
221 median growth of its profits despite the continuing downward trend in GDP growth rates.
Table 8.2: GDP Growth and ETEBA Net Profits GDP Growth Rate
ETEBA: Rate of Change in Net Profits
1965-
1975-
1987-
1965-
1975-
1987-
1974
1986
2001
1974
1986
2001
7.71
2.73
2.55
40.60
4.88
24.50
Median 8.95
4.15
3.30
17.68
0.43
7.64
Std.
6.57
4.67
2.71
73.90
34.13
56.46
Min
-9.70
-3.90
-2.80
-36.55
-39.01
-49.22
Max
13.20
9.60
7.20
197.83 59.26
Mean
Dev.
138.12
Source: Own Calculations
The picture we obtain for Investment Bank in Figure 20b is less encouraging for establishing any relationship between the rate of growth of GDP and the rate of Figure 20b: Changes in Investment Bank Net Profits and GDP 7000,00 6000,00 5000,00 4000,00 3000,00 2000,00 1000,00 0,00
Rate of Change of Net Profits % (Constant 1982 Prices) GDP Rate of Change % (Constant 1982 Prices)
-1000,00 -2000,00 -3000,00 -4000,00
Source: Investment Bank Annual Reports & Own Calculations
222 change of net profits. The later exhibit an alteration of positive and negative values not only during the period after 1974 but also during the golden age of Greek economic development in the mid-1960s and early 1970s. Furthermore, the recovery of net profits during the early 1990s was rather faible to be attributed either to economic or to financial development. In addition, the Bank presents a very large fluctuation in the rate of change of its net profits during the period 1985 – 1990 which cannot be attributed to any canonical phenomenon of its operation but rather it should be considered as outliers with little explanatory significance for the evolution of net profits of the Bank. Table 8.3 below gives a clearer picture of the situation. Observing the median rather than the average values we conclude that Investment Bank‟s net profits grew, more or less, in the same downward pattern with GDP growth rates. The distinctive characteristic of this data compared to that of ETEBA is that financial deregulation after 1987 did not have a positive effect on the Bank‟s rate of change of profitability.
Table 8.3: GDP Growth and Investment Bank Net Profits GDP Growth Rate
Investment
Bank:
Rate
of
Change in Net Profits 1965-
1975-
1987-
1964-
1977-
1987-
1974
1986
2001
1974
1986
1997
7.71
2.73
2.55
6.40
658.14
-726.53
Median 8.95
4.15
3.30
2.95
0.00
-102.43
Std.
6.57
4.67
2.71
118.55
1971.76
1171.66
Min
-9.70
-3.90
-2.80
-275.07
-112.09
-2662.2
Max
13.20
9.60
7.20
180.32
5908.98
28.15
Mean
Dev.
Source: Own Calculations
Finally, Figure 20c exhibits the same data for ETBA. It is obvious from the inspection of the graph that, during the whole period of operation ETBA‟s net profits in terms of rate of change fluctuate greatly without any form of dependence on GDP growth rates. For example, during the period 1971 – 1973 when the Greek economy exhibits rates of growth between 8% and 13%, the Bank‟s net profits present negative
223 rates of change. The situation does not change either during the late 1990s and early 2000s with negative rates of growth predominating. This might mean: firstly that the Bank played its developmental role unsuccessfully in terms of its financial viability. Secondly, that financial development after the mid-1980s affected it negatively rather than in a favourable manner. The disjunction of ETBA‟s rate of change in net profits Figure 20c: Changes in ETBA Net Profits and GDP (Year 1975 excluded) 400 300 200 100 0 Rate of Change of Net Profits %
-100 -200
GDP Rate of Change % (Constant 1982 Prices)
-300 -400 -500 -600 -700
Source: ETBA Annual Reports & Own Calculations
Table 8.4: GDP Growth and ETBA Net Profits GDP Growth Rate
ETBA: Rate of Change in Net Profits
1965-
1975-
1987-
1968-
1975-
1987-
1974
1986
2001
1973
1986
2002
7.71
2.73
2.55
-48.11
2268.74 -33.80
Median 8.95
4.15
3.30
-62.57
0.53
Std.
6.57
4.67
2.71
56.85
7824.07 178.51
Min
-9.70
-3.90
-2.80
-100.0
-91.24
Max
13.20
9.60
7.20
32.68
27111.4 256.75
Mean
-24.26
Dev.
Source: Own Calculations
-587.45
224 and both GDP growth and financial development is evident also from the summary statistics in Table 8.4 above. In median values net profits growth is positive only in the crisis years and certainly negative during financial deregulation. However, the omission of adequate data in the first period and especially before 1968 might indicate a downward bias for the results during the 1960s. Figures 21a,b,c give a picture of two things. First, how closely long-term Figure 21a: ETEBA: Changes in Loans, Investments in Securities and GDP 600
500
400
300
Rate of Change of Long Term and Medium Term Loans %
200
Rate of Change of Total Investments in Securities %
100
GDP Rate of Change % (Constant 1982 Prices)
0
-100
Source: ETEBA Annual Reports & Own Calculations
financing followed the rate of economic development. Secondly, how the latter was related to a financial development indicator such as securities holdings by the Banks. In Figure 21a, we see that ETEBA‟s rate of change of long-term loans followed in general the path of economic development though at an overshooting level for the initial years of operation. This is justifiable, as far as the need for financing developmental projects during the 1960s was pressing. However, during the subsequent years and especially after 1974 the rates of growth of long-term loans follow the fluctuations in economic development rates. The picture is different for the rates of change of securities holdings. They exhibit positive, and in some cases large, figures both during the late 1960s-early 1970s and the period after financial deregulation especially during the late 1990s. The first should be attributed to the policy of the Bank to buy securities of funded enterprises as an alternative form of
225 financing. The second seems to relate to the wave of financial development that affected the operation of the Bank. Table 8.5: ETEBA‟s Loans, Securities and GDP Growth: Summary Statistics GDP Growth Rates
ETEBA
Loans
Growth ETEBA Securities Holdings
Rate
Growth Rate
1965-
1975-
1987-
1965-
1975-
1987-
1965-
1975-
1987-
1974
1986
2001
1974
1986
1991
1974
1986
2001
7.71
2.73
2.55
109.22 -2.11
-6.23
45.34
-0.98
18.15
Median 8.95
4.15
3.30
60.47
-7.86
21.85
-2.28
12.75
Std.
6.57
4.67
2.71
145.76 7.04
8.65
82.86
7.64
39.01
Min
-9.70
-3.90
-2.80
0.59
-14.36
-6.21
-9.07
-29.84
Max
13.20
9.60
7.20
494.73 12.97
5.48
271.46
18.72
102.78
Mean
-1.51
Dev. -12.99
Source: Own Calculations
The distinction between the pattern in the rate of change of loans and securities‟ holdings is evident in Table 8.5 above. Loans‟ rate of growth follow the decreasing change in GDP in all periods up to 1991. The same happens for securities
Figure 21b: Investment Bank: Changes in Loans, Investments in Securities and GDP (1966-1997) 70,00 60,00 50,00 40,00 30,00 20,00 10,00 0,00 -10,00
Rate of Change of Long Term and Medium Term Loans % Rate of Change of Total Investments in Securities % GDP Rate of Change % (Constant 1982 Prices)
-20,00 -30,00 -40,00
Source: Investment Bank Annual Reports & Own Calculations
226 up to the mid-1980s. However, the period of deregulation sees a rise in total investment in securities though not of the same magnitude as that before 1974. Figure 21b reassures our observation for the relation between rates of change of long-term financing and GDP growth rates in this case for Investment Bank. The positive rates during the 1960s and early 1970s are followed by negative rates in the turbulent times in the Greek economy from the mid-1970s onwards. On the other hand, securities holdings though at positive rates in the late 1960s they become negative during the 1970s and 1980s. The pattern of loans‟ growth is the same with that of ETEBA as it was expected. Table 8.6: Investment Bank‟s Loans, Securities and GDP Growth: Summary Statistics GDP Growth Rates
Investment Bank Loans Investment Bank Securities Growth Rate
Holdings Growth Rate
1965-
1975-
1987-
1965-
1977-
1987-
1965-
1977-
1987-
1974
1986
2001
1974
1986
1991
1974
1986
1997
7.71
2.73
2.55
40.37
-5.00
-12.29
734.18
-7.10
-4.96
Median 8.95
4.15
3.30
32.29
-5.78
-9.00
13.32
-12.74
-5.35
Std.
6.57
4.67
2.71
29.84
2.78
8.03
2288.89 17.75
24.16
Min
-9.70
-3.90
-2.80
10.87
-8.57
-22.14
-19.82
-31.77
Max
13.20
9.60
7.20
113.84 -1.33
-4.58
7248.27 42.79
Mean
Dev. -15.91
44.83
Source: Own Calculations
Figure 21c presents the same data for ETBA. As we see, ETBA maintains positive rates of growth of long-term financing not only during the late 1960s and early 1970s but also for most of the years during 1978 – 1991 which indicates its persistent endeavour to revive the economy during the adverse times. On the other hand, securities holdings‟ rate of change fluctuates for the whole period of operation between positive and negative values. However, the much greater variance during the 1990s indicates the effect of financial markets deregulation and the rising importance of securities management during this period.
227
Figure 21c: ETBA: Changes in Loans, Investments in Securities and GDP 200
150
100 Rate of Change of Long Term and Medium Term Loans % 50
Rate of Change of Total Investments in Securities % GDP Rate of Change % (Constant 1982 Prices)
0
-50
-100
Source: ETBA Annual Reports & Own Calculations
Table 8.7 below provides a clearer picture for the pattern of growth rates of loans and securities in the respective periods. Loans‟ growth remains positive but in addition, it accelerates during the last period 1987 – 1991 reaching the average Table 8.7: ETBA‟s Loans, Securities and GDP Growth: Summary Statistics GDP Growth Rates
ETBA
Bank
Loans ETBA Securities Holdings
Growth Rate
Growth Rate
1965-
1975-
1987-
1966-
1975-
1987-
1966-
1975-
1987-
1974
1986
2001
1974
1986
1991
1974
1986
2001
7.71
2.73
2.55
9.67
0.01
9.29
3.44
1.42
21.49
Median 8.95
4.15
3.30
13.25
0.56
11.17
1.00
3.14
-0.47
Std.
6.57
4.67
2.71
13.87
4.49
7.34
13.51
14.49
62.70
Min
-9.70
-3.90
-2.80
-10.65
-7.17
1.03
-17.24
-20.86
-82.03
Max
13.20
9.60
7.20
26.76
6.74
17.75
34.03
21.64
169.77
Mean
Dev.
Source: Own Calculations
228 levels of the 1960s-1970s maybe in an attempt to keep viable and non-viable firms alive despite the adverse economic environment. On the other hand, although securities holdings grew quite fast in 1987 – 2001 on average, the median value for the period is negative and close to zero. Hence, the degree to which ETBA managed to conform itself to the new opportunities given in securities‟ markets is rather ambiguous.
2.9. Conclusions: Development Banks and Institutional Change
The analysis provided in Sections 5, 6, 7 and 8 of this paper attempted to answer the question of the contribution of development banks in the institutional transformation and development of the Greek economy along with the effects that such a process had on the purpose and functioning of development banks themselves. Section 5 gave a short overview of the historical development of each bank and it established three major periods under which their history can be divided. The first period covers the years of high growth of the Greek economy until the early ‟70s and is marked by a host of initiatives of these institutions towards both the industrialization of the economy and its financial development. The second period is characterized as the “crisis years” and extends from the first oil crisis to the mid-80s. This is the period where development banks were called to play a role supportive for the old industrialization model by assuming the responsibility to rescue and reorganize troubled firms with visible adverse consequences for their financial health. Finally, the last period from mid-80s onwards was the period of financial liberalization in which development banks had the task of reorganizing themselves in a changing financial environment, thus proving in practice their dynamic nature. The analysis indicated that all banks, depending on their resources and scale of operation, contributed to economic development through various forms of financing of leading industries such as chemicals, paper, metal, textile, food, building materials and also shipping and tourism. The means used for financing included loans and share participation while during the crisis period they used methods such as debt rescheduling, loan securitization and suspension of interest due in order to help the reorganization of industrial firms. However, what is less well known is that financial
229 development was a continuing concern for the three banks even from the first period of their operation. All banks indicated the need for institutional change in their Annual Reports but they also took measures towards this direction. Their initiatives included the establishment of mutual funds, a clearing office for unquoted shares, channeling of their securities‟ portfolio to the capital market, issuing their own securities to the public in order to both obtain additional funds and create a securities‟ culture, underwriting of new issues and the introduction of leasing practices. These initiatives accelerated during the deregulation period as expected, but the important point is that they were present as early as the late 60s and early 70s and hence, they prepared the introduction of market-friendly instruments during the financial liberalization period. To this end we need also to consider the technical and management support of Greek firms by the specialized personnel of the banks and the studies elaborated both for issues related to the development of various industries and those related to the development of the capital market and the financial structure of the economy. Section 6 supplemented the previous analysis by examining the financial statements of the banks. It answers the question of how changing economic and institutional conditions were reflected in the financial data of the banks. Serial trend analysis of gross income, financial and payroll expenses and net profits reveal the differences between banks concerning their operation among the three periods. Gross income and financial expenses rise through these periods for ETEBA and ETBA while it falls for Investment Bank during the last period. On the other hand, net profits reveal that ETEBA was the only bank with rising average profits throughout the whole period of examination while the other two exhibit a falling trend presenting negative profits at constant 1982 prices during the deregulation period. This gives a first clue on how each bank fulfilled the tasks described in Section 5 concerning the efficiency of their operation in financial terms. On the other hand, serial trend analysis concerning loans and placements in securities indicates the differences between the two institutions that were under the control of commercial banks and the publicly owned bank. ETEBA and Investment Bank see their long-term loans to decrease steadily during the deregulation period. This does not happen in the case of ETBA with rising loan activity even after the mid-80s. The picture is different for the securities in the portfolio of banks that are rising for all banks, except Investment Bank, on average throughout the whole period of examination. However, only for the
230 private bank ETEBA there seemed to be a substitution of securities‟ holdings for long-term financing. It seems that the presence of the state in the case of ETBA acted as an additional restraint towards its early internal transformation in the face of the changing financial environment. This is also reflected in the evolution of share capital and reserves which falls for ETBA in the crisis years while it is rising on average for the private banks. ETEBA increases its own funds and both ETEBA and Investment Bank decrease their borrowing during the deregulation period as concessional finance during this period comes to an end. On the contrary, ETBA increases its borrowing along with its capital in the deregulation period, indicating a Bank persisting to act in the old developmental manner to the degree that increased borrowing is closely correlated with increased loan financing. However, the puzzling issue is that provisions for bad loans exhibited a falling trend for ETBA in the deregulation period indicating a disregard of the related risks of loan financing. The result of the analysis of Section 6 is that, although the changing financial regime was directly reflected in the changing nature of the two private banks, the public ETBA perceived the demands of the new financial conditions at a delay in an effort to reconcile the old development banking role and the new investment banking role. Furthermore, between the two private banks, ETEBA seems that it achieved its transformation with success in financial terms. These results are reaffirmed by the analysis of Section 7 where the examination of various financial ratios makes the comparison between banks clearer. Although Return on Total Assets and Return on Earning Assets are overall rising on average for all banks, Return on Equity is rising only for ETEBA while it falls during the last two periods for Investment Bank and ETBA. Net Interest Margin rises again only for ETEBA (median values) and follows a falling trend for the other Banks (on average). On the other hand, the much stricter measures of Gross and Net Profit Margins are positive in all periods only for ETEBA while they are negative for Investment Bank in all periods and for ETBA in the first periods. Again, in terms of the solvency position of the banks, Loss Ratios are rising during the crisis period for ETEBA and Investment Bank and falling for ETBA throughout all periods indicating the less prudent policy of the later to decrease provisions in the turbulent years. This contradicts the prudent management of ETEBA which is also indicated by the much lower increase in its average cost of debt through the periods comparing to the other private bank. The lower cost for ETBA indicates
231 the privileges of a government institution. On the other hand, debt-equity ratios fall during deregulation only for ETEBA and rise for Investment Bank and ETBA. Sections 6 and 7 gave us the picture of how the external environment affected the banks and their transformation. However, as we show in Section 5, the banks also played a significant role to this transformation. How this role is reflected in their financial data is analyzed in Section 8. Net profits growth should be the reflection of GDP growth as indicator of economic development. This is the case for Investment Bank with falling net profits growth although the pattern for ETBA is unclear. However, ETEBA sees a rise in its net profits growth during the deregulation period indicating its positive reaction in financial deregulation and its successful transformation. On the other hand, the picture we obtain for loans and securities‟ holdings growth with respect to GDP growth indicates the continuing endeavour of banks to contribute to economic and financial development even if they had financial losses. Hence, despite its losses ETBA‟s loans growth rate, although falling during the crisis years as the effect of diminishing GDP, exhibits a rise in the deregulation era in an effort to reassume its developmental role. The same happens for securities‟ holdings for all banks after the mid-80s as they all try to respond to the new financial environment maintaining positive growth rates on average, except Investment Bank. However, the negative median values for both Investment Bank and ETBA indicate their less successful role in exploiting the opportunities of financial development. Where does this analysis lead us concerning the nature of development banking and its relation to institutional development of an economy? Development Banks are known for their role as promoters of economic development by financing leading sectors of an economy under preferential rates within a financial repression regime. Hence, their reputation in the economics profession followed that of their encompassing financial regime after the stagflation crisis of the 1970s. However, this seems to have covered with a “veil of ignorance” their second important role, that of promoting institutional transformation and hence, financial development. Those who do not disregard history know that political decisions on regulation or deregulation do not come at a vacuum. Financial regulation as a dominant policy in the post-war period echoed the need for reconstruction and rapid economic development conditioned on the haunting memories of the Great Depression in the 1930s. On the other hand, although financial deregulation during the 1980s was an international phenomenon that affected countries with different institutional infrastructure, the
232 internal process of transformation that made such shift in each economy possible cannot be disregarded. That is, although political decisions have their reasons relating to the existing international economic environment and the viability of each country within it, the process of change is much more complex. In this context, the double role of Development Banks as promoters of both economic and institutional transformation makes them an appropriate object of study in order to understand the process of financial development in an economy. Under the above rationale, this paper examined development banking in Greece during a period extended by the early 1960s to the early 2000s. However, our aim was not to give a mere description of the institutions operated in the economy under the rubric of Development Finance Companies, although such a detailed research is lacking in the literature. Our major concern was to shed light in the nature of these institutions as transforming entities directly related to the changing financial and economic environment in the Greek economy during the same period. In this sense, the financial performance of development banks was not examined independently of the general institutional regime that affected it. Using North‟s (1990) conception of institutional change we approached the history of these banks as the microeconomic indicator of the change in the financial institutional infrastructure of the economy. We believe that both the examination of the historical evolution of the operation of the Banks as it was reflected in their Annual Reports and the patterns of change exhibited by their financial statements justifies our argument for the hybridical micro-macroeconomic nature of these institutions especially as far as institutional development in a developing economy is concerned. The analysis revealed that ETBA, ETEBA and Investment Bank were both agents of economic and institutional change and at the same time objects of this change through their internal transformation. In this sense, Diamond‟s (1982a,b) conception of the dynamic nature of development banks in the endeavour to promote change and adjust to it complements North‟s (1990:112,138) idea for radical changes initiated by the state to overcome path dependency. In fact, development banks were at the financial arena the agencies sponsored by the state to implement such change. On the other hand, the nature of the polity as an agent that promotes long-run developmental goals and not short-run electoral purposes is important. This is translated in North‟s (1990:48,138) conception of the state as an agent supported and supporting these social groups that are prone to change as this is reflected in the
233 altering of pay-offs matrix they face. The decision of the Greek state to establish or promote the establishment of specialized institutions aimed at both economic and financial development as early as the mid-1960s is an indicator of its developmental role. Development banks attempted to overcome the inertia characteristics of the “corporatist” model described by Katseli (1990). Financial underdevelopment as reflected in the oligopolistic character of the Greek banking system was partly balanced by the new practices, attitudes and techniques brought to the market by these banks. However, the dependence of the private Development Banks on their mother institutions and of ETBA on state decisions was decisive concerning their ability to make the great difference. Although financial development did not progress along with economic development, this was not the Banks‟ fault but reflected the ability of the state to promote both targets of development effectively. Furthermore, in periods, such as the dictatorship era 1967 – 1973 institutional change came to a halt or was based on distorted incentives for particular social groups and this was also reflected in the performance of the Banks especially after the burst of the two oil crises when these distortions came apparent. But even during the post-dictatorship period the “fiscal regime” was not supportive to the role the Banks meant to play in institutional transformation. When the international financial system moved on to liberalization the Greek state did not follow a path such as the one indicated by Thomadakis (1993, 1995) that is the support of public investment for developmental and also economic stability purposes. Hence, Development Banks were transformed to institutions supporting failed enterprises rather than financing new innovative ones. This analysis indicates that the major constraint in the operation of the banks towards economic and financial development was the state itself. Hence, the reconcilability of goals for economic and financial development was greatly influenced by the determination of the government to support a balanced path of institutional change or to pursue a more short-sighted policy disregarding the long run effects for the economy. However, despite the conflicting views about the form and sustainability of Greek economic development during the 1960s and 1970s, the long run historical perspective that we followed establishes the fact of a major change of regime both in the real economy and the financial structure. Greece‟s economy might not have grown in the 1990s as fast as it did in the 1960s but this was also partially due to the reason that the country had reached a level of maturity that had never encountered before. Investment opportunities were both less in volume but also different in nature as the
234 economy managed to pass to a higher level of economic development. Furthermore, institutional development was now the major need for the economy operating in the new conditions. This was a major indicator that the policy of the transformation of the economy during the previous decades was rather successful as far as the structure of incentives given in the institutional matrix called for a change in the overall regime. In North‟s (1990:112) terminology, incremental change that broke the path dependency of institutional underdevelopment was crucially supported by the operation of development banks, along with other factors, and this should not be disregarded when assessing the contribution of these institutions. Hence, what our paper establishes is that institutional development did not come as “a manna from heaven” by unilateral decisions of the state during the 1980s and 1990s as Pagoulatos (2003) believes. This is only part of the story. In fact, Development Banks acted in a persistent manner in favour of financial development as early as in the 1960s. Their role as capital market substitutes contributed to the training of the enterprises and the investment public to practices and techniques of modern capital markets. On the other hand, they prepared and proposed to the government measures that should be taken and new financial instruments that should be used in order to promote financial development in accordance with the pursued goal of economic development of the country. Hence, financial liberalization during the 1980s was not a surprise to them at least at the level of the institutional goals they posed. In this respect, the developmental goal of their operation should be assessed as a success. In this sense, the data that justify the perception of Development banks as both promoters and objects of change also justifies our assertion for their unique role as unified entities of the evolution of the financial system. Another point that emerges from our analysis is that development banks cannot be assessed as traditional banking institutions. Indeed, concerning their profitability, this seemed to range from mediocre to a failure. Of course, things could be different if the macroeconomic conditions during the 1970s and 1980s were different and if government policies during these periods were less demand-driven in a pseudo-Keynesian manner (Psalidopoulos (1990)). Besides, development banks‟ double role made them crucially dependent on government policy. To the degree that the state was supportive, development banks took bold initiatives – with more or less success depending on the competence of their management – towards financing industry and promoting new financial techniques. Their ultimate constraint was the
235 existing financial environment and their interaction with it that led to their gradual transformation during the 1990s. It is true that the examination of the data indicated various differences among the three Banks. ETEBA seemed to be the more successful on financial grounds while Investment Bank suffered great losses and after a halt of operation entered a period of reorganization during the 1990s. On the other hand, ETBA as a state-owned bank followed a completely different path in many respects compared to the other two private banks and seemed to disregard criteria of private profitability in favour of developmental goals posed by the government. However, all of them faced the same dilemmas during the mid-1980s and took the same decisions for transformation during the 1990s when the support of the state was gradually decreasing. This was the time of truth for them when the changes for which they prepared their clients were now implemented on themselves. This is how they became the reflections of financial development in Greece. These observations lead us to the result that Development Banks in Greece were in fact, both subjects – promoters and initiators – and objects of financial development as far as their transformation was a reflection of the transformation of the financial structure of the country. They were so interrelated with the existing financial environment that its liberalization meant their complete transformation and not just a change of levels from less to more competitive operation as it happened to the other commercial banks. This “privileged” connection between development banks and the financial structure made up their uniqueness as institutions and the inability to assess them and model them as any other banking firm. The same particularity of these Banks rendered government policy – mainly in the form of Monetary Committee directives – the ultimate risk factor of their operation and the main constraint that they faced during their forty-years functioning in the Greek Economy. Although, our paper is a case study of development banking in Greece, we believe that it sheds a new light on the relation between development banking and financial development in general. At first, this seems to be a neglected part of the literature that identifies development banks with financial underdevelopment rather than development. However, as our study showed, this disregards the process of institutional transformation that the operation of development banking initiates at the microeconomic level. Furthermore, the conception of these banks as capital market
236 substitutes when the later is non-existent or underdeveloped should not only be conceived as a repression of the free market – to the degree that such a market practically does not exist. It should rather be understood as the initiator of the practices and techniques used in developed capital markets in order to educate the general investing public and prepare the process for the establishment of smoothly operating market mechanisms. On the other hand, we cannot disregard the various constraints already mentioned for the success of such a policy as these are reflected in the role of the government and the competence of the managers of the banks. Hence, although the role of development banking is certainly in favour of financial development, the effect of the latter on development banks depends on the above constraining factors. The particularities of each historical situation where development banking practices were implemented can condition but not change this general conclusion.
237
Chapter 3
Is There an Optimal Degree of Financial Regulation?
238
Abstract
Financial reform is in fact a change in regulations concerning the operation of financial markets. A major event such as a financial crisis indicates the need for such reform in order to restore financial stability. Hence, new regulation comes to cope with the causes of recently exhibited financial fragility in the economic system. In this context the paper asks whether there is an appropriate degree of regulation that reaches an optimum or if such an assertion is a chimera. More specifically, what are the microeconomic conditions that underlie the macroeconomic decision for new regulation? The paper attempts to answer these questions through a mathematical model of interbank market equilibrium. The general conclusion is that successful regulation depends on the phase of the “Minsky-Kindleberger cycle” that the economy finds itself. Hence, every major shift in the financial regime reflects a corresponding change in the perceptions of agents about current and future economic conditions. More than that, the latter shapes the direction of change in financial structures through financial innovation and its impact on the regulatory framework.
239
3.1. Introduction Financial regulation relates to government intervention in the financial system in order to overcome market failures. The latter are usually connected to the adverse externalities imposed on depositors by bank failures spreading in the whole economic system which are often related to the existence of information asymmetries in the market. Regulation instruments that might be used to counter these effects include deposit interest rate ceilings – such as “regulation Q” in the United States until April 1986 – entry and merger restrictions, portfolio restrictions and reserve requirements, deposit insurance and capital requirements (Freixas & Rochet (1997:257-259). However, the question of the optimal degree of financial regulation as it is posed in the literature is conditioned by the opposition between market self-regulation and government regulation. According to Stigler (1971) economic regulation is the outcome of the demands of specific industries with enough power to influence the political system in pursuit of securing their profitability. This contradicts the view that regulation might also emerge for the benefit of the public or for the accomplishment of a social goal (unless the protection of the said industries accommodates this social purpose). It is a view of regulation as oligopolies protection through the control of entry using various means including price fixing or through occupational licensing. Then an industry that will demand regulation will need to take into account the costs of achieving this legislation that include the political transaction costs of persuading the general public for the benefits of the legislation. Financial regulation could be considered to be a particular case of economic regulation in the sense of Stigler (1971). Indeed, Benston and Kaufman (1996) consider bank regulation as the outcome of government attempts to extract rents from the regulated industry. Hence, control of entry increases the profits of existing banks but also increases the “taxing” of these profits in the form of low or negative rates of loans extending to the government by the bank. Government regulation is not justified on the basis of avoiding wide spread effects of bank failures under a self-regulation line of thinking. Market discipline can compel banks to take care of their liquidity ratios while banks will seek to provide information through financial statements,
240 audits etc. that would assure the public for their solvency. On the contrary, government regulation might degrade these incentives for banks and hence, increase their risk exposure. But even if the failure of many banks at the same period was possible, this would not lead to a general collapse to the degree that depositors could redeposit their money in the solvent banks. Benston and Kaufman (1996) believe that it is not true that depositors or shareholders are not able to distinguish between a solvent and insolvent bank. Hence, a market solution that would leave badly managed banks to fail would benefit the efficiency of the system without harming informed depositors. On the other hand, deposit insurance might provoke more problems than those it was meant to solve. The most important problem is moral hazard, as banks might indulge in risky lending being sure that in case of failure taxpayers will bail them out. Hence, deposit insurance to be effective requires extensive monitoring of the banking system, prohibitions of certain activities and regulations concerning capital requirements. According to Benston and Kaufman (1996) only the latter seems operational because of the difficulties to assess the risk exposure of banks or the inadequacy of prohibitions such as the separation of commercial and investment banking in the US to limit risk. A different perspective is taken by Dow (1996) within a post-Keynesian view of the role of liquidity in an economy plagued by fundamental uncertainty. Banks are producers of money to the degree that their liabilities are used as such. Moneyness, on the other hand, of these liabilities is a public good that should be safeguarded by the state by inspiring confidence on the retaining of the value of bank money. In the context of fundamental uncertainty this function of government regulation acquires great importance. Out of this observation emerges the significance of the lender of last resort facility to install confidence in the system when the latter starves from liquidity the moment that it desperately needs it. In this sense, moneyness is in fact a convention obtained by government guarantees. The need for government intervention is based on the assertion – the opposite by that entertained by Benston and Kaufman (1996) – that even for central banks themselves it is difficult to segregate illiquid or insolvent banks. Hence, moneyness of bank liabilities cannot be maintained exclusively through market discipline mechanisms. In addition, Benston and Kaufman (1996) assertion that agents would simply leave insolvent banks for those with healthier portfolios simply disregards Minsky‟s warning for the spread of overoptimistic expectations to all market participants during euphoria as a prevailing
241 convention of the moment. However, Dow (1996) recognizes that regulation has costs but she asserts that there is no costless solution to any economic problem. Instead, one should assess the trade-off between costs and benefits that could be obtained through financial regulation. In this sense, following a cost-benefit view of the issue, Llewellyn (1999) bases the rationale for financial regulation on the welfare benefits that it might have concerning the maintenance of stability of the system, the contribution to the soundness of the operation of financial institutions so as to minimize their risk and the protection of the consumer of financial services. Specifically, financial regulation might take two forms: prudential regulation and conduct of business regulation. The justification for prudential regulation rests on issues of asymmetric information and moral hazard between the financial institution and the consumer of financial services. Asymmetric information means that agents cannot segregate sound from unsound institutions when they sign a financial contract. Hence, post-contract behavior of the institution becomes a reason for regulation. Conduct of business regulation refers to rules concerning the behavior and practice of financial firms with respect to their customers including issues such as honesty, competence, fairness etc. Regulation is called forth for reasons related to systemic stability when the social costs of bankruptcies of banks and other financial institutions exceed the private costs and the bank does not include these social costs in its pricing. Even if the probability of a general collapse of the financial system because of individual banks failure is low, if this really happened the costs for the economic system would be high enough so as to justify regulation as “insurance premium against „low-probability-high-seriousness‟ risks” as Llewellyn (1999) points out. In addition, the moral hazard problems related to deposit insurance and the lender of last resort demand rather than dismiss the need for prudential regulation and supervision. In addition, the particular nature of financial products whose value depends on the behavior of the financial institution after the contract has been signed is a strong case for post-contractual monitoring by the regulatory agencies. Pre-contractual regulation and post-contractual monitoring contribute to the establishment of agents confidence and the encouragement of investment and saving. In effect, regulation lowers the transaction costs incurred by consumers of financial services. If regulation reveals the insurance premium paid by risk averse consumers then there is demand for such a service and the costs of regulation are not a waste for the economy as a whole. Furthermore, market discipline
242 through reputation effects cannot always work for several reasons: it might take a long time after risky behavior is revealed, information might be insufficient and shifting between institutions might be difficult when long term contracts has been signed with penalties for pre-mature termination. Llewellyn (1999) does not assert that regulation is always a “positive sum game” where benefits exceed costs. However, it is always such a game when it enhances efficiency, competition and confidence. On the contrary, the risks of overregulation relate to practices that limit competition and impede innovation although this should not be the case to the degree that regulation relates to disclosure requirements that enhance competition by increasing transparency and the proportion of informed consumers of financial services. Llewellyn (1999) gives a detailed analysis for the rationale and objectives of financial regulation despite ignoring the possibility of using financial regulation in order to achieve social objectives such as industrial development through channeling of resources to particular sectors as Carmichael (2001) mentions. Carmichael (2001) also indicates the means used by prudential regulation to cope with asymmetric information such as entry requirements, capital requirements, restrictions concerning the balance sheets of financial institutions, liquidity requirements and deposit insurance schemes. On the other hand, systemic stability is preserved both through prudential regulation and the lender of last resort facility. The criteria for judging the effectiveness of a regulatory framework should include the fair dispersion of the regulatory burden to the financial institutions, cost effectiveness, transparency, flexibility and accountability. Furthermore, Stiglitz (2001) contradicts financial regulation with the wave of deregulation of the last decades. Deregulation and the shift to free markets was accompanied by the focus on capital requirements as the single regulatory means in compliance with the new market ideology. However, capital adequacy requirements are not a panacea. In the course of financial liberalization, increasing deposit rates along with increased capital requirements (which entail the increase of high cost equity capital) decrease the franchise value of banks (the present value of future profits) and hence, increase the incentives for excessive risk taking. A way to avoid this problem is to impose, along with high capital requirements, deposit rate ceilings in order to prevent banks from engaging in risky activities. In general, capital adequacy requirements, deposit and lending rates ceilings and entry restrictions are all
243 measures that alter private incentives and align them with social returns to the degree that they inhibit risky lending and they avoid the moral hazard problem given deposit insurance schemes. On the other hand, direct constraints on the processes and kinds of loans that should be extended, the collateral requirements that should be demanded, the use of particular financial instruments such as derivatives, the leverage of firms that are entitled to obtain finance are additional means of financial regulation to avoid the systemic effects of bank failures. Especially in crisis periods, collateral and capital adequacy requirements contribute to the worsening rather than the improvement of the situation for financial institutions. Decreasing asset values entail decreasing collateral values thus giving a boost to the downward direction of the market as borrowers default on their loans and defaults lead to further sales of assets and further fall in prices. Furthermore, capital adequacy requirements in crises compel banks that are unable to meet them to restrict credit extension to firms that need it thus contributing to the deepening of crisis. Instead, the government should rescue solvent but illiquid banks but with increase of their supervision that might also include restrictions on the kinds of lending and other activities they should be engaged in. Stiglitz (2001) is in favour of a “dynamic portfolio approach” to financial regulation that includes both incentives and constraints being aware of the various interactions between them so as to avoid overregulation and promote competition and openness preserving at the same time the prudential supervision of the system. Crockett (2003), on the other hand, considers the relation between financial and monetary stability which is important since, in our opinion, reflects the rupture of the late 1970s early 1980s in policy thinking in favour of less regulation and government intervention to restore monetary stability possibly disregarding the risks of financial fragility. Financial stability is defined as the prevalence of such conditions in financial markets so that they can orderly implement savings mobilization, provision of liquidity and resources allocation – that is they can perform their intermediation function in a efficient way. Monetary stability, on the other hand, is the stability of the value of money which entails low and stable inflation rates. As Crockett (2003) indicates the financial liberalization wave was based on the assumption that financial markets function in the same way as any other market and hence, competition would bring about quite stable equilibrium prices while low inflation would contribute to financial stability. However, to the degree that intrinsic values of assets in financial markets are hard to assess and depend to a great degree on
244 psychological propensities that condition expectations, financial markets are fundamentally different from product markets and are much more prone to instability exacerbated by the phenomenon of self-fulfilling prophesies. On the other hand, the process of financial liberalization along with technological innovation during the last decades has opened new channels for instability: a) Increased competition among financial institutions in the new deregulated environment has decreased their net profit margins and has increased the incentives for excessive risk taking. b) The development of new financial instruments has decreased the demand for liquidity and raised leverage ratios, the latter being aided by the attempt to raise stock market value of firms in an already rising market. c) The increase of incentives for further risk exposure to the degree that the value of official safeguards is raised and hence, it has increased the hidden "subsidy” of financial institutions that assume these new risks. d) Financial globalization and free international capital flows have contributed to the spread of financial risks worldwide. On the other hand, monetary stability per se, although important for efficient resource allocation, was not sufficient for financial stability probably because of excessive optimism brought about by the successful control of inflation and the expectation that monetary policy might be less stringent in the future. The general conclusion of Crockett (2003) is that market discipline by itself cannot ensure financial stability. It is true that prudential regulation has recently evolved into “prudential management of risk” that rests upon a financial infrastructure that requires more adequate information, more efficient contract enforcement and greater transparency in corporate governance. All these might improve risk management of individual banks and financial institutions but they do not capture the widespread accumulation of risk in the economic system. Such concentration of risks takes place during the boom and they materialize in crisis. Risk models such as Value at Risk (VaR) has the property to underestimate the risk in a rising market and overestimate the risk exposure in a falling market. Hence, they contribute to the boom while precipitating the downturn. It is, in a sense, an example of the fallacy of composition. If all market participants follow their individual VaR models, although acting rationally at the individual level, they fall into the trap of herd behavior at the economy level. These problems call for economy wide supervisory structures that self-regulation of the market is unable to provide for. Besides, Wood (2003) returns to the issue of the relationship between price and financial stability indicating that price stability aids financial stability by
245 decreasing the volatility of the yield curve (of short and long term interest rates) and hence, it contributes to more accurate assessment of credit and interest rate risk. He agrees that financial regulation is also needed but he asserts that this should be proscriptive rather than prescriptive. This means that it is more efficient to set a general context of what should not be done by financial institutions and let the latter choose by themselves the appropriate actions to preserve soundness of operation, rather than impose the same code of behavior to everyone which might impede competition and innovation. Finally, a useful categorization of the means of financial regulation is given by Davies (2003) who considers four ways to cope with the duration and spread of financial crises: international macroeconomic supervision, market discipline, corporate governance and prudential supervision. The first relates to the need for regulation at the international level given the increased volume of worldwide capital flows. The second expresses the self-regulation view according to which, the market is the best regulator of itself if market participants are provided with adequate information. The latter raises issues such as accounting standards, auditing, transparency and adequate enforcement mechanisms. Corporate governance refers to internal control systems and is closely related to information disclosure to the market. Finally, prudential supervision is seen as a necessary complement of self-regulation in order to cover institutions that have a key influence on the stability of the system. However, an important component of prudential regulation policy is considered to be the education of consumers of financial services in order to understand the risks and functioning of financial markets. The above review of the literature revealed the problems and disputes concerning the justification for government intervention and regulation as opposed to market self-regulation. Two main strands of thinking can be discerned. The first, which has been the orthodox approach from the 1980s onwards, believes in the efficiency of unregulated markets and casts a great deal of blame to government intervention and excessive regulation for financial fragility and crises. The other school of thought, which we will call it quite loosely “Keynesian” 1, considers markets as inherently unstable and prone to excessive volatility and disruptive crashes. The 1
We say “loosely” because we do not want to charge on Keynes‟ thought any form of government intervention and regulation that had been imposed on financial markets especially during the post war period. However, Keynes‟ ideas on the fundamental instability of a market economy and especially its financial markets did give the impetus for the development of a pro-regulatory mode of thinking.
246 government, in this case, could contribute to a more smooth operation of the markets through its demand management policies but also via its structural, regulatory and crisis management policies. The counterargument of the orthodox school is that the government cannot know better than the market whereas political incentives for reelection contribute to the implementation of policies in favour of the incumbent oligopolies that stifle innovation. Although the second part of this argument reiterates the theme of research of new political economy, its first part denotes the view infavour of markets‟ self-regulation given some general rules of operation that would promote transparency. For “Keynesians”, transparency is not enough because fundamental uncertainty which surrounds financial markets and their participants also haunts their decision making process. Whatever amount of information might be available, this would always be assessed not only probabilistically but also with various degrees of belief and confidence that are subjectively/psychologically determined. More and better information is not enough because the benchmark of the optimum level of information cannot be objectively determined. For the same reason, self-regulation is not adequate to prevent exacerbations in risk exposure and crises. Regulation in the form of government intervention – either at the national or at the international level through coordination of national governments – to set rules, limits or intervene more actively in the operation of domestic and international financial markets is advocated by this school of thought. What is at stake in the above discussion is the trade-off between the pros and cons of different degrees of financial regulation. In fact, this trade-off constitutes the central question posed in our paper: is there an optimum degree of regulation? Although, the state cannot be considered the benevolent guarantor of social welfare and nor are the markets the efficient mechanisms of resource allocation, both coexist in the history of systems of financial governance. Of course, there are periods of time, as in the post-War era, when government regulation predominates while in some others, especially from 1980s onwards, government deregulation and markets‟ self regulation is the rule. This means that the trade-off of pros and cons of financial regulation is historically determined and thus, amenable to change. Therefore, we cannot answer to the previous question unless we have a clear understanding on how financial regulation emerges in the first place. This question is addressed in the Sections of the paper that follow both historically and theoretically. Section 2 seeks such a historical pattern and asserts that, although the role of the
247 government might be ambiguous concerning its efficiency to cope with financial crises, an examination of the optimal degree of regulation should be placed in the context of its relation with financial innovation and crises. If this is the case then Section 3 poses the question whether there is any theoretical model that can adequately describe the dynamics of innovation, crises and regulation implied by historical evidence. We assert that such a model can be found in the MinskyKindleberger theory of financial cycles to the degree that this theory identifies the causes for the emergence of financial crises in the workings of a financial system plagued by fundamental uncertainty and surrounded by inherent instability. In this sense, the optimum degree of regulation assumes a material base rooted on the workings of a market economy. Given this dynamic view of the optimal degree of regulation the last question is: Under which conditions should a regulatory framework defined within the above context change? Section 4 answers this question through our assertion that regulation should be assessed on the grounds of prevailing economic conditions and financial structures in the interaction of government with economic agents. The question answered in this section concerns the microeconomic behavioural conditions of regulatory change. A regulatory framework is in fact a structure of incentives offered to agents in order for them to act in a specific way and this structure depends or it should depend on the phase of the Minsky-Kindleberger cycle that the economy places itself. This thesis is supported by a mathematical model of the banking sector where prevailing economic conditions are reflected in the liquidity preference functions of banks and these affect their lending behavior. Then the government or a monetary authority can act as an agent of different degrees of regulation depending on the phase of the cycle. Finally, Section 5 concludes.
3.2. How Financial Regulation Emerges in History? One of the tasks of financial regulation is the smooth operation of the payments system and this is a function performed by the Central Bank. Hence, the history of financial regulation is inevitably related to the history and evolution of central banks. An inclusive story on these grounds is narrated by Goodhart (2007). The question that he poses is how financial regulation emerged historically. His conclusion rests on the interactive character of regulation to the degree that financial
248 innovation brings in new risks that lead to crisis episodes which in turn generate new forms of regulation and supervision. Central banks play a central role in this process. They were initially those institutions that became the bankers of the government: they helped the government to obtain the funds needed for conducting wars while it also became its adviser in debt management issues. Governments granted privileges to these banks making them the dominant institutions in the mid-19th century with other banks holding deposits in them. At the same time they also played the role of lender of last resort when there was a desperate need for liquidity in the banking system. At the end of the 19th century the Bank of England was a central bank that managed the monetary system through the gold standard, conducted the payments system, set the interest rates through open market operations and performed the lender of last resort function by deciding whether it would lend and at which collateral during a crisis. In addition, by the early 20th century the Bank of England abandoned every commercial activity. The monetary and financial regimes during the period 1919 – 1973 were characterized by the collapse of the gold standard and the financial turbulence in the 1930s, the adoption of controls on external trade and capital flows, direct controls on the banking system and the requirement of holding government debt as a means to fund the war expenses. After the end of the war, and until the early 1970s the Bretton Woods system operated smoothly by imposing capital controls and resting on the robustness of the US economy to provide exchange rate stability. This period 1945 – 1973 is characterized by the absence of banking crises which is, as Goodhart (2007) stresses, a unique phenomenon in the history of banking. However, the directed lending practices that prevailed during this period with the implicit or explicit government support contributed to the underdevelopment of risk management both within individual commercial banks and in the central bank. In addition, the system of controls generated institutions such as “fringe banks” with the only purpose to evade these controls as happened in UK in the 1960s. The emergence of a more liberalized system in the early 1970s and the absence of adequate supervision of the financial system led to the fringe bank crisis in the UK. In addition, the growing spread of financial business worldwide led to the need for international agreements concerning the regulation and supervision of financial institutions. The Basel Accords were the outcome of this endeavour. On the other hand, Capie (2007) seeks to identify the role of interest groups in shaping regulatory policies for their benefit. A typical example is banking regulation
249 in the US even from the civil war era. The interest groups that participated in this process were banks, depositors and the regulatory authorities themselves. A strong coalition that succeeded in maintaining restrictions in bank branching was that of the small unit banks. These banks along with depositors were also the supporters of deposit insurance initiated in the 1930s. Of course, regulation does not emerge because interest groups demand it but as a government answer to a financial crisis. What interest groups can affect is the direction of the proposed regulation. The case was different in England before 1945. During the 19th century England was characterized by a movement against the big government which resulted in the demise of the interest groups‟ influence on government policy. The effective lender of last resort function of the Bank of England along with self-prudence of the banking system led to a period of financial stability with no financial crises after 1866. No crises meant no need for further regulation no interest groups lobbying or government rent seeking. The picture changes between the two World Wars and especially after 1945. This was the period where regulation came as a substitute for the diminishing trust in the financial system first breached by the government by allowing inflationary policies and a complex fiscal system. In a similar vein, White (1997) explicates the emergence and endurance of deposit insurance schemes in the US. Federal Deposit Insurance was initiated by the Banking Act of 19332. However, deposit insurance was not new in the US as it was adopted by several states before and after the Civil War. A second attempt to adopt deposit insurance took place at the level of individual states after the panic of 1907. The result of these schemes was rather disappointing since adverse selection and moral hazard problems along with the insufficient incentive structure led these systems to failure in the 1920s. Nevertheless, deposit insurance was a persisting demand of small unit banks that wanted to protect themselves from the competition of large diversified urban banks. It was clearly a conflict of interests that was reflected in the political arena by the two relating opposing views in the Congress. However, the balance of power changed in 1933 because of the large losses of depositors during the period 1930 – 1933. In fact, it was the moment when the unit banking side of the controversy was given a boost by the widespread climate of uncertainty and fear of 2
The Banking Act of 1933, also known as “Glass-Steagall Act” initiated the prohibition for the same banking institution to practice both investment and commercial banking activities and the establishment of the Federal Deposit Insurance Corporation in order to insure bank deposits.
250 depositors. As White (1997) asserts, the 1933 Act was a victory for small rural banks and small depositors and a defeat for large urban banks and wealthy depositors who would pay taxes to fund these schemes. He also stresses that an alternative to deposit insurance was branching and diversification of banks. It seems that the regulations prevailing in the majority of US states that confined branching and geographical diversification was the cause of the further regulations of the 1930s including deposit insurance. On the other hand, Lightfoot (2003) sets the issue of financial crises and financial regulation in its historical context in order to discern examples of beneficial and detrimental regulation. The Banking Act of 1933 aimed at protecting uninformed depositors from the risks of investment banking operation implemented by their commercial banks is considered by Lightfoot (2003) as costly and harmful regulation to the degree that the market itself had solved the problem of conflict of interest between bank insiders and depositors. In the 1920s, banks had higher capital-asset ratios and investors demanded a higher return by the “universal” banks so as to compel the latter to establish separate affiliated institutions that implemented investment banking. On the other hand, he points out the shortcomings of the Basel Accords3. As mentioned also by Stiglitz (2001) risk-based capital requirements lead to the paradox that banks need to hold higher capital-asset ratios exactly when the economy needs more funds and hence, curtailing of lending in periods of distress aggravates the latter. This kind of regulation has contributed rather than prevented the burst of crisis in Japan in the late 1980s and the early 1990s when banks lent against collateral in a rising market while these loans were used for investing in the same assets so as soaring prices to have created a bubble. White (1997), but also Capie (2007) seem to agree on the view expressed by Caprio and Vittas (1997) concerning the lessons obtained by financial history. The government should establish a regulatory framework that would guarantee effective information dissemination while also put in order its public finances. Then it should leave the market develop on its own. Crises may be the result of less rather than more 3
Basel Accords referred to guidelines concerning banking supervision issued by the Basel Committee on Banking Supervision comprised of central bankers and regulators from eleven countries. Basel Accords include Basel I (1988) and Basel II (2004) while a revision entitled Basel III is under way. Basel I introduced minimal capital requirements for banks according to a credit-risk classification of their assets. Basel II dealt also with operational risk and market risk (risk due to movements in asset prices), the latter calculated by a method called Value at Risk (VaR) (Balin (2008)). For VaR see also p. 275of this text.
251 market solutions. For example, a major reason for bank failure is the restrictions on their diversification both in products and geographically. A more comprehensive assessment of the relation between financial innovation, financial crises and regulation is given by Hoffman, Postel-Vinay and Rosenthal (2007). Crises are important as milestones in the evolution of financial markets and the reshaping of financial institutions. Financial innovation and financial crises are usually inseparable in the history of financial markets. The development of financial institutions rests, according to Hoffman, Postel-Vinay and Rosenthal (2007), on three major factors: the size of government debt, the relative importance of the middle class and the dissemination of information in financial markets. Two major causes of crises are identified: the treatment of financial markets by the government in its attempt to fund its debt and the information dissemination problems that plague these markets. A government with a large debt facing a shock will find that it is politically more favourable to plunder financial markets rather than raise taxes or cut spending. Adverse treatment of financial markets might take the form of default on sovereign debt or compulsory further lending of the government by the banks and savers. Such behavior lowers agents‟ trust on the financial system and its effective functioning along with the uncertainty about the protection of their financial claims. Information asymmetries is the second cause of financial crises with major examples the South Sea Bubble of 1720, the Latin America mining stock crash of 1825, the Internet Bubble etc. Asymmetric information is the symptom of the development of financial markets as they increase in size and sophistication. Hence, if the cause of a crisis in a small market is the lack of diversification, the cause in a larger market is asymmetric information that accommodates opportunism in the form of adverse selection or moral hazard. Solutions that have been historically proposed include the writing of more incentive-compatible contracts, screening and monitoring, specialized institutions that lower information cost. However, what is important is that crises alter the value of information for market participants. In booming markets, rules of prudent behavior, such as scrutinizing investment projects, are relaxed because such endeavour is not considered worth of the expense. If some act in this way, all act in the same way in an attempt not to lose business to the competitor. However, after the crisis, market participants will demand new rules and regulations as now the value of information is raised and it seems to worth the cost, either individually or at the social level. In addition, depending on the nature of the recent crisis, the kind of information
252 demanded changes and determines the new regulations. In this sense, crises contribute to institutional change as they reveal the loopholes for risk management of the previous institutional infrastructure. However, the direction of regulatory change after the crisis will depend on the size of the middle class, the political system and the severity of the shock. The argument for the importance of the middle class goes as follows: in an economy with a large middle class and hence, less income inequality, more people are able to provide collateral for borrowing. In such an economy the demand for domestic financial services will increase to the degree that a growing middle class demands loans to start a business. In addition, the middle class is more interested in the development of local financial markets because it has less opportunities for international diversification compared to the rich class. The dependence of the middle class on collateral lending for business purposes relates to their interest for the development of features of capital markets that relate to contract enforcement and orderly operation of the market for assets where their collateral can be traded. On the other hand, a rising middle class with the beneficial effects on financial development described above adds on the fragility of financial markets as indebtedness rises among the middle class with limited opportunities of diversification. If crises decrease the proportion of the middle class in the population, then demand for financial intermediation falls and capital market development comes to a halt. However, this might not be the case if the middle class has enough political power to persuade the government to intervene through measures that will alleviate its financial distress and promote financial innovation. If the gains from resolving market failure are greater than the costs of intervention in terms of rent-seeking advantages of officials then government intervention would be successful. New regulations, new rules, new financial instruments will emerge. However, the creation of new institutions after a crisis generates new opportunities and new risks. Besides, crises can be seen as a useful source of information for the efficiency of financial institutions and the financial structure of the economy. But even if we accept the above political economy models concerning the way by which financial regulation emerges, there remains the problem of the kind of regulation that one should demand. To say that the appropriate regulation is the one which does not impede financial development, as Hoffman, Postel-Vinay and Rosenthal (2007) claim, it opens the problem rather than close it. Which kind of regulation offers itself both to stability and innovation? The answer should rest on the
253 kind of economic reality that this regulation faces according to Best (2005), namely, a fundamentally uncertain environment that generates ambiguity. Best‟s (2005) arguments revolve around issues of international financial governance before and after the demise of the Bretton Woods system. However, her ideas are directly pertinent to the domestic financial arena too. According to her, there are three kinds of ambiguity: a) Technical ambiguities emerging by insufficient or incorrect information which, however, can be surpassed by institutions that will provide more accurate and greater in volume information in the context of more transparent institutions. So, technical ambiguities pertain to the view encountered above that considers transparency the ultimate solution to the problem of financial crises in a framework that recognizes the self-equilibrating nature of markets if enough information is provided to them. However, as Best (2005) claims, there are also two further kinds of ambiguity. b) Contested ambiguities that refer to the conflicts of view and interests between the various participants in financial markets. These are conflicts between such groups as bankers and policy makers at a national level or between creditor and debtor nations in the international sphere. To the degree that these conflicts take on a political vestment and they emerge by political differences on the appropriate explanations and solutions for major economic problems, they also demand political rather than technical solutions. c) Finally, there are also the so-called intersubjective ambiguities which are in fact ambiguities of interpretation of economic concepts. Best (2005) gives an example on the different way by which conflicting theories interpret the maxim of free markets. For a certain school of thought free trade goes hand in hand with free capital movements and both give meaning to what is called free markets. For another school thought, regulation of capital flows was vital during the post war era for free trade to flourish and hence, the maintenance of a free market system demanded the combination of capital controls with free international trade. Hence, if the political interest of both views is to defend free markets, they differ on how they define this value. This kind of ambiguities is important for the way economic ideas are mediated in a given political and social context. Crucial for this communication of ideas is the establishment of confidence based on common beliefs and conventions that condition the interpretation made by a policy maker or an economic agent. The result of this discussion is that each kind of ambiguity demands its own remedy, technical, political or conventional, depending on its source. Suppressing all
254 of them to the category of technical ambiguities obscures the process of international financial evolution – we would also add the development of domestic institutions – to the degree that the latter is determined by the interaction of the foregoing ambiguities. Furthermore, focusing only on technical ambiguities conceals the neoliberal view that government action is the ultimate source of ambiguity. The opposite view held by Keynes is that financial speculation is the main source of ambiguity in a market economy because of the vulnerability of intersubjective expectations. If the neoliberal view believes that it is possible to eliminate (technical) ambiguity by increasing transparency, the “Keynesian” view believes in the management of ambiguity through government intervention to the degree that (intersubjective) ambiguity is inherent in the market economy. Hence, a successful regulatory regime will not seek to eliminate ambiguity because it knows that this is impossible. Its success is derived by the recognition of all three forms of ambiguity and the design of institutions to reduce information asymmetries, to pose under a state of negotiation contested ambiguities and to establish and develop norms and conventions that would reduce the volatility of intersubjective ambiguities. Incorporating ambiguity as it is indicated above in the governance structure of the economy would furnish it with greater flexibility in order to cope with future uncertainties. In this sense, managed ambiguity is constructive rather than disruptive. In addition, a regulatory regime that would recognize the persistence of ambiguities would also be able to manage differing norms and conventions, incorporate new ideas and adjust to changing conditions. According to Best (2005) such a framework characterized the early Bretton Woods regime before the more rigid interpretations by the IMF in the mid-1960s. The initial ambiguity of the agreement was reflected on many issues that were left open to negotiation on a case-by-case basis such as: what does constitute a fundamental disequilibrium that would make a change in exchange rates acceptable for a country? Or, who should adjust in case of international disequilibrium? Of course, such ambiguities in the interpretation of the agreement could work both ways as was revealed by the mid-1960s turn to more narrow conceptions inspired by the neoclassical synthesis. This was the era of increasing speculation in international capital markets and the undermining of capital controls by the flourishing of the Eurodollar markets. The adjustable peg exchange rate system turned into a rigid fixed exchange rate system. IMF conditionality imposed on borrowing developing economies replaced its previous case-by-case policy. The collapse of the regime
255 reflected this shift from a more flexible self-reflective regime to one that demanded to eliminate rather than manage ambiguity, the policy analog of the shift from Keynes‟ ideas to neoclassical synthesis. However, the latter was unable to face the problem of inflationary expectations and the ensuing stagflation to the degree that it had rejected Keynes‟ notion of intersubjective basis of forming expectations. Intersubjectivity was turned into its head by the rational expectations hypothesis and the new classical economics as it was confined to the perception of agents concerning how credible government policy is, since the latter and not the market is the source of instability. However, in this case, agents know the true model by which the economy functions and hence, form efficient markets with adequate flow of information if left unimpaired by government policy. This was the essence of the deregulation movement of the 1980s worldwide. In this framework, the discipline forces are speculative capital movements and the imposition of common practices of transparency in information dissemination along with the removal of any political interference. This was the answer of IMF to Asian financial crisis of 1996 – 1997. But for Best (2005), as it has been demonstrated above, transparency is not adequate. What is needed is a reform of the international financial system towards more flexibility that would accommodate the inherent ambiguity of the markets. To this direction, proposals alternative to the dominant view include a managed exchange rate system, the revision of the doctrine that capital controls are necessarily damaging, a case-by-case assessment of conditionality requirements for adjustment, changes in the role and mandate of international financial institutions such as the IMF. As the above analysis indicated, an interrelation can be established between regulation and financial innovation with crises episodes being the defining moments of changing regulations in financial history. The direction of this relation is two-sided since regulation can lead to financial innovation as an answer to it and crises provoked by innovation that evades existing regulation can bring in new regulation. The role of the government is not so straightforward in the literature since new political economy concerns about short-sighted rent-seeking policies condition the assessment of the efficiency of government intervention. Nevertheless, one should weigh the danger that government decisions are subject to political considerations with the risks imposed on the economy by the fundamental uncertainty about the future and the detrimental effects for financial and economic stability. In our opinion, such trade-off considerations are profound and basic for the question of the optimal
256 degree of regulation. Even if a government can possibly overregulate a financial system seeking short-term rents or favouring certain interest groups, there is no other way to judge such detrimental behavior than to place it in the context of the operation of the economy in the specific period of time. Although historical contexts differ, the pattern of innovation, crises and regulation determined by the decisive role of agents‟ confidence on their probabilistic beliefs in a fundamentally uncertain environment is a recurring one that encompasses any failures of government policy. The task of the next section is to seek for a theoretical representation of this pattern that history exhibits.
3.3. Regulation and The Minsky-Kindleberger Model of Financial Cycles
As we have seen in the literature review of the previous section, whichever strand of thought one might choose, a relationship can be established between government regulation and the degree of systemic stability, although the positive or negative effect of the former on the latter is a matter of dispute. In this sense, the role of the government intervention in the financial system is ambiguous and for some theorists can even be the cause of, rather than the remedy for, financial crises. Nevertheless, to address the question of optimum regulation (and hence, optimum government intervention) we need a model on how the workings of the financial markets and innovation might lead to a financial crisis and how the government reacts as it takes on a role in this context. Even if we accept that overregulation might lead to systemic instability in the same way as inadequate regulation, we need a benchmark to make our assessments. Such a benchmark should be searched in a model where: 1) the possibility of financial crises is included in its workings instead of being exogenous and 2) the government can assume a role that might be beneficial or detrimental to the functioning of the system. In what follows we describe the MinskyKindleberger model of financial cycles as the basic theoretical framework for an assessment of the degree of regulation based on the above criteria. In this paper we use the term “financial crisis” in the sense of Kindleberger 4
(1978) . Kindleberger, based on Minsky (1972) and his “Financial Instability 4
Although Kindleberger (1978) is entitled as a history of financial crises, it is in fact an attempt to derive a typology of financial crises using Minsky‟s (1972) framework and plenty of historical data.
257 Hypothesis” (further developed also in Minsky (1977), (1978)) initiates a typology of financial cycles – henceforth called in this paper “Minsky-Kindleberger cycles” – that can be characterized by five successive phases: “displacement”, “euphoria”, “mania”, “distress”, “panic”. “Displacement” indicates the initial, exogenous to the economic system, shock that yields new profit opportunities for the economic agents. If those who gain from these new conditions in the economy exceed those who loose then an economic boom is set out aided also by an accommodating increase in bank credit. This phase is characterized by a feedback among rising demand, rising prices, new profit opportunities and rising speculation. This is the so-called “euphoria”. “Euphoria” progressively transforms itself into a “bubble” to the degree that “overtrading” predominates. The latter notion indicates the feedback among pure speculation, overestimation of expected returns and excessive leverage that expands among the population. However, as the boom proceeds and prices and interest rates rise, there would be a turning point at which some insiders would like to reap their gains by selling out their positions. This would initiate a phase of falling prices but rising demand for money (liquidity) and interest rates. This is the “financial distress” phase characterized by a move from financial and real assets to money. Then “distress” may evolve into a “panic” and crash as far as prices continue to decline, bankruptcies increase and the need for liquidity becomes desperate. Behind this descriptive typology, as we have already noted, lies Minsky‟s theoretical construct concerning the inherently destabilizing role of financial structures in capitalist economic development. As Minsky (1980a) indicates, the mix of financial positions of economic units determines the degree of financial stability. In general, the financial structure of an economic unit can be characterized as hedge, speculative or Ponzi. In hedge financing units the expected cash flow receipts exceed debt payments due in every period so that interest rate changes cannot affect the solvency of the unit. If one calculates the difference between the present value of the firm‟s project cash flows and the present value of debt payments, this difference remains positive in every period. Hedge units can go bankrupt only if revenues proved to be less than expected to cover commitments. Speculative units are those whose expected cash receipts are overall greater than expected payment commitments but in some periods commitments exceed receipts. These are units that exhibit early deficits and later surpluses. Interest rate increases yield lower present values for all cash receipts but this decrease affects proportionately more the distant cash flows. Hence, a
258 previously positive overall difference between receipts and payments where later surpluses counterbalanced early deficits might reverses itself because of the rise in interest rates (a present value reversal). Assume that gross cash flows are consisted of an income portion and a depreciation portion. The income portion corresponds to interest payments while the depreciation portion corresponds to principal repayment. Then, speculative financing in deficit periods is characterized by the fact that the income proportion of cash flow is greater than the interest due but the depreciation portion is less than the repayment of principal due. A speculative unit can use the excess of income portion over interest to repay part of the debt although debt refinance is needed. On the contrary, Ponzi units are speculative units in which in some or in all early periods, nor interest payment due is covered by the income portion of receipts, although the present value of the sum of all expected future receipts minus payments is positive. Hence, Ponzi units need to borrow to pay the interest payments on their debt. It is obvious that rising interest rates may generate present value reversals as in speculative units but also increase the debt of Ponzi units as they need to borrow more to discharge their interest payment commitments. Minsky (1977) sees investment as a major determinant of profits while the latter determines the ability of various economic units to fulfill their debt commitments. Investment demand is important to the degree that its vulnerability – because of the subjectivity of attached expectations – affects both aggregate demand and the viability of the debt structures of economic units. Now the story goes as follows: In times of prosperity, such as economic booms, debts are easily repaid and there is an incentive for increased leverage. This means that there is a relaxation concerning the acceptable debt structures of firms as assessed by bankers and lenders. Then more speculative and even Ponzi finance units are being accepted. As debt increases, investment increases and the market price of capital assets increases also. On the other hand, financial innovation increases the availability of finance to economic units and raises the ratio of prices of assets relative to current output increasing investment demand. In a dual price framework, as explained in Minsky (1980b), there are two sets of prices, one for capital assets and one for current output. The former is determined by long term expectations of the purchasers of capital goods and the later by the short term expectations of producers of investment goods. As investment demand increases beyond the level accommodated by internal financing, the demand price of investment (the price of capital assets) becomes a downward
259 sloping curve as borrower‟s risk decreases the maximum price the purchasers of capital are willing to pay. In addition, the supply price of capital becomes an upward sloping curve as the minimum price that producers of investment goods are willing to accept increases with the premium charged by lenders (lenders‟ risk). Then investment demand is determined where the demand price for investment (the price of capital assets) equals the supply price of investment goods. An increase in long term expectations that increases the demand price of capital more than its supply price, and hence, it increases the ratio of the two prices, increases investment demand. On the other hand, the rise in investment leads to a rise in profits and a rise in output price. However, as Minsky (1980b) indicates, either because of central bank action or because of increased excess demand for finance, interest rates will rise in the course of the boom. As interest rates rise, the price of capital assets falls and the supply price of investment goods rises thus leading to a fall in investment demand. As investment decreases, profits fall and since the latter determine the cash flow receipts, the ratio of debt payments to cash receipts increases. Furthermore, as Minsky (1978) stresses, the increased proportion of speculative and Ponzi financing in the financial structure of the economy during the boom, made the economy more sensitive to interest rate changes. Rising interest rates along with falling profits contribute to the present value reversal referred to above. Falling profits and rising interest rates lead to further fall in the market price of capital assets relative to their supply price. When profits decrease, as Minsky (1980a) remarks, hedge financing units become speculative and the latter become Ponzi. The process becomes a vicious cycle of financial failures, falling investment, falling profits etc. The boom has been transformed into a crash through the change in the financial structure of the economy concerning the proportion of speculative and Ponzi units which reflect the increase in the proportion of unsustainable debt. Of course, the above is only one part of the story for both Kindleberger and Minsky. The part described above concerns the course of events if the market is left alone to resolve the crisis. The missing part refers to what the government could do in order, either to prevent a crisis from bursting out or to smooth out its effects. What happens during the initial phases? Is it possible to prevent a mania by restraining euphoria? According to Kindleberger (1978), euphoria that leads to speculative mania is fuelled by credit expansion which could possibly be checked by central bank intervention. However, given the process of financial innovation and “monetization of
260 credit” that is on its way during this phase, monetary policy can possibly moderate but not eliminate mania. As mania and the boom go on, mob psychology develops and attempts to cut off this process by warnings or the announcement that the economy has approached an alarming limit (for example a credit limit or a gold reserve ratio) may precipitate rather than prevent the transformation of mania to panic. Furthermore, Kindleberger (1978) considers three ways by which a panic could stop. 1) Prices could fall at such low levels that agents would find it profitable to move from money to assets again. 2) Trade of securities is confined by limits on price downward movements and various measures of suspending trading. 3) The existence of a lender of last resort could, even with the mere expectation that it would act if needed, restore confidence and restrain the rush for liquidity and panic. The first is a market solution while the other two are clearly interventionist ones. The argument in favour of intervention is that it will impede the spread of bankruptcies into healthy investments that are unable to find finance even at high interest rates because of credit rationing given the general mistrust that prevails. At the center of an active management of a financial crisis lies the lender of last resort function assumed by the government or the central bank in order to provide liquidity when it is mostly needed so as to prevent panic from being developed. Along with its beneficial effects also comes its shortcoming as moral hazard can prevail among banks that know in advance that will be rescued by the tax payers money if something goes wrong. The answer to this problem for Kindleberger (1978) is to leave the matter in such an ambiguity so as, on the one hand, to give the incentive to market participants to take care of the soundness of their operations but, on the other hand, not to spread excessive uncertainty in the market and contribute to its instability. Minsky (1982), on the other hand, indicates that the management of a financial crisis involves two kinds of actions. The first concerns the lender of last resort function by the central bank (“the Big Bank”). The second refers to the support of investment and hence, business profits trough government budget deficits (“the Big Government”). Returning to the moral hazard problem, Minsky (1969) proposes that the central bank allows small crunches to occur from time to time in order to transmit the message that it will not permit unsound financing during the boom. The conclusion derived by the analysis above is the inevitability of financial instability of market economies given that government intervention is limited. On the other hand, intervention through monetary and fiscal policies might prevent the
261 development of major crises such as the Great Depression of 1929 but not without a cost. The cost paid in the 1970s took the form of stagflation. Hence, what the above analysis indicates is the effectiveness and limitations of demand management policies to prevent financial crises. What we have not considered so far is another form of government intervention that refers to institutional policy and specifically financial regulation. A hint for the existence of some kind of relationship among financial regulation, crises and financial innovation is already present in both Kindleberger and Minsky. As we have already noted above, Kindleberger (1978) stresses the difficulty to control money supply in “euphoria”. Even if the definition of money is given, financial innovation and the “monetization” of various means of credit contribute to the expansion of means of payments although money narrowly-defined has not increased. Minsky (1977) observes the same phenomenon of financial innovation during the boom along with two interesting remarks. Firstly, that policy “fine-tuning” can only be temporarily effective within the financial structure of a typical capitalist economy. Secondly, there is a need for policies that would restrain speculative tendencies of agents, policies that would “enforce a „good financial society‟”. In Minsky (1980b) he insists that, given the inherent instability of capitalism, change in its institutional structure is necessary. However, measures to control money – or banking – are not enough. What is needed is constraints on the liability structures of economic units. Minsky (1972) claims that the central bank should not impose interest rate controls on commercial banks during the phase of euphoria. Such controls would impede competition and innovation and such prohibitions is not the appropriate answer to instability and the endeavour to restore confidence in the system. On the other hand, Minsky (1980c) warns about the need to supplement the lender of last resort function with the appropriate regulations that would confine the risk exposure of financial institutions. History has revealed a vicious cycle: antiinflationary policies lead to debt-deflations (such as the Great Depression of the 1930s) while demand policies to avoid debt-deflations and depressions may lead to disrupting inflationary environments (just like the stagflation of the 1970s). One can avoid this vicious cycle through structural reforms including the financial system. Minsky (1957) takes an interesting position on the relationship between financial innovation and fragility. As he notes, rising interest rates and increased cost of money during the boom give the incentive to explore new ways of financing and hence,
262 contribute to financial innovation. However, such innovations that yield cash substitutes decrease the liquidity of the economy increasing equivalently its risk and fragility. On the other hand, the central bank will not be prepared to intervene in the market in order to stabilize the new assets. Furthermore, Minsky (1957) indicates that the regulatory defense of the system looks like the Maginot line. It is a response to the shortcomings exhibited in previous crises with the definition of money and financial instruments prevailing then. However, financial innovation described above brings in new opportunities and new risks to the system that are not faced by the existing institutional/regulation structure. If financial regulation satisfies the caprice of an imprudent short-sighted government then it cannot eliminate instability because it might be one of its sources in the first place. However, what the Minsky-Kindleberger model indicates is that our world is a world plagued with fundamental ignorance of the future where expectations depend more on the degree of confidence by which they are held rather than on objective knowledge of the probability distributions. The latter indicate that market economies are inherently unstable but it does not mean that regulation can effectively prevent this instability in the longer term. This is the conclusion derived by the previous discussion that conditions regulation on a “Minsky-Kindleberger” model of financial cycles. In this context, even the liberal views that are suspicious of government intervention can be justified as critiques of excessive or short-sighted regulation rather than as dismissals of government regulation altogether. If regulation cannot prevent instability permanently it can certainly confine its effects for the financial and real structure of the economy. In this sense, we assert that as the economy, in its historical evolution, passes through the phases described by the Minsky-Kindleberger financial cycles model, regulation and its degree should depend on it. Alternatively, changes in regulation should reflect different phases of the financial cycle. This is the theme of the next section.
3.4. In Search of the Optimum Degree of Regulation
263
3.4.1 A Model of the Interbank Market Based on Banks’ Liquidity Preference Function In this section of the paper we want to propose a theory of change in the institutional infrastructure that determines the degree of government intervention to impose rules and limitations that change the incentives for financial market participants. In this sense, we understand financial regulation for the maintenance of stability of financial markets as an interactive policy between agents and the government rather than as a unilateral decision of the authorities with the tacit consent of the public. This interplay will help us understand not only the reasons of acceptance of certain regulations but also the reasons for their evasion through new financial instruments and hence, the process of financial innovation. In this sense, regulation should respond to previous crises by changing the incentive structure that leads to a certain behavior of agents or functioning of the market which was blamed for the past crunch. On the other hand, this new regulatory framework gives the incentives not only to avoid the aforementioned harmful activity but also to adapt new means of exploiting profit opportunities through financial innovation. This is exactly the point that we want to focus. A new regulation, as a new structure of incentives, is also a new set for profit opportunities with unknown and unexpected consequences for financial stability. Regulation can never be complete for the same reasons that free markets will always be characterized by episodes of market failures: fundamental uncertainty. If we consider financial regulation as a contract among the government, financial institutions and investors then this should be an incomplete contract that cannot prescribe the action that should be taken in every situation encountered in the uncertain future. However, it is possible to devise a contract that would be revised according to the phase of the financial cycle the economy is placed at. Our paper is an attempt to model the process of financial regulation as the process by which such a contract is written among the three parties mentioned above. A central market in our model is the interbank market which demands a detailed description before we embark on a model for the banking firm. We assume that every bank can have both short-term liquid assets and liquid liabilities. Hence, the net position in the interbank market for every bank where
denotes liquid assets and
is given by the difference liabilities in the form of short-
264 term securities. We assume that there are different motives in holding liquid assets and liabilities. Demand for liquidity by a bank that borrows from the interbank market has the meaning of a demand for cash reserves in exchange for short-term securities supplied by these banks, the latter entering as liabilities in their balance sheets. The rationale for this trade is to supplement liquid reserves if the volume of their loans is to remain unaffected by the increase in defaults expected in current period. On the other hand, demand for liquid assets has the meaning of obtaining securities as assets substituting loans and shortening the maturity of their portfolio, by supplying extra liquidity to net borrowers in the interbank market. The justification for this operation is to guard itself against future defaults expected for the next period but not currently affecting bank‟s liquidity position. Banks as lenders will provide such liquidity to other banks as borrowers at a price that determines the interbank rate. We assume that the preference for liquid liabilities (issuing of short-term securities as liabilities) as expressed by the liquid assets ratio is proportional to current period‟s expected default rate
with
for every bank i.e.
(1)
with
being the proportionality factor. In order to justify this relationship note
that for a liquid assets‟ ratio defined as the ratio of short term securities to deposits ,
that is the funds borrowed at the
interbank market should be at such a level that they could repay, if needed, the proportion of deposits that corresponds to loan losses and which is not covered by required reserves. A rising
corresponds to rising demand for current liquidity or
rising supply of short-term securities in the interbank market. On the other hand, the preference for liquid assets
depends on the present value of future (next period‟s)
expected demand for liquidity as this is expressed by the expected default rate for period
conditioned on the (assumed unchanged by regulation) required reserves
ratio:
(2)
265
However, depending on whether
or
some banks end up as net
lenders and others as net borrowers in the interbank market. This distinction is important for their profit maximizing behavior as this will be described in the next section. Since these inequalities depend on the difference
, we assume
that a bank becomes a net lender in the interbank market if:
(3) that is if defaults in the next period are expected to exceed the future value of current defaults, or the amount of liquidity needed in the future is expected to increase above current demands for liquidity. In this case, a bank that wants to insure itself against future liquidity problems will become a net lender in the market so as to both shorten the maturity of its portfolio and obtain cash at an interest in the next period when these funds would be most needed. On the other hand, a bank
is a net borrower in
the interbank market when:
(4)5
5
Hence, by (3)
with
and by (4)
with
. Although this might seem counterintuitive, as it is explained below, the interbank rate depends on expectations for future defaults over current defaults. If this ratio is given and hence, remains unchanged then, a rise in the interbank rate should only be accompanied by a fall in the liquid assets ratio follow.
, thus yielding
from which
and
266 which means that the present value of next period‟s expected defaults is less than current defaults so that the bank assess as a priority to insure itself from current unexpected withdrawals of deposits up to the magnitude of current loan defaults. Hence, we can discern two types of banks: net lenders of type where net borrowers of type
where
given a number of
and
banks.
However, in order to derive equilibrium in the interbank market we need to take account not only of banks‟ net positions but rather of their gross supply and demand for liquidity. Since aggregate borrowing of liquidity of the magnitude should be satisfied by aggregate liquidity supply
then
in equilibrium we should have:
(5) Then substituting the expressions for liquidity preference by (1,2) we obtain6:
6
Since
267
(6)
Equation (6) indicates that the equilibrium interbank rate is proportional to the expected next period default rates and inversely proportional to current default rates both conditioned on current deposit levels for each bank. Alternatively, the interbank rate depends on the relationship between future and current liquidity needs in the market as these are expressed by the interaction of liquidity preferences of lenders and borrowers. The higher future liquidity needs are expected to be, given current ones, the higher the interbank interest rate demanded by lenders and paid by borrowers in equilibrium. Hence, if
or future liquidity needs (supply in the
interbank market) fall short of current ones (demand in the interbank market), this would indicate a falling ratio of future expected over current default rates on the LHS of (6) which in turn is an indication of optimism and leads to a lower interbank rate in equilibrium on the RHS of (6). The opposite happens when
as
a rising ratio of future expected over current default rates signifies a rise in pessimism and leads to a higher interbank rate in equilibrium.
Figure 1: The interbank market
Figure 1 above indicates diagrammatically equilibrium in the interbank market. For given current default rates
that determine current liquidity demand in each period
268 , the price for its supply
is determined by future expected liquidity needs which in
turn depend on next period‟s expected default rates liquidity curve
. Aggregate supply of
is downward sloping with respect to the
interbank rate and depends positively on future expected default rates. Aggregate demand for liquidity
is independent of the interbank rate and depends
positively on current default rates. A rise in the ratio
moves aggregate supply
curve to the right and the interbank rate above in equilibrium. A fall in the ratio moves aggregate supply curve to the left and the interbank rate falls in equilibrium. However, in order to establish an upper bound for this rate let us formulate the notion of trust and financial innovation as these are expressed in our model. To do this we need to analyze the interbank rate into two components:
(7)
where
is the risk-free Treasury Bill rate and
with
is an average, across banks, factor of degree of confidence with which they hold their expectations about economic prospects7. Independently of banks‟ final position as net lenders or net borrowers that affects their profit maximization problem, as we shall see in the next section, they all participate in the market as both lenders and borrowers and hence, they all contribute by their individual risk assessment to the average degree of confidence factor. This factor acts as a mark-up or risk premium on the risk-free interest rate taking values above or equal to zero. An extreme value of the average degree of confidence factor of
indicates a high degree of
confidence on held expectations, or alternatively a high level of trust prevailing in the interbank market, so as the interbank rate to be equal to the risk-free interest rate8. On the other hand, a value of
is an indication of very low confidence and
distrust that raises the interbank rate well above the risk-free rate. Then a rising interbank rate or a rising risk premium in the market corresponds in equilibrium to 7
We denote the upper value of the factor of degree of confidence or risk premium equal to some unspecified positive value . 8 Furthermore, note that even in the case of zero expected defaults , the interbank rate cannot be lower than the risk free rate, the latter representing the time value of money.
269 higher expected default rates in next period for given current default rates as can be seen by (8) below:
(8)
To put it differently, optimism in the market as exhibited by low given
, reflects itself in a low risk premium
. If, on the other hand,
pessimism prevails because of high expected future defaults given current defaults, the risk premium will be high thus raising the interbank rate. In terms of (8) an extremely high
indicates a break of trust in the market since expected
default rates conditioned on current deposit levels
are in aggregate so
high that it is doubtful whether future liquidity demands could be serviced without a liquidity crunch. Alternatively, since equilibrium in the interbank market is in fact attained as the outcome of equilibrium transfer of liquidity between periods, a high degree of trust and confidence that lowers the cost of interbank lending is an indication of financial innovation. This is because this transfer of liquidity between periods and
, takes the form of exchange of risk between profit maximizing net
lenders and net borrowers in the market. The risk of deposits withdrawal incurred by net borrowers in period
is transferred to net lenders who undertake it at a price
denoted by the level of the interbank rate. A low level of
is an indication of
financial innovation, that is of financial instruments that make this transaction possible. But no such technical instrument or form of security can represent financial innovation if it is not based on the mutual benefit and mutual trust of the two parties of the transaction. In this sense, trust and confidence in the market is positively correlated with financial innovation that makes the exchange of risks possible at a low cost. The major risk factor that banks face in our model is the default on loans rate. In the above analysis we saw how current and expected default rates affect banks‟ liquidity preference and interbank market equilibrium. However, before proceeding to the description of our banking firm model we need to consider the effect of the default rate on another variable: the cost of equity capital.
270 We denote by variable
the cost of equity capital of bank
at time . Define the
as a benchmark cost of equity capital of a banking firm with zero
defaults
, current and expected. Then, for a risk factor
pertaining to
bank at time ,we can write the equation:
(9)
Equation (9) says that the cost of equity capital for bank is a mark-up above the cost of equity of a benchmark bank without defaulted loans. The mark-up factor is the risk factor of the bank
. Although, only bank managers are aware of the true
that
makes up, along with the risk factors of other banks, the average degree of confidence factor of the banking sector a proxy of it as
, we assume that equity market participants can obtain . Hence, the risk factor of bank
which is used as a
mark-up factor by equity holders is the average risk factor of the banking industry adjusted by the ratio of current over past defaults, the latter being a proxy for the ratio for bank . Then, the market value of bank‟s equity at time , function of this cost of capital with default rates for given
. Hence, a rise in current over past
or a rise of the average risk factor
rise of both, raises the bank‟s
is a
for given
and hence, its cost of equity capital
or a at time . In
this sense, expectations about the state of the economy derived by the level of which is closely related to the conditions in the interbank market and expectations about the individual situation at which each bank is placed as given by the ratio affect the cost of capital for each bank. If modeling of the interbank market through default rates permit us to say something about liquidity management by
271 banks, allowing default rates to affect the cost of equity capital brings in this model an element of market discipline useful for regulatory purposes9.
3.4.2 A Model of the Banking Firm Assume a monetary economy10 comprised of three kinds of agents: firms, banks and the government11. The monetary economy includes
banks which extend loans to
firms
and hence, create deposits in the context of a fractional reserve system. The banking model described here is based on the Monti-Klein model of the banking firm in imperfect competitive conditions (Cournot oligopolies) as this is described in Freixas and Rochet (1997:51-60), Studart (1995:39-44) and Matthews and Thompson (2005). Bank‟s
. The Assets‟ side is
balance sheet takes the form
comprised of loans
, required reserves
holdings of liquid assets
and excess reserves in the form of
. The latter indicate the net position of the bank in the
interbank market and can be positive or negative depending on whether the bank is a net lender or net borrower in the interbank market for reserves. If bank lender then
is a net
, (short term securities as an asset). If the bank
is a net borrower then liability). The Liabilities‟ side is comprised of deposits
, (short-term securities as a and equity capital
maximization problem is solved for every bank at the beginning of period
. The in terms
of expected values of the variables for loans, deposits, short-term securities, equity capital and marginal costs during this period and for prices determined at the
9
However, a reasonable objection is that euphoria that inflates asset prices emerges because market discipline in the above sense cannot function effectively either because uniformed investors cannot have even the proxy knowledge of past default ratios for each bank or because informed professional institutional investors simply disregard the signals given by these ratios and charge unjustifiably low risk premiums. 10 Since this is a monetary economy all variables and rates of return referred in the text are nominal. 11 We do not include households as a separate agent although they exist in the background as consumers and savers. However, we want to stress expenditure and especially investment expenditure decided by firms and financed by banks through their loans. For this reason we will focus only on the part of money held by banks as required reserves and the liquidity preference of banks as demand for liquid assets above the required reserve ratio.
272 beginning of the respective period of time. A bank
maximizes its profits that it
expects to receive at the end of the period as given by the relation below12:
(10)13
where is the loan rate,
is the deposit rate,
of return on equity capital. If by bank
is the interbank rate and
is the volume of loans to be decided
plus the volume of loans extended by other banks is the volume of deposits to be accepted by bank
deposits of other banks vectors
and plus the volume of
then a Cournot equilibrium is characterized by
with
maximizes the profit
is the rate
such that every pair of bank
,
taking as given the chosen volume of deposits and
loans of other banks. However, we assume that the choice on the volume on deposits to be accepted by bank
is directly dependent on the volume of loans it decides to
extend. Deposits act as a necessary input in the process that characterizes the operation of the banking firm to extend credit. Profit comes from lending using the input of deposits at a market cost represented by the deposit rate. Hence, using the balance sheet constraint, the optimum level of deposits is derived by the optimum level of loans through the relationship:
(11a)
12
We drop the expectation operator for simplicity of exposition. We assume, as in Heid (2007), that banks do not lose the interest on defaulted loans because this is paid before firms default. In addition, we assume that the principal of defaulted loans(write-offs) is covered by equity capital at the market cost so as for equity capital to have namely, the defaulted principal written off at the expense of equity capital of the previous period is expected to be replenished by drawing an equal amount of equity capital by the market at the cost . Hence, the cost of write-offs is immediately transformed to a cost of raising an equal amount of equity capital from the market. Hence, contrary to Heid (2007) who does not include the possibility of raising capital from the market, the effect of defaults on equity capital in our model is through the effect of default rate on the cost of equity capital. 13
273
(11b)
where
is the required reserves ratio,
is the liquid assets‟ ratio and
the capital/asset ratio. As can be seen by (11), the optimum level of deposits, for given optimum level of loans, falls with a rising capital/asset ratio, and increases with a rising required reserves ratio. However, for a net lender, optimal deposits rise with a rising liquid assets (excess reserves) ratio for given optimal loans since additional deposits are needed to support excess reserves in the form of liquid assets. On the contrary, for a net borrower bank optimal deposits fall with a rising liquid assets ratio since in this case short term securities represented by
are a liability of the net
borrower in the interbank market and they substitute deposits for given optimal level of loans. The required reserve ratio and the capital/asset or capital adequacy ratio are directly influenced by the existing regulatory framework of the financial system. On the other hand, the liquid assets ratio as described in the previous section was related to a behavioural relationship that gave rise to a liquidity preference function for banks. Finally,
is the operating cost which depends on the volume of loans
extended – assuming a negligible operating cost of keeping deposits – and the institutional conditions in the financial markets (concerning information asymmetries and contract supervision and enforcement) that determine the cost of loan contracts. Total cost increases as loans increase because of the effort needed to identify the risk of an additional project proposed for finance. The existence of asymmetric information that plagues the relationship between a firm and a bank
indicates the
need for the latter to utilize its own resources in order to discern the creditworthiness of the borrower given its past history of performance, management competence and the perceived prospects of the proposed projects in a rather noisy environment. This devotion of rare resources from the bank is expressed on average in its operating cost function. In addition we assume a downward sloping market demand for loans by firms
,
as the demand for loans to finance investment projects falls with
a rising loan rate. Furthermore, there is an upward sloping market supply of deposits by households-savers
,
which means that a rise in the volume of
274 deposits available to banks demands a rise in the deposit rate offered. However, we shall work with the inverse functions
and
respectively. We shall also
assume for simplicity that a change in the amount of deposits accepted by each bank will not affect the market deposit rate so as each bank to act as price taker in the market for deposits. In addition, deviating from the classical representation of the Cournot model, we treat loan supply by each bank as a function of loan supplies of all other banks such as
for
and
. Finally note that by (11) and the definition of the liquid assets ratio we obtain the expression:
(12a) (12b)
Hence, the bank‟s maximization problem becomes:
(13)14
(14a)
(14b) 14
To make the exposition less cumbersome we have dropped the arguments from the functions of and . However, we keep in mind that for net lenders, for net borrowers and for both net lenders and net borrowers.
275
Define
the share of bank
on total loans extended by the banking
sector . Also we may define the elasticity of market demand for loans . Then, given the inverse function rule that
by (14) we
obtain:
(15a)
(15b)15
15
Note that if the deposit rate had been affected by a change in the amount of deposits
we would have
then by (10)
and hence the LHS of (14) would become
276
Expressions (15a) and (15b) are the respective Lerner indices that represent a measure of the market power of bank as this is expressed by its market share on the market elasticity of demand for loans
conditioned
. Lerner indices are of the form
and hence, the (weighted by the price) difference between price and marginal cost indicates the deviation from competitive conditions. Marginal cost here is represented by the marginal cost of deposits
minus/plus the return on liquid
assets conditioned on the ratio of these assets to deposits factor
, the marginal cost of equity capital
capital/assets ratio and the marginal operating cost of bank
and adjusted by the adjusted by the relevant
.A high
(greater share
in the market for loans) means either a greater penetration in the market
with a wider clientele or a deeper and more extending relationship with existing customers who consist a significant proportion of existing demand for loans. However, note that the market share of each bank is also affected by the term which represents the reaction of banks
different from to a change
in the loan supply by bank . This term should be positive to exclude negative market shares. However, the question arises whether the sum of partial derivatives is positive, zero or negative. Note that:
(16)
Hence,
is confirmed either for partial derivatives which are
positive in total (indicating a rise (fall) in loan supply by banks
as a reaction to
277 a rise (fall) of loans by bank ) or for partial derivatives which end up negative in their sum provided that their absolute value is less than one. The latter means that the reply of banks
to a rise (fall) of loans by bank
would be a fall (rise) in their loan
supply in the aggregate but less than proportional to it. Finally, the case of zero sum of partial derivatives is the classical Cournot model assumption in which every oligopoly takes loan supply of other oligopolies as given and does not except it to change. If the latter is the benchmark case then a sum of positive partial derivatives indicates a lower market share than the benchmark as other banks respond by increasing their loan supply as bank
increases its own. On the contrary, a negative
sum of partial derivatives denotes a market share of bank higher than the benchmark as other banks respond with a fall in their loan supply, although less proportional than the rise in loan supply of bank . The Cournot equilibrium concerning the quantities of loans – and through them of deposits – for each bank depends on the respective marginal costs and the reaction derivatives
as these affect the reaction function
given by
(14a,b). For given market prices for loans, deposits, liquid assets and equity, and for given required reserves ratio, these reaction functions, and hence the volume of loans extended by each bank , depend on the volume and sign of its liquid assets ratio on its capital/asset ratio
and on its marginal operating cost
increasing marginal operating cost for bank
,
. At first,
not taking into account its net position
in the interbank market and leaving its capital/asset ratio unchanged, leads to lower volume of loans16 and lower market share17. Indeed, by implicit differentiation18 we obtain:
16
As Varian (1992:289) indicates, a rising marginal cost for one of the firms participating in the oligopolistic structure of an industry would decrease its output as this is derived by the respective Cournot equilibrium. 17 A falling amount of loans for one of the oligopolies entails a falling share in the market if all other oligopolies extend a positive amount of loans or the market share of bank is less than one. Indeed, given the definition of the market share
we have: .
18
Defining
278
(17)
On the other hand, a rise in its capital/asset ratio, other things unchanged, yields:
(18) For
,
,
and
the sign of (18)
depends on the term within the brackets. Then . The last relationship entails a positive margin between the cost of equity capital and either the net cost of deposits
in the case of net lender
bank or the cost of deposits plus other borrowed funds borrower bank, adjusted by the factor
in the case of net
. In other words, if the cost of equity
capital is greater than the cost of other sources of funds such as deposits and interbank funds, then an increase in the capital/asset ratio, would decrease the market share of the bank. Note the following relationship derived by the balance sheet constraint:
(19) Then by implicit differentiation we obtain:
279
(20)
Hence, an increase in equity capital for a given level of loans would have the effect of lowering deposits and hence, changing the composition of the liability side. If the cost of equity capital is higher than the net cost of deposits then there will also be a rise in the cost of funds that would demand a higher return on loans to cover this added cost. Then by
and
we obtain that a rise in the loan rate would
lead to lower aggregate loans extended by the banking sector in equilibrium and a lower share for each bank. The above relationship is also understandable as a deviation from a minimum required capital adequacy ratio
. Indeed, if
then the bank effectively maintains a higher than required capital/asset ratio which adversely affects its market share. The above analysis gave the profit maximization characteristics of a banking sector organized around oligopolistic structures. According to Cournot-type equilibrium, banks determine quantities of loans and deposits given the choices of other banks and prices. Prices for loans, deposits and equity capital on the other hand, are determined respectively in the market for loans where banks‟ offers interact with firms‟ demand and in the market for deposits and the market for equity capital where banks‟ demand interact with savers‟ supply. If firms negatively related to the loan rate and
is aggregate demand for loans by is the supply of savings in the
form of deposits positively dependent on the deposit rate and negatively related to the return on equity and
in the form of equity capital positively related to the
return on equity and negatively related to the deposit rate then:
Market for loans
(21)
280
Market for deposits
(22) Market for banks‟ equity
(23)
Interbank Market
(24)
Equilibrium in the loan market described by (21) determines the loan rate at the level at which aggregate supply of loans of the banking industry determines the level of investment demand of firms that is satisfied given the deposit rate, the interbank rate and the cost of equity capital. Equation (22) describes equilibrium in the market for deposits where the deposit rate is determined given the loan rate, the interbank rate and the cost of equity capital. Furthermore, (23) denotes equilibrium in the market for bank capital and determines the return on equity for each bank given the deposit rate, the loan rate and the interbank rate. Finally, (24) describes equilibrium in the interbank market obtained by aggregating over all banks yielding a zero net position in that market19. By this condition we obtain the interbank rate given the loan rate, the deposit rate and the cost of equity capital. The right hand side of the first two equations can be derived by aggregating over all banks the respective supply of loans and demand for deposits as these are obtained for each bank by the first order conditions (14a,b). 19
This should become clear in the next subsection since aggregating over all banks, demand for short term securities should equal their supply and these should cancel out as leaving the above expression (14) to describe interbank market equilibrium.
281
3.4.3 Changing Market Shares and the Financial Cycle Different liquidity preferences in this model as expressed by net lenders and net borrowers indicate differing market shares in credit market. The attempt of a net borrower bank
to maintain its level of extended loans despite expected defaults by
supporting its liquid reserves with funds borrowed at the interbank market it would be successful if another bank(s) substitutes bank‟s
decides to decrease its own market share as it
short-term securities for loans at a price. The above entail a
change in liquid assets ratios for each bank. By the balance sheet constraint we obtain for a net lender bank
and for a net borrower bank . Then
while
. Hence, a rise
in the supply of securities by the net borrower bank
that is met by a rise in the
demand for liquid assets by the net lender bank
entails a fall in the loans extended
by the second for given loan volume extended by the first. Define:
(25a)
(25b)
We will examine the effect on the market share of a change in the liquid assets ratio for given prices, marginal costs and required reserves ratio but allowing the
282 capital/asset ratio to change as the market share changes. Hence, for a net lender bank we have20:
(26) While for a net borrower bank – let us denote it as bank
20
Since
then
– it is given by:
from which we obtain for
.
283
(27)
In order to derive the signs for (26) and (27) observe that both denominators and
are
positive as a product of positive variables. On the other hand, are also positive since, for
and
and
namely, part of the loans for both types of banks is funded by deposits.
We have also seen in (18) that
for
. Hence, the signs of (26)
and (27) depend on the difference
and on the sign of
. As we have seen above,
,
for namely21,
and
the liquid asset ratio is negatively related to the volume of loans for a net lender bank and positively related to the loans extended by a net borrower bank while the volume of loans for both is positively related to its market share. Hence, we should have and capital/asset ratio decreases and
21
. Furthermore, by for
,
and by the definition of
we obtain that
and
since, as
increases and assuming that the respective equity capitals
Since, as we have already seen in footnote 10, :
for
.
and
284 remain unchanged, capital/asset ratios
increases and
decreases. The same
holds if we take into account the effect of the cost of equity capital on the market value of equity capital in case of rising default rates. Since since both
and
and
and
then, as default rates increase and risk
factors are adjusted upwards by (9)
and
rise although in differing degrees
depending on their respective ratios between current and past default rates and
. Since net borrowers are more desperate for current liquidity as opposed
to net lenders then we might assume that for given past default rates we would have and hence, in the market value of equity this case,
might rise faster than and
. The result would be a fall
accompanied by falling
holds unambiguously and
and rising
. In
holds for a fall in market
value of equity of the net lender less or equal to the fall in loan supply. Hence, and
entail:
(28)22
At first we can compare this result with that obtained when market shares are unresponsive to changes in liquidity positions which would entail that:
(29) 22
If the deposit rate as responsive to
,
changes then (28) would become
which entails The last relationship says that the interbank rate is less than the market deposit rate adjusted both by the required reserves ratio and the market power of bank in the market for deposits. A higher share for given elasticity of supply of deposits raises the upper bound above which bank‟s entry in the interbank market ceases to be advantageous. To put it differently, the higher the market power of a bank in the market for deposits, the higher the interbank rate should rise to put it out of the interbank market.
285
Note that equation (28) means that the unit cost of funds in the interbank market should be less than the corresponding cost of funds in the market for deposits adjusted by the required reserves ratio if a change in market shares is to be attained through a change in liquid assets ratios. This gives a meaningful upper bound for the interbank rate in the sense that a rate above that level
would indicate the cease of
trading in the interbank market. This is because, for this market to function, the net borrower bank should face a cost of funds in the interbank market lower than that in the deposit market so as to induce it to seek for funds in this market. On the other hand, the net lender bank should accept a return on short term securities lower that that prevailing in equilibrium with market shares unaffected by liquidity positions so as to induce the net borrower bank to accept borrowing from it in the interbank market. Furthermore, raising the deposit rate to attract more deposits is not an optimum solution for a bank such as
that wants to support its current liquidity
position for two reasons. Firstly, as we have seen above, future expected liquidity needs of the net lender bank depressed the interbank rate below its equality with the adjusted deposit rate so as raising funds in the interbank market to be cheaper. Secondly, a rise in the deposit rate raises the costs of funds and decreases profitability and the market share independently of the type of bank, as it can be seen by (30) below for
:
(30)
However, if banks were segregated by a characteristic other than their liquidity needs, such as their marginal cost then a rise in the deposit rate to attract deposits could be counterbalanced by a fall in marginal operating cost and thus it could contribute to a rise in market share as we have seen in (17) above. However, we will stick to the case of similar banks except for their liquidity preference function as the major condition on the maximization problem of banks that segregates their market behavior.
286 Now suppose that the economy is placed at the rising phase of the cycle. At this point optimism prevails which means that the rate at which current liquidity needs are traded for future ones is close to the risk-free rate. In other words, by (8) current default rates and the respective needs for liquidity equal the present value of future expected default rates using as a discount rate a rate close to the time value of money. If current default rates are at a level which is considered to be normal for the conditions that prevail in the economy then optimism means that it is not expected that these rates will change significantly in the future. Hence, the rate at which funds are loaned is just the one corresponding to the time value of money without any risk premium. This has its repercussions in both (8) and (9) affecting both the level of the interbank rate and the cost of equity capital for each bank . Indeed, if banks‟ average risk factor
is close to zero then the interbank rate is close to the risk free rate and
the cost of equity capital for each bank capital without defaults
is close to the benchmark cost of equity
, the mark-up above it depending only on the agents‟
expectations described by the ratio of current over past defaults for each bank
.
If default rates are indeed considered normal then this ratio would be low contributing to a low cost of equity capital for this bank. Although, as we have seen, the capital/assets ratio is falling for a net borrower bank since it holds that
,
keeping default rates at low levels does not add significantly to the cost of equity capital ratio
and hence, it does not burden further the already decreasing capital assets . This means that financial innovation in the beginning of the cycle that
makes possible borrowing from the interbank market, retards the fall of capital assets ratio of net borrowers ratio
before reaching the level of minimum capital adequacy
set by the regulatory authorities. On the other hand, a depressed interbank rate makes it possible for net
borrowers to maintain their loan activity despite current default rates that could provoke a liquidity problem to the bank if
and would demand premature
liquidation of loans. To establish this observe that by the balance sheet constraint for zero initial net position in the interbank market for a bank
we obtain:
(31)
287 Now assume that the bank faces current defaults of
. Then (31) can be written as:
(32)
Note that the LHS is just the original
augmented by a volume of loans pertaining
to the acquisition of liquid reserves at the interbank market given that write-offs remain constant at the level
are fully replenished by new equity for the latter to . Hence, in this case in which defaulted loans
were replaced by an equivalent amount of new loans and the corresponding deposits were not called on by depositors, the loan activity of bank
and its
share in the loan market increased. However, even if these deposits had been withdrawn (32) would have been replaced by:
(33)
that is the volume of loans would have been the same as before. However, since this would have meant a lower market share for a net lender bank that had provided this liquidity to bank
the market share of the latter would have been increased even in
this case. Even more important is the fact that the trade in the interbank market makes possible for the net borrower bank to circumvent the constraint on its loan activity placed by the reserves requirement ratio. Indeed, if interbank trade were not possible (33) would have become after deposits withdrawals:
288 (34)
namely loans would have to be cut by an amount equal to the withdrawals .23 Therefore, optimism of net lenders in the interbank market at the beginning of the financial cycle validates optimism of net borrowers in the credit market and makes it possible for the latter to maintain their loan activity despite defaults. This kind of risk sharing between the two types of banks is an indication of financial innovation in the form of new instruments or techniques that permit this optimism to manifest itself. What would be the effect on the loan rate and hence, on total loans extended? In this case, as the loan market share of bank share of bank
decreases and the loan market
increases through interbank market equalization of supply and
demand for short-term securities, the effect on the loan rate is ambiguous. Indeed, implicitly differentiating (25a,b) yields:
(35)
23
Note that in this case we still assume that write-offs of defaulted loans that would burden equity, they would be replenished by resort to the capital market to raise an equal amount of equity capital. However, this is not a realistic assumption because in our model risk assessment in the capital market requires the proper functioning of the interbank market. If the latter does not exist or it is unable to operate, raising capital from the capital market is also difficult, at least at a reasonable cost of equity capital. Hence, if write-offs were not replenished we should have .
289
(36) Both (35) and (36) are positive since,
,
,
,
and the term in the brackets , for
is the marginal cost derived by the first order conditions (13a,b)
and hence, it is also positive. Then by (35) a fall in the market share for a net lender bank
is related to a fall in the loan rate and hence, a rise in total loans demanded by
firms since by the downward slopping demand for loans we have
. Then,
equilibrium in the credit market attained by (21) corresponds to a greater volume of loans supplied by the banking industry in the aggregate
at a lower loan
rate. On the other hand, by (36) a rise in the market share of bank
would have the
opposite effect as it would entail a rise in the loan rate and a corresponding fall of loans demanded and extended in equilibrium for the banking industry as a whole. Hence, since a fall in the market share for a net lender bank and a rise in the market share for a net borrower bank yield opposite effects on the loan rate the direction of change in the latter is ambiguous. However, we can discern the direction of change by applying condition (28) and working backwards. From the equilibrium condition in the interbank market (5) and equations (3) and (4) we have:
290
(37)
Hence, for belonging to type
with bank and bank
being of type , for common prices and for
(dropping subscript for simplicity) we have:
291
(38)
As it can be seen by (38) the fall of the loan rate because of the fall in the market share of the net lender bank
is less that the rise in the loan rate because
of the rise in the market share of the net borrower bank
. Hence, a change in
market shares effected by a change in interbank market positions would ultimately lead to a rise in the loan rate and a fall in the aggregate amount of loans in equilibrium. This is important as far as a rise in the loan rate could have the effect of leading to present value reversals for some firms according to Minsky (1980a) .A “present value reversal” that increases the fragility of the financial system and the possibility of a firm‟s bankruptcy happens when the present value of the cash flows of firm‟s projects is lower than the present value of its debt payments, both discounted by the same discount rate, the lending rate. This could come about because of a rise in interest rates in case of early deficits and later surpluses in the difference of receipts minus debt payments according to Minsky (1980a). Assume that each firm is described by an investment project – or a portfolio of investment projects – with expected return
, and variance
takes the form of an annuity for in present value terms we have:
at each time and the loan obtained by the firm periods paying an amount
at each period. Then
292
(39)
To sum up, euphoria prevailing in the market makes possible the extension of loans in volumes not justified by current default rates while exerting an upward pressure in loan rates provoking present value reversals to firms with the more weak financial structures. This would entail that current default rates for every period would increase as we move up the cycle. If financial innovation through this exchange of risks between periods and liquidity needs continues to be validated by euphoria in the market, an increase in current default rates will not affect significantly future expected default rates and the risk premium in (8) and (9) will remain low. However, after some point continued interest rate increases and spreading of present value reversals would lead to a reassessment of risk premiums in the interbank market thus exerting upward pressure in both the interbank rate and the cost of equity capital. At the top of the cycle, as
the high cost of equity capital would indicate pessimism
prevailing in the economy although the exact level for each bank would depend on the ratios
for
. This effect would be much more important for net
borrowers as their capital assets ratios
would fall faster as
reaching quickly the minimum capital adequacy ratios
increased thus set by regulatory
authorities. It is as if market discipline imposed by current and prospective bank shareholders had provided the means by which capital adequacy requirements set by regulatory authorities would have been effected. The rise in the interbank rate will reach its maximum level as the interbank rate would increase up to the level of the adjusted deposit rate
. Beyond this
point the interbank market ceases to operate as interbank funds are no longer cheaper than deposits as an alternative source of funds. Trust has broken up as the risk premium
is very high and confidence is very low. Financial innovation that gave
the opportunity to banks to circumvent reserve requirement regulations and delay the effect of capital adequacy requirements, is no longer validated by optimism and hence, is no longer operational. At this instnat, the lending rate is very high corresponding to a lower equilibrium volume of loans as available funds are scarce. The only alternative source of borrowed funds is the deposit market but this requires a rise in the deposit rate and hence, a further rise in the loan rate thus leading to a
293 vicious circle. On the other hand, it is doubtful whether depositors would increase their bank deposits in the first place and not run on them plagued by what Kindleberger called “panic”. At this point, the “Big Government-Big Bank” mix of Minsky could operate so as to prevent in this case both the bank panic and economic downturn. As far as the operation of the Central Bank is concerned, the latter could accommodate the demand for funds by net borrowers by discounting banks‟ short term securities at a rate close to but below
and increasing high powered money in terms of bank reserves. Such
an operation could restore the liquidity position of net borrowers and permit them to revitalize their loan activity as now Central Bank intervention would have the same effect as the original functioning of the interbank market. What is more important is that government intervention at this point of the cycle restores trust as the basic precondition for the re-functioning of the interbank market and the proper functioning of the deposit market. On the other hand, since extreme skepticism prevails as we are at that part of the cycle that is characterized by falling profits, bankruptcies, increasing default rates and pessimism, we have a situation where there is not only unsatisfied demand for liquidity by net borrowers but also shortening of investment horizons by both borrowers and lenders. In this case the monetary authority can sell government securities to net lenders to cover their unsatisfied demand after the closure of the interbank market at the risk-free rate
. In this way it satisfies their
need to shorten the maturity of their portfolio and at the same time collects funds that can be used by the government for public spending to sustain economic activity. The government undertakes the task to implement the maturity transformation that the private sector cannot realize and thus support investment although banks‟ horizon becomes shorter and their unwillingness to lend could aggravate crisis. However note that our proposal is that the government should borrow from net lender banks at the risk-free rate but lend net borrower banks at a higher rate close to
. This has two
consequences: Firstly, the government obtains a risk premium by net borrowers which is close to the market risk premium thus lessening the burden of tax-payers from the rescue of banks. Secondly, since it pays only the risk-free rate to net lenders for government securities, this is an incentive for net lenders to enter again the interbank market and seek for higher rate of returns including a risk premium given that the
294 operation of the market has now been normalized after the rescue of net borrowers by the government. However, although it is wise to rescue a solvent but illiquid bank, it is always a dilemma to save an insolvent bank. Assume that the above operation continues and every time banks of type
find themselves in difficulty because of a rise in their
current default rates, the governmental authority supplies the appropriate amount of liquidity by discounting their securities at a price close to
. Then the question
arises. Is this operation worthwhile? Which is the limit of solvency for a bank? The problem is crucial because initial government intervention to provide liquidity changed the incentive structures not only of depositors but also of banks. The latter know that liquidity will be available whenever needed and hence, they do not need to take much care of the risk exposure of their portfolio. They can exploit new profit opportunities emerging from riskier loans without necessarily bearing the consequences. If
(
) is the rate of default on a bank‟s loans in period
then
is the proportion of healthy loans in the portfolio. Assume that the bank can securitize and sell its loans at their face value in case of a liquidation of its assets. Then, a bank is solvent if the market value of the liquidation of all its assets is just enough to cover its debt liabilities, i.e. deposits.
(40)
Relation (40) indicates that a bank is just solvent if its default ratio equals its equity/assets ratio, that is if equity capital assessed in its market value is just enough to cover the losses from bad loans. Hence, regulation in the form of capital adequacy requirements would establish such a rule in order to change the incentive structure towards more stability of the financial system. We have seen that borrowing from the interbank market entails a rise in the capital/assets ratio for net lenders this ratio for net borrowers
. This is because, by
,
and a fall of and by the
295
definition of capital/asset ratio and
for
we obtain that
. However note that by (36) borrowing from the interbank market would
not have any effect on the volume of loans extended if it had financed withdrawals of deposits. Then
in a situation where deposits decrease by the amount of
withdrawals as liquidity preference increases24. Indeed, from the expression for loans derived by the balance sheet constraint and allowing loans, deposits and liquid asset ratio to change we obtain:
(41)
Then if the total derivative
24
we have:
On the contrary, both mathematically and theoretically relationship
equal that is deposits are not affected by the increase in liquidity.
holds if other things are
296 (42)
Hence, when funds borrowed from the interbank market are used to pay out deposits withdrawals, an increase in the liquid asset ratio (liquidity preference) for bank related with falling deposits case
and constant loans
is
which also entails that in this
if the effect of the rising cost of equity capital is not taken into account.
However, since
,
still holds. Hence, one can assume that as
optimism prevails in the market the capital/assets ratio of net borrowers‟ decreases mainly because of their rising share in the loan market for low and stable cost of equity capital, while the capital/assets ratio of net lenders increases. As pessimism dominates given large default rates and deposit withdrawals, the capital/assets ratio of net borrowers still falls, but in this time mainly because of the rising cost of equity capital, while that of net lenders rather stabilizes as falling loans are accompanied by falling market value of equity. Then the problem for the regulatory authority is to set a minimum
below which the capital/assets ratio of net borrowers should not fall in
the upswing. This capital adequacy ratio could depend on average default rates for specific industries of the economy that are financed by banks so as
. An
increase in equity capital because of an increase in the riskiness of its portfolio is a disincentive for bank
if equity capital is more expensive than borrowed capital. We
have seen in (18) that the share in the credit market for a bank an increase in its equity capital
if
is inversely related to . This holds
independently of the net position of the bank in the interbank market. However, as we have seen above, net borrowers reach this minimum level much faster as we move up the cycle and default rates increase. Hence, capital adequacy ratios might function countercyclically if set at levels high enough while their effect will be felt more by those whom activity this measure is meant to confine in the first place, the net borrowers. This establishes a way by which market discipline expressed by the level of the cost of equity capital for each bank both validates regulatory requirements and ensures their implementation according to the individual risk characteristics of each bank. The first is attained through the banking industry average risk factor
while
297 the segregation is realized by the agents‟ perception for the financial condition of each bank through the ratio
assessed for each bank .
However, setting such a minimum capital adequacy requirement in the phase of “euphoria” raises a further problem. An increase in equity capital as a regulatory requirement might function as an incentive for banks to embark in risky activities in order to counterbalance the increased cost of capital. Indeed, by the first order conditions (14) we obtain the same relationship:
(43) If the cost of equity capital is higher than the cost of borrowed funds adjusted by the factor
then there will be an upward pressure in the lending rate after an
increase in the capital/assets ratio. Such a development would raise the possibility of adverse selection of projects that would afford to pay a higher interest because they run a much higher risk, thus confirming Stiglitz (2001) critique for the inadequacy of capital requirements. Again, regulation created a new set of profit opportunities for banks as they bypass regulatory requirements that were meant to restrain their risk exposure. In this case, as Stiglitz (2001) indicates, increased capital requirements along with ceilings imposed by the regulatory authority on deposit rates might prove more effective. Indeed, by the first order conditions (14) we obtain:
(44)
Hence, a policy of increased capital requirements as the risk exposure of the bank increases might be accompanied by a further regulation concerning a ceiling in deposit rates so as for loan rates to remain at roughly the previous levels.
3.4.4 Explaining Regulation in a Minsky-Kindleberger Framework
298 The previous analysis wants to establish the interaction between crises, innovation and regulation. Every new regulation emerges as an answer to a previous structure of incentives that developed new problems for financial stability, and seeks to establish a new structure of incentives. However, this new structure will create new profit opportunities and new dangers for stability that need to be met by a new regulation and so on. We have seen in the previous section how optimism in the upswing of the cycle validates financial innovation in the interbank market that makes the exchange of risk between net lenders and net borrowers possible. This innovation based on mutual trust of financial institutions renders the required reserves regulation ineffective and delays the effect of capital adequacy requirements at least for the part of the market entitled as net borrowers as it permits them to continue their loan operation at least at the same levels as before despite current defaults. If a given reserve requirement/capital adequacy requirement constitutes a certain structure of incentives imposed on each bank to maintain liquid reserves and take care of its solvency position through the magnitude and quality of its loan activity, then mutual trust of banking institutions circumvents this regulation. On the other hand, when this trust is broken at the beginning of the crisis it is too late for this regulation to play its role. The economy has benefited by the extended loan activity of banking institutions at the cost of increased fragility of the financial system. Of course, market discipline in the form of rising cost of equity capital along with minimum capital regulations might restrain the process of euphoria. Nevertheless, as we have seen, a strict capital adequacy requirement in the euphoria phase might also be ineffective or counterproductive if it leads to adverse selection effects. In short, a structure of regulations sets both the incentives to comply with these regulations and those to circumvent them. If a regulation is imposed so as to raise the cost of a certain behavior then financial innovation is nothing more than new ways to obtain the same results as those yielded by the prohibited behavior at a lower cost. For example, if the penalty for borrowing by the Central Bank to restore liquidity during the euphoria is greater than the risk premium required by net lenders in the market there would always be a way to circumvent the required reserves regulation. On the other hand, since banks know that the stability of the financial system is a public good they would always have the incentive to enter more risky activities in order to counterbalance the high cost of equity capital requirements.
299 Besides, either an accommodating function of the monetary authority in the downturn or a restraining position in the upturn will have repercussions in the real economy and hence, on the default rates and the degree of confidence of banks. Accommodation in crisis will retain default rates at low levels and stop the deterioration of confidence or even improve it after some point. Moreover, control of credit extension in the upturn may curtail over optimism and after some point may even reverse the situation. Hence, in the above model the default rates of banks at each period ,
as these are adjusted by the degree of confidence factor or the risk
premium in the interbank market are the crucial links between the level and degree of regulation and the behavior of banks and the real economy. A rising periods leads to rising
between
which if left unmet in the interbank market when the risk
premium is too high and trust breaks down, could lead to government intervention in the interbank market to re-vitalize its operation. On the other hand, a rising
also
adjusts upwards the cost of equity capital thus making capital adequacy requirements more pressing for banks with falling capital/assets ratios. As minimum regulatory level of equity/assets ratio
approaches the
, the risk of insolvency increases
and additional regulatory measures might be needed. Different degrees of regulation are needed for the different phases of the Minsky-Kindleberger cycle. From the first order conditions (14) we obtain that:
(45)
Hence, a rise in capital adequacy requirements given (43) or in reserve requirements by (45) is going to be more productive in the upswing when banks‟ overconfidence leads them to accept riskier projects and when a rise in the loan rate may act as a restraint for some borrowing firms. The effect of rising cost of capital might add to the efficiency of high capital adequacy requirements especially for net borrowers who lead the euphoria process. However, as we have seen, adverse selection might increase in this case the risk exposure of banks and hence, a ceiling on deposit rates might moderate both the rise of the loan rate and the adverse selection problem. On the other hand, in the downturn, capital adequacy requirements or reserve requirements should not act as an impediment to credit extension. At this
300 phase of the cycle regulation should be more relaxed so as for the loan rate to fall and economic activity to be revived thus contributing in lower default rates and restoring of confidence. Does this mean that the downturn should be accompanied by deregulation while the upturn by increased regulation? The model indicates different degrees and qualities of regulation in each period. The upswing should be characterized by increased capital requirements along with direct intervention in deposit rates and increased monitoring to avoid adverse selection. On the other hand, the downturn is characterized by a relaxation of the above forms of regulation accompanied by increased involvement of the government in the investment process and the revitalization of the interbank market. The model of regulatory change that we have developed in this paper rests on the assertion of Section 3 that financial instability is an inherent and periodic phenomenon of market economies and hence, regulation cannot prevent instability altogether. The historical Section also exhibited that cost for increased financial stability in the post war period was monetary instability during the 70s. This means that our paper asserts that there is no appropriate degree of regulation irrespective of the specific economic conditions or the phase of the economic and financial cycle the economy places itself. In this sense, the post-war regulatory framework might be the appropriate answer for the devastated European economies of the 40s but it seemed to lose its responsive character during the 60s when governments believed mistakenly that demand management policies could combat inherent instability of market economies. In the same context the answer of the 80s was deregulation instead of a new form of regulation appropriate for the prevailing economic conditions of that era. In terms of our model, the immediate post-war period can be identified as a crisis period that needed extended government support as it indeed happened but the period from mid-60s to early 70s should be identified as a booming period where “displacement” was also aided by inflationary government policies. As Best (2005) would assert, a false interpretation of Keynesianism in this period gave rise to a false (and rigid) interpretation of regulatory policies. The same rigidity pertains to the post 80s period although now market fundamentalism is the rule and crises came back demanding again a more responsive regulatory framework dependent on the phase of the financial cycle.
301
3.5. The 2007 – 2010 Crisis It seems that the dichotomy between government regulation and market selfregulation still persists in the explanation of the 2008 financial crisis. Indeed, Peláez & Peláez (2009:234-236) summarize the debate concerning the initiation of the credit crisis by opposing the view that blames loopholes of regulation against that which discerns excessive or imprudent government intervention as the cause. The first view called by the authors “official regulatory view”, focuses on the various complex financial products used by banks to avoid regulatory capital requirements disregarding risk considerations. The crisis was due to such off-balance sheet activity by banks to evade regulatory requirements and hence, it demands stricter regulation so as to avoid financial instability. The second view blames the ease money policy of the Fed along with the policy followed by the Government Sponsored Enterprises Fannie Mae (Federal National Mortgage Association, FNMA) and Freddie Mac (Federal Home Loan Mortgage Corporation, FHLMC) that guaranteed or acquired about one and a half trillion dollars of nonprime mortgages with the government consensus. The result was the impression that housing prices would rise indefinitely while market discipline in risk calculation was severely relaxed. The crisis burst out when the Fed raised the interest rate with cumulative effects for mortgage rates and mortgage monthly payments beyond the capacity of the debtors. The proposal of this approach is for a “balanced regulation” that would not degrade market incentives for financial innovation. Does the theme repeat itself? Beneficial versus disruptive government intervention and regulation? This might be a way to see things. In this sense, Calomiris (2009) attributes the crisis to government‟s “errors of commission” rather than regulatory “omission”. If financial managers took on excessive risk this was due to a regulatory environment that encouraged them to underestimate risk, for example in the subprime market for mortgages. Such environment consisted of: 1) accommodative interest rate policy by the Federal Reserve in the period 2002 – 2005 that resulted in low short-term interest rates along with a flat yield curve. However, according to Brunnermeier (2009), lax monetary policy was followed by the Fed in order to avoid deflation after the Internet bubble had come to an end. Furthermore, Mohan (2009) indicates that global imbalances in the form of surpluses accumulated by China and oil exporters as opposed to deficits especially for the US economy were reflected to reserves recycled
302 in US government securities and securities of the Government Sponsored Enterprises in the mortgage business, Fannie Mae and Freddie Mac. These capital inflows led to lower long term rates and the flat yield curve. 2) Furthermore, Calomiris (2009) describes a series of government policies that contributed to the crisis including political pressures to Fannie Mae and Freddie Mac to participate in subprime mortgages despite their high risk as a means to promote government‟s housing policy and a legislation in 2006 that permitted rating agencies to apply lower standards of risk assessment in securitization related to subprime mortgages. As a result, government policy gave the incentives for distorted risk assessment. 3) In addition, specific government regulation such as the one that limited the ability of pension funds, mutual funds, insurance companies and banks to hold stocks in financial institutions in proportions that would permit them to exert, as informed investors, stockholder discipline to the managers of these firms and contain excessive risktaking. 4) Prudential regulation based on credit risk assessment by credit rating agencies and banks‟ internal assessment models was also ineffective. As Crotty (2009) puts it, high ratings assigned to banks‟ assets by credit rating agencies would entail lower levels of capital adequacy requirements according to Basle Accords, higher leverage ratios, greater profits for banks and larger bonuses for managers. Furthermore, rating agencies were paid by the banks whose assets they rated. This meant that higher ratings made everyone happy (as long as “euphoria” was maintained, we should add). On the other hand, Calomiris (2009) adds that moral hazard problems emanating by the too-big-to-fail problem was an additional factor that contributed to excessive risk-taking by major institutions as long as failure would burden the tax payers‟ wallet. On the other hand, Tymoigne (2009 a,b) attributes the crisis to a more fundamental process of transformation in the financial structure of the economy from hedge to Ponzi financing sustained by all market participants: bankers, rating agencies, homebuyers, institutional investors and the government. Securitization was at the centre of this process and involved the packaging of bank loans in homogeneous categories in terms of credit risk, loan-to-value features etc. and the issuing of securities backed by them (Asset Backed Securities) through Special Purpose Entities (SPE) established exactly to implement this asset transformation. The initial motive was to remove from banks‟ balance sheets credit and liquidity risk embedded in these loans and hence, decrease required capital. As Brunnermeier
303 (2009) indicates, this should mean to shift risks “to those who wish to bear it”. Hence, security buyers, Tymoigne (2009 a) continues, were offered securities with credit ratings comparable to corporate bonds but with higher returns. Furthermore, bank borrowers as households and firms were benefited by securitization to the degree that lending volumes increased as banks were able to transfer the risks embedded on them to SPEs and ultimately to security holders. Besides, the benefit for government in promoting its homeownership policy and for the rating agencies in obtaining fees by the banks they rated were adequately analyzed above by Calomiris (2009). However, what caused an increase in systemic risk and a threat to financial stability according to Tymoigne (2009b) was securitization, as a financial innovation, in the context of a lax regulatory environment that validated it as this was reflected in the deregulation process in the 1980s and 1990s. What this policy of deregulation disregarded was that securitization encouraged limited diligence of banks for the quality of their loans to the degree that they would unload them to security holders. In this sense, it loosened the link between debtors and creditors while it misrepresented marketability of these securities in good times as liquidity. To this contributed the long period of economic stability and low default rates before the crisis that increased the levels of leverage tolerated by market participants along with acute competition and a belief to the efficiency of market mechanisms to achieve the social optimum even for regulatory purposes. However, this was exactly the fault of the system as Minsky‟s “stability is destabilizing” would put it. Although these views might emerge from opposing theoretical traditions, this paper asserts that there is a way to obtain a synthesis that would move us forward beyond the dilemma “more or less government regulation” to the question of “what kind of government regulation”. In this context we introduced in this paper a model of regulatory change dependent on two major factors: a) the phase of the financial cycle that the economy places itself and b) the interaction of government with market participants in the form of incentive structures as the principle that should lead the formation of regulation. These same points seem to emerge also from the literature spurred by the current crisis. Crotty (2009) blames the perverse incentives inherent in the New Financial Architecture characterized by increased financial innovation and deregulation as major causes of the crisis while Demirgüç-Kunt & Servén (2010) insist that the current crisis does not represent simply a failure of free markets but rather “the reaction of market participants to distorted incentives”. In the same sense,
304 Carvajal et al. (2009) in a IMF Staff Position Note indicate that prudential regulatory requirements “should use incentives for behavior to be consistent with systemic stability”. Hence, the point of the literature and of this paper is to design the appropriate mix of incentives that would ensure that market participants would act in accordance with financial stability rather than against it. This should be the guide for the formulation of new regulatory policies. On the other hand, even if such incentive structures were designed they could not have been permanent policy frameworks but they should have depended on the financial cycle. This is a major step forward taken by the literature and market practitioners. Indeed, the new form of regulation is called “macroprudential regulation” which, according to the Chairman of the Board of Governors of the Federal Reserve, Ben Bernankee (2009) should focus on systemic risks, that is risks related to the financial system itself. Another bank official, the Deputy Governor of the Reserve Bank of India, R. Mohan (2009) indicates that macroprudential regulatory measures such as banking capital requirements should increase in booms when increasing leverage and maturity mismatch increase systemic risks and it should decrease in the downturn. Another proposal by Rajan (2009) is for “contingent capital” arrangements contracted by banks in the upswing when capital is cheap to be infused in the system in the downturn. For example, banks could be obliged to issue debt that would convert to equity in case of crisis in the financial system or if the banks‟ capital ratio fall below a threshold. Of course, macroprudential regulation has its shortcomings as indicated by Demirgüç-Kunt & Servén (2010) as the encouragement of disintermediation in favour of less regulated entities and countries and the possible costs for financial innovation along with the political costs entailed when the authorities try to strengthen regulation in the upturn. Carvajal et al. (2009) also indicate the need for a more comprehensive regulation that would encompass all entities deemed important from a systemic point of view while also point out the inevitable trade-off between the gains and costs of extending the perimeter of financial regulation. However, as Thomadakis (2010) puts it, regulation is necessary for the efficiency of financial markets if it is to be comprehensive, countercyclical and based on international coordination. The point made in this paper is that regulation is a contract written among the parties participating in the financial market and the government, but this is an incomplete contract vulnerable to future innovations that would evade current
305 regulatory provisions. It is for this reason that such a structure of incentives should reflect the financial cycle in the macroprudential sense of the literature and it is at this point that the government should prove its commitment to long-term financial stability and its resilience to political cycle temptations.
3.6. Conclusion Regulation in general and especially financial regulation has been the object of contestation and dispute in the literature from the 1970s onwards. The chronological landmark is not accidental since it relates to the major shift in theoretical perceptions and policy prescriptions away from government management and intervention policies towards more open, free and self-regulated markets. This paper puts itself in this discussion on both theoretical and historical grounds. The basic problem with the literature on financial regulation is that it is divided between proponents of market self-regulation on the one hand and defenders of government intervention and regulation on the other without addressing these differing policy proposals in a unified framework. In this sense, the trade-off between the advantages and disadvantages of different degrees of government regulation are vanished under an absolute claim in favour of or against government intervention in general. On the contrary, this paper seeks for a unified framework in order to encompass different regulatory policies and assess the optimum degree of financial regulation. In this context, Section 2 reviewed the debate on how financial regulation emerged in history. The motive that repeats itself is proved to be the following: free market financial innovations that are both the cause and effect of euphoric expectations and the attempt to exploit profit opportunities, lead to financial crises. Regulation is then the answer to previous crises. Federal Deposit Insurance and the investment/commercial banking separation initiated by the Banking Act of 1933 emerged after the Crash of 1929. Some researchers characterize these regulations as harmful because they inhibited diversification and degraded incentives of selfregulation. It seems that the politics of regulation become an integrated part of explanation for many economic historians. What is at stake is rent seeking or government debts financing through selective intervention in markets and political
306 balance among different interest groups. The dilemma between market self-regulation along with a lender of last resort function of the central bank and a more extended government regulation is set again. However, the post-war financial history cannot assume conflicting interpretations as far as the disappearance of banking crises during the period of high regulation 1945 – 1973 is concerned. This was an asset of this system along with its shortcomings revealed after the collapse of the Bretton Woods system as world stagflation crisis. Politics are important especially when regulation is considered as a contract between parties which in this case are social interest groups to the domestic level or countries and international financial organizations at the world level. However, the specifics of such contracts in different historical periods cannot change the common underlying structure described in theory: regulation is an answer to crises and crises is the outcome of market activity and innovation in the context of a fundamentally uncertain environment. Seeing things this way overcomes the view of regulation as an expression of governmental voluntarism and relates the former to successful or unsuccessful reactions of domestic or international financial structures to challenges emerged by the nature of the operation of market economies. If economic reality is ambiguous and uncertain then regulation must also be ambiguous in order to be flexible. Furthermore, this view justifies different degrees of regulation for different historical periods and the need for a system of regulation that is more responsive to changes in economic conditions. Based on these observations, in Section 3 we sought for a model that would encompass the process of innovation, crises and regulation in the characterization of the workings of the financial system. We asserted that “Minsky-Kindleberger” theory of financial cycles is an adequate construct to build upon. Although “MinskyKindleberger” theory is concerned more with financial crises rather than with regulation, it has the advantage of relating developments in the financial sector with real economic conditions in an interactive way that might give an explanation both for the emergence and the need for regulation and for regulatory change. What makes this model unique is the co-existence of real economic conditions that determine firms‟ performance and profit opportunities with the psychological factors that enter and condition the related probabilistic assessments and ultimately yield the succession of phases of “displacement”, “euphoria”, “mania”, “distress” and “panic”. Another asset of this approach is the provision for government intervention to prevent financial crises although bad timing of intervention or excessive reliance on demand policies
307 might have its costs on the efficiency of intervention. In this sense, financial regulation as a policy aiming at influencing the financial structure of a capitalist economy emerges as a necessary complement of “Big Bank-Big Government” policies. However, the question is: how much regulation is needed and when? The model described in Section 4 of this paper attempts to give an answer to this question based on a mathematical modeling of the interbank market. In this sense, it indicates a pattern of regulatory change depending on the “Minsky-Kindleberger cycles” of the economy as these are reflected in the financial conditions of firms and are expressed in bank‟s expectations in the form of degree of confidence. Banks rest at the centre of this model as the major vehicles of credit extension in a market economy. Since credit builds up in the upswing of the financial cycle and dries out in the downturn and since credit is the link between the financial sector and the real economy then banking behavior should be at the centre of the analysis. Banks finance firms and hold expectations about their projects. These two agents are enough to describe the emergence of crises. Euphoria is reflected in banks expectations for firms‟ prospects and innovation in the interbank market accommodates it. Then, a real event such as a major failure expressed as piling up of firms‟ defaults on bank loans turns overconfidence into pessimism and the boom into a crisis. A third agent should then be introduced in the model if we are to explain regulation as an intervention that changes the structure of incentives for economic agents. The government or a monetary authority can intervene either in the boom to curtail euphoria before it is developed into a crisis or during the slump to prevent financial collapse. Different phases of the cycle demand different forms of regulation and intervention. Capital adequacy requirements along with other regulations to prevent adverse selection and excessive risk taking are more useful during a boom rather than in the downturn. Successful responses to a crisis should include liquidity supply at a rate close but below the prevailing market rate and government public expenditure to support real assets investment. If the latter entails directed lending then so be it. The optimum degree and form of regulation has to do with the specific answer that each phase of the cycle, with its particular characteristics, demands. The purpose of this paper was to seek for a way to assess the degree of financial regulation in different economic conditions. For this reason it focused only on two regulatory instruments, the reserve requirement ratio and the capital adequacy ratio. Other means such as portfolio restrictions or institutional interventions in the
308 form of transparency requirements were not considered. Inclusion of such issues might add to model‟s realism but at the expense of clarity of exposition and delivering of the main message of the paper: the intimate relationship between the degree of financial regulation (whichever its means) and the phase of the financial cycle. Besides, the chosen regulatory instruments for our analysis aim at the heart of the causes of banking crises, namely the liquidity and solvency condition of banks. Another point is that our model does not consider non-bank financial institutions. This might seem a significant fault since these institutions such as various funds or insurance companies have had their own contribution in the current financial crisis and their role in the financial system was continuously augmenting during the decades of deregulation. However, our focus on banks could be justified by the fact that banking crises are the most dangerous in terms of systemic risk and financial fragility because banks are ultimately related to the payments system in an economy. Liquidity and solvency become problems to the degree that financial claims cannot transform orderly and readily to money when this is demanded by their holders and banks are the institutions that cater liquidity to agents. Even in the current crisis the financial system was brought on the brink when banks were obliged to re-assume the risks that were supposed to have been taken out of their balance sheets thus resulting in both liquidity and solvency problems for them. Nevertheless, current demands for comprehensive regulation that would encompass all systemically important institutions indicate the need for the enhancement of the above model to include such entities as separate agents in the financial system that condition the level of regulation and its instruments. A more serious objection is that the model implicitly refers to a closed economy, at least as capital flows are concerned, so as for the monetary/regulatory authority to be able to set its own standards and rules independently on what happens to the rest of the world. However, this is certainly not the case in the real world. Capital is free to flow out of the country if regulatory standards differ among nations. Furthermore, financial cycles are not the same among countries but they are interconnected as far as financial integration deepens. Hence, a model that would encompass external constraints in the optimum path of financial regulation would be a fruitful extension of the one presented here. In this context, complex issues such as regulation coordination among nations given convergent but not identical financial cycles could be considered.
309 Nevertheless, the most important fault of the described model is that it gives snapshots of the true dynamics of the process of financial innovation, crises and regulation rather than the whole picture in motion. Since both the historical process described in Section 2 and the Minsky-Kindleberger theoretical model of Section 3 are both dynamic in nature we consider the model of this paper as a first approach to the problem. A dynamic optimization model where the government solves its cost of intervention minimization problem would build on the above results and give answers concerning government intervention and regulation that the above model cannot grasp such as policy time inconsistency problems or smoothing effects of government intervention through the cycle.
310
Concluding Remarks
The present study aimed at addressing three issues concerning the relationship between financial regulation and financial development that could clarify the nature and significance of their interconnection. The first paper developed a mathematical model in order to show that financial regulation might be beneficial rather than detrimental to financial development. The crucial point here is the connection of the administratively set interest rates with safeguard provisions. The latter should both alleviate the negative effect of rates set by fiat on savings and contribute to the institutional transformation of the economy. This could be achieved by setting forth mechanisms that introduce a more transactions-costs economizing contracting scheme between firms and lenders. The substitution of free market mechanisms by government sponsored hierarchical modes depends on asset specificity, which in finance takes the form of increased verification costs of asset returns and depends on the real and institutional domestic economic conditions. Hence, the paper argues that financial repression/regulation is in fact a policy of adjustment of the economy to adverse economic situations, such as but not confined to, the magnitude of the Great Depression in the 30s‟ or alternatively, a policy of economic and institutional development for both LDCs and developed economies. On the other hand, financial regulation cannot be confined only to emergency cases, as far as a continuous presence of the regulatory authority both as signal of future drastic intervention and as monitor of the system is needed. This version of regulation just confirms the fragility of even developed financial markets and the need for regulation and development to go hand in hand and reinforce each other. The common factor of both is the demands of the real economy and their reflection to the adequate institutional infrastructure of the economy. The second paper tried to alleviate “the veil ignorance” that surrounds the change from a regulated to a deregulated financial regime in 1980s under the rubric of
311 financial liberalization. The focus is on the Greek case and the paper establishes that institutional development did not come as “a manna from heaven” by unilateral decisions of the state during the 1980s and 1990s. On the contrary, Development Banks acted in a persistent manner in favour of financial development as early as in the 1960s. Their role as capital market substitutes contributed to the training of the enterprises and the investment public to practices and techniques of modern capital markets. On the other hand, they prepared and proposed to the government measures that should be taken and new financial instruments that should be used in order to promote financial development in accordance with the pursued goal of economic development of the country. Hence, financial liberalization during the 1980s was not a surprise to them at least at the level of the institutional goals they posed. Another point that emerged from our analysis is that development banks cannot be assessed as traditional banking institutions. Their double role made them crucially dependent on government policy. To the degree that the state was supportive, development banks took bold initiatives – with more or less success depending on the competence of their management – towards financing industry and promoting new financial techniques. Their ultimate constraint was the existing financial environment and their interaction with it that lead to their gradual transformation during the 1990s. These observations lead to us to the result that Development Banks in Greece were in fact, both subjects – promoters and initiators – and objects of financial development as far as their transformation was a reflection of the transformation of the financial structure of the country. They were so interrelated with the existing financial environment that its liberalization meant their complete transformation and not just a change of levels from less to more competitive operation as it happened to the other commercial banks. This “privileged” connection between development banks and the financial structure made up their uniqueness as institutions and the inability to assess them and model them as any other banking firm. The same particularity of these Banks rendered government policy – mainly in the form of Monetary Committee directives – the ultimate risk factor of their operation and the main constraint that they faced during their forty-years functioning in the Greek Economy. Our final paper used both historical paradigms and mathematical techniques to build a model of regulatory change in search of an optimum degree of regulation given differing economic conditions. The model was based on “MinskyKindleberger” theory of financial cycles as encompassing the process of innovation,
312 crises and regulation in the characterization of the workings of the financial system. Its advantage rests on relating developments in the financial sector with real economic conditions in an interactive way that might give an explanation both for the emergence and the need for regulation and for regulatory change. Another asset of this approach is the provision for government intervention to prevent financial crises although bad timing of intervention or excessive reliance on demand policies might have its costs on the efficiency of intervention. The model described on these grounds is based on a mathematical modeling of the interbank market. In this sense, it indicates a pattern of regulatory change depending on the “Minsky-Kindleberger cycles” of the economy as these are reflected in the financial conditions of firms and are expressed in bank‟s expectations in the form of degree of confidence. Banks rest at the centre of this model as the major vehicles of credit extension in a market economy. Banks finance firms and hold expectations about their projects. Euphoria is reflected in banks expectations for firms‟ prospects and innovation in the interbank market accommodates it. Then, a real event such as a major failure expressed as piling up of firms‟ defaults on bank loans turns overconfidence into pessimism and the boom into a crisis. A third agent should then be introduced in the model if we are to explain regulation as an intervention that changes the structure of incentives for economic agents. The government or a monetary authority can intervene either in the boom to curtail euphoria before it is developed into a crisis or during the slump to prevent financial collapse. The optimum degree and form of regulation has to do with the specific answer that each phase of the cycle, with its particular characteristics, demands. The three papers whose results are described above were written just before and in the midst of one of the most worrisome financial and economic crises the World has passed through since the Great Depression of the 1930s. One of the most pressing issues that this turmoil has posed is the re-examination of the relationship between financial regulation and innovation and development in the financial sector especially during the deregulation era. We hope that the papers presented here have contributed to the pluralism that the relevant debate demands for the sake of financial stability and economic development.
313
APPENDIX Financial Data and Indices
314
Description of the Data
In this Appendix we present the data obtained by the financial statements of the three Development Banks. This data is presented in two sets of Tables. Tables iA (i = 1, …, 9) present the figures at current prices as depicted in the Balance Sheets and Income Statements of the Banks. Tables iB present the same data at constant 1982 prices so as to obtain a picture of the real magnitudes of these figures by excluding the distorting effect of inflation which reached extremely high levels from 1973 onwards. Unfortunately, the data obtained by the Balance Sheets of the three Banks had several flaws. 1) It was not complete. Especially, for Investment Bank, we lack any data for the year 1975 and the period 1993 – 1995 as the related Annual Reports were not available. The same holds for ETBA for the period 1964 – 1966 and the year 1969. Whenever this was possible we complemented these gaps with data obtained by other Reports. 2) It was not compatible among banks at least until 1993 when all banks introduced a unified accounting framework. However, till then the same items might be presented in the Banks‟ balance sheets and income statements under different headings. It was our task to collect them in categories that would make them as much comparable as possible among banks. 3) Even after 1993, there were problems in identifying items and categories between accounting systems so as to obtain a comprehensible picture of the evolution of banks‟ financial data. This is the reason why some data do not appear in our data set after a certain year. Hence, long and medium term loans are not reported separately in the financial statements after 1992 because of the change in the Accounting System. The same holds for domestic and foreign borrowed funds after 1994. Nevertheless, we think that the data as presented here has succeeded in giving a clear outline of the salient financial characteristics of the three banks. Below we give a detailed description of the data as found in the Banks‟ statements in two tables.
315 Table A covers the period until 1993 in which accounting systems were not standardized. Table B gives the data from 1994 onwards under the common accounting system adopted by the Banks. However, a few points need to be metioned. 1) We haven‟t reported extraordinary revenues or expenses so as to keep in track with the normal operation of the banks. 2) Gross Income is just the sum of the categories “Interest, Dividends and Other Banking Revenue” and “Capital Gains & Other Income” and hence, extraordinary revenues are not included. 3) Borrowed funds include both long term funds and funds pertaining to Banks‟ bond issues. 4) In the case of ETBA, “Capital gains and other income” category also includes income from the exploitation of Industrial Areas (ΒΙ.ΠΔ). In addition, note that in the ensuing tables we have included in some cases the description of the data in the Banks‟ statements in Greek for the interested reader to locate them quickly in the related Balance Sheets. Some final remarks concerning the transformation of data whenever needed: Data in years 2001 and 2002 was reported at Euros and was converted into Drachmas using the parity
Also, data for ETBA until the early 1971 was
reported in US dollars and converted for the purpose of this study under the parity Finally, GDP growth rates have been calculated by us using data on GDP as this is given by the Ministry of National Economy (2001, 2002).
316
Data Heading Interest, Dividends & other Banking Revenue
Capital Gains and Other Income
Financial Charges
Personnel Payroll and Social Security Charges
Net Profits Dividends
Table A: Financial Data until 1993 Description in the Financial Statements of the Banks ETEBA Investment Bank ETBA Interest, dividends, Interest, dividends, Revenues from commissions, commissions, other interest on loans, income from banking income, participation in investments, fees, revenues from enterprises, other income from exchange rate revenues from banking activity differences exchange rate (ζπλαιιαγκαηηθέο differences δηαθνξέο (ζπλαιιαγκαηηθέο πηζησηηθέο), δηαθνξέο revenues from πηζησηηθέο) financial securities (έζνδα από ηίηινπο) Capital gains from Miscellaneous N.A. portfolio securities income (ινηπά sales, έζνδα) miscellaneous income Financial charges, Interest and Interest paid and expenses from commissions paid, other financial exchange rate contributions for expenses, differences the subsidization of commissions paid, (ζπλαιιαγκαηηθέο loan rate charged to contributions for δηαθνξέο exporters (εηζθνξέο the subsidization of ρξεσζηηθέο) γηα επηδόηεζε loan rate charged to εμαγσγηθνύ exporters (εηζθνξέο επηηνθίνπ), γηα επηδόηεζε expenses from εμαγσγηθνύ exchange rate επηηνθίνπ), differences premiums paid for (ζπλαιιαγκαηηθέο insuring against δηαθνξέο exchange rate risk ρξεσζηηθέο) (αζθάιηζηξν ζπλαιιαγκαηηθνύ θηλδύλνπ) Salaries, Salaries, Salaries, contributions to contributions to contributions to Social Security Social Security Social Security Funds and other Funds, retirement Funds, retirement personnel expenses compensations compensations (απνδεκηώζεηο (απνδεκηώζεηο απνρώξεζεο) and απνρώξεζεο) and other personnel other personnel expenses expenses Net Profits before Net Profits before Net Surplus before taxes taxes taxes Dividend N.A. N.A.
317
Directors‟ Fees Long and Medium Term Loans Investment in Shares
Investment in Bonds
Capital and Reserves
distributed Directors‟ Fees Long and Medium Term Loans Investment in Shares (minus installments due) Greek Government Bonds, bonds in foreign exchange, private firms‟ bonds, mutual funds‟ shares Share capital, reserves and retained earnings (ππόινηπν θεξδώλ εηο λέν)
Provisions Local Borrowed Funds
Provisions Time deposits, bank loans, domestic borrowed funds
Foreign Borrowed Funds
Foreign borrowed funds
N.A. Long and Medium Term Loans Participation in enterprises
Investments in Government bonds, bonds of PPC, fixed income securities Share capital, share capital increases, reserves and retained earnings (ππόινηπν θεξδώλ εηο λέν) Provisions Time deposits, Bank of Greece funds, bank deposits, long term loans, bonded loans (long term), short term bonds Credits opened abroad, deposits in foreign currency
N.A. Long and Medium Term Loans Participation in enterprises (shares held minus installments due) Government and firms‟ bonds
Own funds, reserves, increases of share capital
Provisions Long term liabilities to Bank of Greece, Short term bonds
Long term liabilities to foreign banks
318 Table B: Financial Data as of 1994 Data Heading Description in the Financial Statements of the Banks (common accounting system) Interest, Dividends & other Banking Interest and comparable revenues (ηόθνη Revenue θαη εμνκνηνύκελα έζνδα), income from securities (έζνδα από ηίηινπο), commissions‟ income (έζνδα πξνκεζεηώλ) Capital Gains and Other Income Results from financial activities (απνηειέζκαηα ρξεκαηννηθνλνκηθώλ πξάμεσλ), other income (ινηπά έζνδα) Financial Charges Interest and comparable expenses (ηόθνη θαη εμνκνηνύκελα έμνδα), commissions‟ charges (έμνδα πξνκεζεηώλ) Personnel Payroll and Social Security Personnel expenses (Γαπάλεο Charges Πξνζσπηθνύ) Net Profits Net Income before taxes (απνηειέζκαηα ρξήζεσο πξν θόξσλ) Dividends Dividend distributed Directors‟ Fees N.A. Long and Short Term Loans Claims against clients (απαηηήζεηο θαηά πειαηώλ) (provisions excluded) Investment in Shares Shares and other variable income securities, participation in affiliated enterprises, participation in non-affiliated enterprises Investment in Bonds Bonds and other fixed income securities Capital and Reserves Share capital, difference from share issuing at a premium (δηαθνξά από ηελ έθδνζε κεηνρώλ ππέξ ην άξηην), reserves, difference from asset revaluation, retained earnings (ππόινηπν θεξδώλ εηο λέν) Provisions Provisions against risks (Πξνβιέςεηο γηα θηλδύλνπο θαη βάξε) Local Borrowed Funds N.A. Foreign Borrowed Funds N.A.
319 Table 1A:ETEBA: Revenues, Expenses and Net Profits (in Million Drs.) Current Prices
YEAR 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Interest, Dividends & other Banking Revenue 7.76 7.53 24.54 46.55 57.89 86.44 134.52 212.38 285.09 377.43 537.21 722.86 861.20 1031.45 1285.80 1700.16 2514.63 3401.72 4166.02 5880.04 6930.61 7827.68 9081.49 10439.18 11146.10 11208.10 15727.13 21001.86 23280.29 23044.70 21801.26 15890.43 11961.51 16140.66 31601.02 36768.12 51462.31 24422.20
Capital Gains from Sold Securitie s & Other Income 0.01 0.02 0.18 0.57 5.08 7.46 33.32 48.86 30.88 36.77 86.34 88.13 80.00 77.73 71.71 192.63 52.45 2.31 27.27 305.71 841.50 941.26 1378.56 4100.46 1962.95 806.66 4175.10 3443.33 3056.07 3913.06 2896.78 10386.14 25582.19 15753.18 8689.73
Gross Income 7.76 7.54 24.56 46.73 57.89 87.01 139.60 219.84 318.41 426.29 568.09 759.63 947.54 1119.58 1365.80 1777.89 2586.34 3594.35 4218.47 5880.04 6932.92 7854.95 9387.20 11280.68 12087.36 12586.66 19827.59 22964.81 24086.95 27219.80 25244.59 18946.50 15874.57 19037.44 41987.16 62350.31 67215.49 33111.93
Financial Charges 0.10 6.02 17.86 25.18 45.35 78.86 131.29 187.94 255.91 374.77 493.45 643.89 788.91 898.80 1101.56 1630.44 2212.83 2816.06 3782.61 4777.16 5823.39 7396.21 9010.15 9512.51 9620.72 10984.08 15489.34 18570.78 17669.17 16355.11 10475.32 5695.98 9280.04 23152.66 32940.81 44043.05 15612.65
Personne l Payroll & Soc. Charges 1.80 3.01 3.64 4.02 5.39 7.65 8.73 12.13 15.61 20.05 27.06 33.78 50.59 59.98 78.61 95.62 111.31 227.06 205.86 309.89 323.84 365.95 403.27 452.57 522.58 619.16 834.21 1106.95 1201.84 1232.11 1680.39 1922.14 2323.96 2822.19 3151.35 3707.30 3468.20 3476.13
Net Directors' Profits Dividend Fees 3.92 2.57 8.00 12.77 6.00 0.37 12.21 9.00 0.44 15.29 12.00 0.41 24.06 15.00 0.47 26.71 18.00 0.48 64.49 27.00 1.28 84.17 29.70 1.38 70.25 34.50 1.36 90.04 45.00 1.40 162.70 60.00 1.49 201.60 98.33 1.49 207.34 108.17 1.31 238.37 137.67 1.75 439.91 283.20 1.78 571.25 327.25 1.79 563.86 354.94 1.79 1050.98 400.26 1.79 930.62 309.63 1.79 677.18 226.56 1.66 526.50 226.56 1.64 656.91 302.08 1.50 667.83 362.50 1.84 821.04 385.15 2.29 2354.65 783.90 2.26 4232.79 1409.20 2.26 2491.28 829.21 2.26 4401.58 1472.64 2.26 5394.24 1699.20 5993.86 2039.04 6864.78 2492.16 4980.37 2741.37 12105.80 3239.80 22823.28 5981.18 16890.87 7487.85 16381.47 7484.36
320 Table 1B:ETEBA: Revenues, Expenses and Net Profits (in Million Drs.) Constant 1982 Prices
CPI (1982 = 100) 15.0 15.5 16.2 16.5 16.6 17.0 17.5 18.0 18.8 21.7 27.6 31.2 35.4 39.7 44.7 53.2 66.4 82.7 100.0 120.2 142.4 169.9 209.9 243.3 276.2 314.1 378.3 452.1 524.0 599.4 664.7 723.8 783.1 826.2 865.9 888.4 916.8 948.0
Deflat ion Coeffi cient 0.15 0.155 0.162 0.165 0.166 0.17 0.175 0.18 0.188 0.217 0.276 0.312 0.354 0.397 0.447 0.532 0.664 0.827 1 1.202 1.424 1.699 2.099 2.433 2.762 3.141 3.783 4.521 5.24 5.994 6.647 7.238 7.831 8.262 8.659 8.884 9.168 9.48
Interest, Dividend s & other Banking Revenue 51.73 48.58 151.48 282.12 348.73 508.47 768.69 1179.89 1516.44 1739.31 1946.41 2316.86 2432.77 2598.11 2876.51 3195.79 3787.09 4113.33 4166.02 4891.88 4867.00 4607.23 4326.58 4290.66 4035.52 3568.32 4157.32 4645.40 4442.80 3844.63 3279.86 2195.42 1527.46 1953.60 3649.50 4138.69 5613.25 2576.18
Capital Gains from Sold Securiti Personne es & l Payroll Other Gross Financial & Soc. Income Income Charges Charges 0.00 51.73 0.00 12.00 0.06 48.65 0.65 19.42 0.12 151.60 37.16 22.47 1.09 283.21 108.24 24.36 0.00 348.73 151.69 32.47 3.35 511.82 266.76 45.00 29.03 797.71 450.63 49.89 41.44 1221.33 729.39 67.39 177.23 1693.67 999.68 83.03 225.16 1964.47 1179.31 92.40 111.88 2058.30 1357.86 98.04 117.85 2434.71 1581.57 108.27 243.90 2676.67 1818.90 142.91 221.99 2820.10 1987.18 151.08 178.97 3055.48 2010.74 175.86 146.11 3341.90 2070.60 179.74 108.00 3895.09 2455.48 167.64 232.93 4346.25 2675.73 274.56 52.45 4218.47 2816.06 205.86 0.00 4891.88 3146.93 257.81 1.62 4868.62 3354.75 227.42 16.05 4623.28 3427.54 215.39 145.65 4472.22 3523.68 192.12 345.87 4636.53 3703.31 186.01 340.79 4376.31 3444.07 189.20 438.89 4007.21 3062.95 197.12 1083.92 5241.23 2903.54 220.52 434.18 5079.59 3426.09 244.85 153.94 4596.75 3544.04 229.36 696.55 4541.17 2947.81 205.56 518.03 3797.89 2460.53 252.80 422.23 2617.64 1447.27 265.56 499.69 2027.14 727.36 296.76 350.61 2304.22 1123.22 341.59 1199.46 4848.96 2673.83 363.94 2879.58 7018.27 3707.88 417.30 1718.28 7331.53 4804.00 378.29 916.64 3492.82 1646.90 366.68
Net Profits 26.13 16.58 49.38 77.39 73.55 89.94 137.49 148.39 343.03 387.88 254.53 288.59 459.60 507.81 463.85 448.06 662.52 690.75 563.86 874.36 653.53 398.58 250.83 270.00 241.79 261.39 622.43 936.25 475.44 734.33 811.53 828.11 876.62 602.80 1398.06 2569.03 1842.37 1728.00
Direct ors'F Dividend ees YEAR 0.00 1964 0.00 1965 0.00 1966 36.36 2.24 1967 54.22 2.65 1968 70.59 2.41 1969 85.71 2.69 1970 100.00 2.67 1971 143.62 6.81 1972 136.87 6.36 1973 125.00 4.93 1974 144.23 4.49 1975 169.49 4.21 1976 247.68 3.75 1977 241.99 2.93 1978 258.78 3.29 1979 426.51 2.68 1980 395.71 2.16 1981 354.94 1.79 1982 333.00 1.49 1983 217.44 1.26 1984 133.35 0.98 1985 107.94 0.78 1986 124.16 0.62 1987 131.25 0.67 1988 122.62 0.73 1989 207.22 0.60 1990 311.70 0.50 1991 158.25 0.43 1992 245.69 0.38 1993 255.63 1994 281.71 1995 318.24 1996 331.80 1997 374.15 1998 673.25 1999 816.74 2000 789.49 2001
321
Table 2A: ETEBA: Loans and Investments (in Million Drs.) Current Prices
YEAR 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Long and Medium Term Investment Loans s in Shares 8.00 15.76 22.10 29.38 137.37 31.10 339.96 40.30 488.56 42.84 900.49 64.68 1643.06 147.90 2428.19 211.79 3364.21 298.38 4274.98 576.54 5469.55 829.30 6095.11 1250.73 7812.44 1469.65 9181.46 1675.56 10297.88 1951.88 12403.10 2304.84 15344.86 2770.62 18395.04 3650.64 21888.51 4276.10 25440.51 4683.34 27707.41 5068.77 29122.70 5774.04 31304.86 6996.41 33432.11 9931.93 40033.50 9935.35 45322.06 9643.74 46746.52 17689.95 48064.14 18000.48 19579.38 22663.20 25105.00 25341.75 21470.33 23415.34 31021.77 53744.17 75968.62 65834.84
Investments Long & in Bonds, Short Treasury Total Term Bonds & Investment Loans Mutual s in (after Funds Securities 1992) 21.00 36.76 21.00 50.38 164.49 195.59 157.75 198.05 144.03 186.87 139.62 204.30 125.69 273.59 107.92 319.71 275.90 574.28 319.00 895.54 293.86 1123.16 256.57 1507.30 221.10 1690.75 193.76 1869.32 177.93 2129.81 150.58 2455.42 96.94 2867.56 172.48 3823.12 165.63 4441.73 171.49 4854.83 177.73 5246.50 185.87 5959.91 367.02 7363.43 5388.71 15320.64 5695.97 15631.32 5037.27 14681.01 5515.11 23205.06 23637.64 41638.12 14282.19 33861.57 49205.70 12448.49 35111.69 47999.35 7116.87 32221.87 32820.81 14219.44 39561.19 35526.90 29048.96 50519.29 41057.22 44480.68 67896.02 66778.76 75639.89 106661.66 134095.3 168165.55 221909.72 177030.8 105062.89 181031.51 173397.1 131632.22 197467.06 151465.7
322
CPI (1982 = 100) 15.0 15.5 16.2 16.5 16.6 17.0 17.5 18.0 18.8 21.7 27.6 31.2 35.4 39.7 44.7 53.2 66.4 82.7 100.0 120.2 142.4 169.9 209.9 243.3 276.2 314.1 378.3 452.1 524.0 599.4 664.7 723.8 783.1 826.2 865.9 888.4 916.8 948.0
Table 2B:ETEBA: Loans and Investments (in Million Drs.) Constant 1982 Prices Investme nts in Long & Bonds, Total Short Long and Treasury Investme Term Deflation Medium Investme Bonds & nts in Loans Coefficie Term nts in Mutual Securitie (after nt Loans Shares Funds s 1992) 0.15 53.33 105.07 140.00 245.07 0.155 142.58 189.55 135.48 325.03 0.162 847.96 191.98 1015.37 1207.35 0.165 2060.36 244.24 956.06 1200.30 0.166 2943.13 258.07 867.65 1125.72 0.17 5297.00 380.47 821.29 1201.76 0.175 9388.91 845.14 718.23 1563.37 0.18 13489.94 1176.61 599.56 1776.17 0.188 17894.73 1587.13 1467.55 3054.68 0.217 19700.37 2656.87 1470.05 4126.91 0.276 19817.21 3004.71 1064.71 4069.42 0.312 19535.61 4008.75 822.34 4831.09 0.354 22069.04 4151.55 624.58 4776.13 0.397 23127.10 4220.55 488.06 4708.61 0.447 23037.76 4366.62 398.05 4764.68 0.532 23314.10 4332.41 283.05 4615.45 0.664 23109.73 4172.62 145.99 4318.61 0.827 22243.10 4414.32 208.56 4622.88 1 21888.51 4276.10 165.63 4441.73 1.202 21165.15 3896.29 142.67 4038.96 1.424 19457.45 3559.53 124.81 3684.34 1.699 17141.08 3398.49 109.40 3507.89 2.099 14914.18 3333.21 174.85 3508.07 2.433 13741.11 4082.17 2214.84 6297.02 2.762 14494.39 3597.16 2062.26 5659.42 3.141 14429.18 3070.28 1603.72 4673.99 3.783 12357.00 4676.17 1457.87 6134.04 4.521 10631.31 3981.53 5228.41 9209.94 5.24 3736.52 2725.61 6462.13 9390.40 5.994 3780.98 2076.83 5857.81 8007.90 6.647 3776.89 1070.69 4847.58 4937.69 7.238 3501.21 1964.55 5465.76 4908.39 7.831 2741.71 3709.48 6451.19 5242.91 8.262 2834.10 5383.77 8217.87 8082.64 8.659 3582.60 8735.41 12318.01 15486.23 8.884 6049.55 18929.04 24978.58 19926.93 9.168 8286.28 11459.74 19746.02 18913.29 9.48 6944.60 13885.26 20829.86 15977.40
YEAR 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
323
Table 3A: ETEBA: Capital and Borrowed Funds (in Million Drs.) Current Prices Capital Local Foreign Total and Provision Borrowed Borrowed Borrowed Reserves s Funds Funds Funds YEAR 1964 183.91 0.03 0.00 1965 219.86 0.36 2.80 2.80 1966 314.88 6.13 172.52 172.52 1967 317.44 14.30 372.28 372.28 1968 320.22 30.89 496.25 496.25 1969 323.77 46.04 756.13 159.87 916.00 1970 334.00 69.09 1286.59 357.84 1644.43 1971 355.91 112.25 1815.94 765.36 2581.30 1972 556.84 153.61 2383.56 1004.09 3387.65 1973 634.25 205.12 3234.26 1297.32 4531.58 1974 684.89 286.42 4425.60 1556.65 5982.25 1975 839.30 393.28 4889.42 1876.85 6766.27 1976 1031.93 451.68 6188.95 2522.68 8711.63 1977 1488.40 488.53 7006.68 3296.80 10303.48 1978 1678.01 630.00 7322.51 3604.58 10927.09 1979 1769.46 901.89 7776.67 5526.95 13303.62 1980 3098.05 1221.65 8542.44 8195.72 16738.16 1981 3337.37 1600.79 9993.28 10052.08 20045.36 1982 4414.76 2066.43 13143.86 12515.50 25659.36 1983 5242.09 2633.64 18048.22 14280.84 32329.06 1984 5832.59 3267.66 22742.48 14608.70 37351.18 1985 6266.77 3968.42 30469.62 13779.39 44249.01 1986 6543.40 4749.24 44119.32 11757.77 55877.09 1987 6892.95 5620.53 48415.46 9129.67 57545.13 1988 8755.10 6390.56 51927.72 7278.31 59206.03 1989 10474.14 6962.39 55086.08 5465.08 60551.16 1990 18714.24 11872.38 57224.07 4019.80 61243.87 1991 21565.64 13182.88 62912.57 7342.57 70255.14 1992 23787.20 14214.36 68382.55 10511.65 78894.20 1993 26492.92 11929.04 59281.27 12480.96 71762.23 1994 29803.73 1207.73 1995 33404.76 1320.33 1996 31809.82 1524.71 1997 30966.35 1524.71 1998 34613.91 1706.85 1999 53544.23 2041.64 2000 60712.76 2511.84 2001 53315.94 2546.03
324
CPI (1982 = 100) 15.0 15.5 16.2 16.5 16.6 17.0 17.5 18.0 18.8 21.7 27.6 31.2 35.4 39.7 44.7 53.2 66.4 82.7 100.0 120.2 142.4 169.9 209.9 243.3 276.2 314.1 378.3 452.1 524.0 599.4 664.7 723.8 783.1 826.2 865.9 888.4 916.8 948.0
Table 3B: ETEBA: Capital and Borrowed Funds (in Million Drs.) Constant 1982 Prices Deflation Capital Local Foreign Total Coefficie and Provision Borrowed Borrowed Borrowed nt Reserves s Funds Funds Funds 0.15 1226.07 0.20 0.00 0.00 0.00 0.155 1418.45 2.32 18.06 0.00 18.06 0.162 1943.70 37.84 1064.94 0.00 1064.94 0.165 1923.88 86.67 2256.24 0.00 2256.24 0.166 1929.04 186.08 2989.46 0.00 2989.46 0.17 1904.53 270.82 4447.82 940.41 5388.24 0.175 1908.57 394.80 7351.94 2044.80 9396.74 0.18 1977.28 623.61 10088.56 4252.00 14340.56 0.188 2961.91 817.07 12678.51 5340.90 18019.41 0.217 2922.81 945.25 14904.42 5978.43 20882.86 0.276 2481.49 1037.75 16034.78 5640.04 21674.82 0.312 2690.06 1260.51 15671.22 6015.54 21686.76 0.354 2915.06 1275.93 17482.91 7126.21 24609.12 0.397 3749.12 1230.55 17649.07 8304.28 25953.35 0.447 3753.94 1409.40 16381.45 8063.94 24445.39 0.532 3326.05 1695.28 14617.80 10389.00 25006.80 0.664 4665.74 1839.83 12865.12 12342.95 25208.07 0.827 4035.51 1935.66 12083.77 12154.87 24238.65 1 4414.76 2066.43 13143.86 12515.50 25659.36 1.202 4361.14 2191.05 15015.16 11880.90 26896.06 1.424 4095.92 2294.71 15970.84 10258.92 26229.76 1.699 3688.51 2335.74 17933.86 8110.29 26044.15 2.099 3117.39 2262.62 21019.21 5601.61 26620.81 2.433 2833.11 2310.12 19899.49 3752.43 23651.92 2.762 3169.84 2313.74 18800.77 2635.16 21435.93 3.141 3334.65 2216.62 17537.75 1739.92 19277.67 3.783 4946.93 3138.35 15126.64 1062.60 16189.23 4.521 4770.10 2915.92 13915.63 1624.10 15539.73 5.24 4539.54 2712.66 13050.10 2006.04 15056.15 5.994 4419.91 1990.16 9890.10 2082.24 11972.34 6.647 4483.79 181.70 7.238 4615.19 182.42 7.831 4062.04 194.70 8.262 3748.05 184.54 8.659 3997.45 197.12 8.884 6027.04 229.81 9.168 6622.25 273.98 9.48 5624.04 268.57
YEAR 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
325
Table 4A: Investment Bank: Revenues, Expenses and Net Profits (in Million Drs.) Current Prices
YEAR 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Interest, Dividend s & other Banking Revenue 0.66 2.89 8.63 15.10 20.93 27.25 32.39 49.53 80.65 112.73 168.02 275.14
Capital Gains from Sold Personne Securitie l Payroll s & Other Gross Financial & Soc. Income Income Charges Charges 0.66 0.09 1.01 2.89 0.25 1.39 8.63 0.73 1.36 15.10 2.12 1.63 20.93 6.52 1.59 27.25 9.41 2.37 32.39 13.62 3.34 49.53 22.18 3.73 80.65 49.99 3.24 112.73 78.67 4.21 168.02 127.43 5.48 275.14 200.10 7.06
464.84 484.73 579.59 863.64 1248.15 1415.31 1535.08 1881.02 2349.54 2449.66 2411.47 3152.71 3409.25 4145.81 5661.73 8745.99 7008.07
78.37 188.31
130.68 97.94
10.10 327.57
Net Directors' Profits Dividend Fees -3.46 -1.63 2.95 7.78 4.88 8.61 8.03 6.17 5.70 6.21 5.90 17.92 7.50 20.74 9.00 22.30 9.00 24.92 9.00 55.64 18.00
464.84 484.73 579.59 863.64 1248.15 1415.31 1535.08 1881.02 2349.54 2449.66 2411.47 3152.71 3409.25 4145.81 5661.73 8824.36 7196.38
341.57 393.62 438.00 645.97 974.40 1171.76 1245.05 1487.55 1831.68 2032.40 2388.28 2667.74 2873.93 3371.45 4347.07 8660.19 7539.66
12.29 16.63 30.85 31.27 41.83 59.03 70.58 97.90 133.61 149.54 180.16 213.18 293.12 365.25 474.21 749.38 766.97
22.11 0.00 0.00 30.55 65.09 5.32 20.45 32.51 38.05 -5.48 -407.40 11.48 -273.08 23.68 -730.83 -1042.78 -1548.83
0.00 0.00 18.00 24.00 18.00 18.32 18.32 24.40 9.82 0.00 0.00 0.00 0.00 0.00 0.00 0.00
140.78 425.51 0.00 0.00
2.51 2.62
202.93 167.55
4088.96 1451.83
0.00 0.00
0.70 1.56 1.87
326 Table 4B: Investment Bank: Revenues, Expenses and Net Profits (in Million Drs.) Constant 1982 Prices
Deflatio CPI n (1982 Coeffici = 100) ent 14.9 0.149 15.0 0.15 15.5 0.155 16.2 0.162 16.5 0.165 16.6 0.166 17.0 0.17 17.5 0.175 18.0 0.18 18.8 0.188 21.7 0.217 27.6 0.276 31.2 0.312 35.4 0.354 39.7 0.397 44.7 0.447 53.2 0.532 66.4 0.664 82.7 0.827 100.0 1 120.2 1.202 142.4 1.424 169.9 1.699 209.9 2.099 243.3 2.433 276.2 2.762 314.1 3.141 378.3 3.783 452.1 4.521 524.0 5.24 599.4 5.994 664.7 6.647 723.8 7.238 783.1 7.831 826.2 8.262 865.9 8.659 888.4 8.884 916.8 9.168 948.0 9.48 982.1 9.821
Interest, Dividend s & other Banking Revenue 4.43 19.27 55.68 93.21 126.85 164.16 190.53 283.03 448.06 599.63 774.29 996.88 1313.11 1220.98 1296.62 1623.38 1879.74 1711.38 1535.08 1564.91 1649.96 1441.82 1148.87 1295.81 1234.34 1319.90 1496.62 1934.53 1337.42
16.69 11.85
Capital Gains from Sold Personne Securitie l Payroll s & Other Gross Financial & Soc. Income Income Charges Charges 4.43 0.60 6.78 19.27 1.67 9.27 55.68 4.71 8.77 93.21 13.09 10.06 126.85 39.52 9.64 164.16 56.69 14.28 190.53 80.12 19.65 283.03 126.74 21.31 448.06 277.72 18.00 599.63 418.46 22.39 774.29 587.24 25.25 996.88 725.00 25.58
Net Profits -23.22 -10.87 19.03 48.02 52.18 37.17 36.53 102.40 115.22 118.62 114.84 201.59
17.33 35.94
1313.11 1220.98 1296.62 1623.38 1879.74 1711.38 1535.08 1564.91 1649.96 1441.82 1148.87 1295.81 1234.34 1319.90 1496.62 1951.86 1373.35
964.89 991.49 979.87 1214.23 1467.47 1416.88 1245.05 1237.56 1286.29 1196.23 1137.82 1096.48 1040.52 1073.37 1149.11 1915.55 1438.87
34.72 41.89 69.02 58.78 63.00 71.38 70.58 81.45 93.83 88.02 85.83 87.62 106.13 116.28 125.35 165.76 146.37
62.46 0.00 0.00 57.42 98.03 6.43 20.45 27.05 26.72 -3.23 -194.09 4.72 -98.87 7.54 -193.19 -230.65 -295.58
1.29 39.65
17.98 51.50
0.32 0.32
25.91 20.28
522.15 175.72
Direct Dividen ors'Fe d es YEAR 0.00 1963 0.00 1964 0.00 1965 30.12 1966 48.67 1967 34.34 1968 34.71 1969 42.86 1970 50.00 1971 47.87 1972 41.47 1973 65.22 1974 1975 1976 0.00 1.76 1977 0.00 3.49 1978 33.83 3.52 1979 36.14 1980 21.77 1981 18.32 1982 15.24 1983 17.13 1984 5.78 1985 0.00 1986 0.00 1987 0.00 1988 0.00 1989 0.00 1990 0.00 1991 0.00 1992 1993 1994 1995 0.00 1996 0.00 1997 1998 1999 2000 2001 2002
327 Table 5A: Investment Bank: Loans and Investments (in Million Current Prices Investme nts in Long & Bonds, Total Short Long and Treasury Investme Term Medium Investme Bonds & nts in Loans Term nts in Mutual Securitie (after Loans Shares Funds s 1998) YEAR 10.93 0.00 1963 1964 62.72 1.00 1.00 1965 138.59 75.00 0.97 75.97 1966 209.03 84.00 0.93 84.93 1967 269.19 109.00 0.90 109.90 1968 305.16 124.00 0.90 124.90 1969 391.03 130.52 0.91 131.43 1970 593.28 131.52 28.48 160.00 1971 967.30 112.82 29.71 142.53 1972 1374.67 135.89 33.33 169.22 1973 2038.93 131.72 24.89 156.61 1974 2875.25 249.74 39.35 289.09 1975 1976 4523.36 508.84 22.74 531.58 1977 4808.80 532.92 15.25 548.17 1978 5250.18 873.51 7.82 881.33 1979 6144.76 895.16 0.33 895.49 1980 7182.08 971.95 0.15 972.10 1981 8283.45 1011.95 10.15 1022.10 1982 9236.52 1113.83 20.15 1133.98 1983 10896.72 1123.83 22.33 1146.16 1984 12737.78 1134.08 54.71 1188.79 1985 14166.12 1156.76 54.71 1211.47 1986 16000.57 1272.50 54.71 1327.21 1987 17697.16 2228.08 0.00 2228.08 1988 18854.69 2246.07 202.19 2448.26 1989 19512.99 1913.30 343.65 2256.95 1990 18298.94 1443.35 411.45 1854.80 1991 17590.04 1833.30 46.40 1879.70 1992 13664.14 1730.70 336.67 2067.37 1993 1994 1995 1996 2805.74 0.00 2805.74 1997 2801.64 0.00 2801.64 1998 0.00 1999 0.00 2000 2001 2002
328 Table 5B: Investment Bank: Loans and Investments (in Million Drs.) Constant 1982 Prices Investme nts in Long & Bonds, Total Short Long and Treasury Investme Term Deflation Medium Investme Bonds & nts in Loans CPI (1982 Coefficie Term nts in Mutual Securitie (after = 100) nt Loans Shares Funds s 1998) YEAR 14.9 0.149 73.36 0.00 0.00 0.00 1963 15.0 0.15 418.13 0.00 6.67 6.67 1964 15.5 0.155 894.13 483.87 6.26 490.13 1965 16.2 0.162 1290.31 518.52 5.74 524.26 1966 16.5 0.165 1631.45 660.61 5.45 666.06 1967 16.6 0.166 1838.31 746.99 5.42 752.41 1968 17.0 0.17 2300.18 767.76 5.35 773.12 1969 17.5 0.175 3390.17 751.54 162.74 914.29 1970 18.0 0.18 5373.89 626.78 165.06 791.83 1971 18.8 0.188 7312.07 722.82 177.29 900.11 1972 21.7 0.217 9395.99 607.00 114.70 721.71 1973 27.6 0.276 10417.57 904.86 142.57 1047.43 1974 31.2 0.312 1975 35.4 0.354 12777.85 1437.40 64.24 1501.64 1976 39.7 0.397 12112.85 1342.37 38.41 1380.78 1977 44.7 0.447 11745.37 1954.16 17.49 1971.66 1978 53.2 0.532 11550.30 1682.63 0.62 1683.25 1979 66.4 0.664 10816.39 1463.78 0.23 1464.01 1980 82.7 0.827 10016.26 1223.64 12.27 1235.91 1981 100.0 1 9236.52 1113.83 20.15 1133.98 1982 120.2 1.202 9065.49 934.97 18.58 953.54 1983 142.4 1.424 8945.07 796.40 38.42 834.82 1984 169.9 1.699 8337.92 680.85 32.20 713.05 1985 209.9 2.099 7622.95 606.24 26.06 632.31 1986 243.3 2.433 7273.80 915.77 0.00 915.77 1987 276.2 2.762 6826.46 813.20 73.20 886.41 1988 314.1 3.141 6212.35 609.14 109.41 718.55 1989 378.3 3.783 4837.15 381.54 108.76 490.30 1990 452.1 4.521 3890.74 405.51 10.26 415.77 1991 524.0 5.24 2607.66 330.29 64.25 394.54 1992 599.4 5.994 1993 664.7 6.647 1994 723.8 7.238 1995 783.1 7.831 0.00 358.29 0.00 358.29 1996 826.2 8.262 0.00 339.10 0.00 339.10 1997 865.9 8.659 1998 888.4 8.884 1999 916.8 9.168 2000 948.0 9.48 2001 982.1 9.821 2002
329
Table 6A: Investment Bank: Capital and Borrowed Funds (in Current Prices Capital Local Foreign Total and Provision Borrowed Borrowed Borrowed s Funds Funds Funds YEAR Reserves 50.00 2.34 0.13 2.47 1963 1964 90.00 14.19 0.07 14.26 1965 150.00 87.68 1.31 88.99 1966 150.28 156.29 2.02 158.31 1967 150.71 240.00 0.14 240.14 1968 151.02 5.50 292.70 4.66 297.36 1969 151.33 10.17 431.01 431.01 1970 151.73 20.03 622.62 622.62 1971 152.21 31.30 788.47 291.00 1079.47 1972 152.68 44.13 1145.52 291.00 1436.52 1973 281.33 59.57 1696.23 231.00 1927.23 1974 403.64 96.26 2570.86 144.60 2715.46 1975 0.00 1976 582.30 229.89 4175.82 4175.82 1977 589.16 286.26 4335.76 4335.76 1978 572.24 372.95 5378.95 5378.95 1979 579.78 479.35 6326.65 6326.65 1980 610.88 608.17 6669.86 280.05 6949.91 1981 936.20 742.44 6849.71 755.65 7605.36 1982 1042.53 885.24 7632.47 1180.06 8812.53 1983 1044.15 1047.33 8741.41 2310.29 11051.70 1984 1046.05 1270.67 9520.70 2837.10 12357.80 1985 1030.75 1389.28 10790.22 2879.49 13669.71 1986 1711.56 1289.86 14067.22 2775.90 16843.12 1987 1723.04 1224.19 15170.52 2423.79 17594.31 1988 1765.00 1259.59 16548.55 2201.38 18749.93 1989 2363.66 1250.44 15832.50 1954.25 17786.75 1990 1485.66 2124.97 14868.78 1679.69 16548.47 1991 283.92 2178.71 16551.20 1374.77 17925.97 1992 -1055.17 427.74 17255.61 1036.09 18291.70 1993 1994 1995 1996 -2556.63 21.50 1997 -1105.25 21.50 1998 1999 2000 2001 2002
330
Table 6B: Investment Bank: Capital and Borrowed Funds (in Million Drs.) Constant 1982 Prices Deflation Capital Local Foreign Total CPI (1982 Coefficie and Provision Borrowed Borrowed Borrowed = 100) nt Reserves s Funds Funds Funds YEAR 14.9 0.149 335.57 0.00 15.70 0.87 16.58 1963 15.0 0.15 600.00 0.00 94.60 0.47 95.07 1964 15.5 0.155 967.74 0.00 565.68 8.45 574.13 1965 16.2 0.162 927.65 0.00 964.75 12.47 977.22 1966 16.5 0.165 913.39 0.00 1454.55 0.85 1455.39 1967 16.6 0.166 909.76 33.13 1763.25 28.07 1791.33 1968 17.0 0.17 890.18 59.82 2535.35 0.00 2535.35 1969 17.5 0.175 867.03 114.46 3557.83 0.00 3557.83 1970 18.0 0.18 845.61 173.89 4380.39 1616.67 5997.06 1971 18.8 0.188 812.13 234.73 6093.19 1547.87 7641.06 1972 21.7 0.217 1296.45 274.52 7816.73 1064.52 8881.24 1973 27.6 0.276 1462.46 348.77 9314.71 523.91 9838.62 1974 31.2 0.312 1975 35.4 0.354 1644.92 649.41 11796.10 0.00 11796.10 1976 39.7 0.397 1484.03 721.06 10921.31 0.00 10921.31 1977 44.7 0.447 1280.18 834.34 12033.45 0.00 12033.45 1978 53.2 0.532 1089.81 901.03 11892.20 0.00 11892.20 1979 66.4 0.664 920.00 915.92 10044.97 421.76 10466.73 1980 82.7 0.827 1132.04 897.75 8282.60 913.72 9196.32 1981 100.0 1 1042.53 885.24 7632.47 1180.06 8812.53 1982 120.2 1.202 868.68 871.32 7272.39 1922.04 9194.43 1983 142.4 1.424 734.59 892.32 6685.88 1992.35 8678.23 1984 169.9 1.699 606.68 817.70 6350.92 1694.81 8045.74 1985 209.9 2.099 815.42 614.51 6701.87 1322.49 8024.35 1986 243.3 2.433 708.20 503.16 6235.31 996.21 7231.53 1987 276.2 2.762 639.03 456.04 5991.51 797.02 6788.53 1988 314.1 3.141 752.52 398.10 5040.59 622.17 5662.77 1989 378.3 3.783 392.72 561.72 3930.42 444.01 4374.43 1990 452.1 4.521 62.80 481.91 3660.96 304.09 3965.05 1991 524.0 5.24 -201.37 81.63 3293.06 197.73 3490.78 1992 599.4 5.994 1993 664.7 6.647 1994 723.8 7.238 1995 783.1 7.831 -326.48 2.75 1996 826.2 8.262 -133.78 2.60 1997 865.9 8.659 1998 888.4 8.884 1999 916.8 9.168 2000 948.0 9.48 2001 982.1 9.821 2002
331
Table 7A: ETBA: Revenues, Expenses and Net Profits (in Million Drs.) Current Prices
YEAR 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Capital Interest, Gains from Dividends Sold & other Securities Banking & Other Revenue Income
Gross Income
Financial Charges
Personnel Payroll & Soc. Charges
Net Profits
267.97 338.25
267.97 338.25
56.92 77.60
48.44 52.39
127.07 169.62
547.21 794.43 844.95 1165.83 1432.15 2711.57 2011.46 1788.70 2544.03 3959.84 6068.82 8162.02 9502.23 12396.77 18264.35 25147.66 27581.98 36713.78 45208.42 58193.83 64875.91 71151.35 81637.37 103830.72 152236.54 174696.06 103946.18 54573.02 61317.53 82250.32 92115.94 55765.60 43725.96
547.21 794.43 844.95 1165.83 1432.15 2711.57 2011.46 1788.70 2544.03 3959.84 6068.82 8162.02 9502.23 12396.77 18264.35 25147.66 27581.98 36713.78 45208.42 58193.83 64875.91 71151.35 81637.37 93036.72 143734.52 181061.31 97493.66 48259.06 68776.72 104089.36 102823.96 60433.78 53500.04
203.81 355.72 478.56 631.73 813.49 931.91 1211.37 1388.54 1732.88 2901.43 4272.25 6847.24 8238.19 9896.09 14896.07 21393.42 24351.34 33098.34 35462.44 48233.38 74164.77 106082.22 125912.97 160820.62 192713.58 194747.28 82936.62 37938.07 31744.76 54187.70 50185.80 33810.68 25825.92
66.51 84.85 111.53
232.91 76.86 34.35 0.00 2.20 676.65 67.24 12.40 50.36 86.33 239.76 147.41 131.90 202.03 263.30 286.04 32.00 27.50 47.33 0.00 -26974.52 -46086.52 -59743.66 -127671.80 -94543.65 -61062.75 -91380.14 -128121.09 10535.59 38561.84 30138.91 -2776.68 14021.74
-10794.00 -8502.02 6365.25 -6452.52 -6313.96 7459.19 21839.04 10708.02 4668.18 9774.08
163.24 203.87 256.53 262.40 324.75 370.81 472.43 745.11 815.58 1078.61 1374.19 1657.61 1860.91 2240.89 2715.69 3391.88 3907.68 4299.19 4443.92 4846.74 5655.16 5977.84 9164.15 7175.96 7629.16 7415.11 7901.46 7933.51 7849.60
Direct Divid ors'F end ees
332
Table 7B: ETBA: Revenues, Expenses and Net Profits (in Million Drs.) Constant 1982 Prices Capital Gains from Interest, Sold CPI Deflat Dividends Securitie Personnel (1982 ion & other s& Payroll & Direc = Coeffi Banking Other Gross Financial Soc. Net Divid tors' 100) cient Revenue Income Income Charges Charges Profits end Fees 15.0 0.15 15.5 0.155 16.2 0.162 16.5 0.165 1624.06 1624.06 344.97 293.58 770.12 16.6 0.166 2037.65 2037.65 467.47 315.60 1021.81 17.0 0.17 17.5 0.175 3126.91 3126.91 1164.63 380.06 1330.91 18.0 0.18 4413.50 4413.50 1976.22 471.39 427.00 18.8 0.188 4494.41 4494.41 2545.53 593.24 182.71 21.7 0.217 5372.49 5372.49 2911.20 0.00 27.6 0.276 5188.95 5188.95 2947.43 7.97 31.2 0.312 8690.93 8690.93 2986.89 653.43 2168.75 35.4 0.354 5682.09 5682.09 3421.95 724.66 189.94 39.7 0.397 4505.54 4505.54 3497.58 660.96 31.23 44.7 0.447 5691.34 5691.34 3876.69 726.51 112.66 53.2 0.532 7443.31 7443.31 5453.82 697.01 162.27 66.4 0.664 9139.79 9139.79 6434.11 711.49 361.08 82.7 0.827 9869.43 9869.43 8279.61 900.98 178.25 100.0 1 9502.23 9502.23 8238.19 815.58 131.90 120.2 1.202 10313.45 10313.45 8233.02 897.35 168.08 142.4 1.424 12826.09 12826.09 10460.72 965.02 184.90 169.9 1.699 14801.45 14801.45 12591.77 975.64 168.36 209.9 2.099 13140.53 13140.53 11601.40 886.57 15.25 243.3 2.433 15089.92 15089.92 13603.92 921.04 11.30 276.2 2.762 16368.00 16368.00 12839.41 983.23 17.14 314.1 3.141 18527.17 18527.17 15356.06 1079.87 0.00 378.3 3.783 17149.33 17149.33 19604.75 1032.96 -7130.46 452.1 4.521 15737.97 15737.97 23464.33 950.94 -10193.88 524.0 5.24 15579.65 15579.65 24029.19 848.08 -11401.46 599.4 5.994 17322.44 -1800.80 15521.64 26830.27 808.60 -21299.93 664.7 6.647 22903.04 -1279.08 21623.97 28992.57 850.78 -14223.51 723.8 7.238 24135.96 879.42 25015.38 26906.23 825.90 -8436.41 783.1 7.831 13273.68 -823.97 12449.71 10590.81 1170.24 -11669.03 826.2 8.262 6605.30 -764.22 5841.09 4591.87 868.55 -15507.27 865.9 8.659 7081.36 861.44 7942.80 3666.10 881.07 1216.72 888.4 8.884 9258.25 2458.24 11716.50 6099.47 834.66 4340.59 916.8 9.168 10047.55 1167.98 11215.53 5474.02 861.85 3287.40 948.0 9.48 5882.45 492.42 6374.87 3566.53 836.87 -292.90 982 9.821 4452.29 995.222 5447.515 2629.66 799.27 1427.73
YEAR 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
333 Table 8A: ETBA: Loans and Investments (in Million Drs.) Current Prices
YEAR 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Long and Medium Term Loans 4395.75 4660.80 4969.95 5662.80 7077.36 9234.78 11713.11 14070.12 16608.09 18873.37 20898.78 22438.03 23359.39 27114.08 33091.97 44088.16 55505.77 65700.28 80574.27 101521.49 121181.82 142095.81 183100.83 237334.62 317802.28 391676.80 472900.45 549840.36 602047.65
Investments in Bonds, Treasury Total Long & Bonds & Investment Short Term Investments Mutual s in Loans (after in Shares Funds Securities 1994) 0.00 1841.61 69.24 1910.85 1939.68 77.37 2017.05 1990.68 76.23 2066.91 2018.28 74.09 2092.37 2031.21 70.65 2101.86 2162.43 66.98 2229.41 2245.37 71.05 2316.42 2598.78 57.62 2656.40 4109.82 4109.82 4281.95 43.86 4325.81 5908.00 40.08 5948.08 6211.52 282.60 6494.12 7289.79 264.02 7553.81 9022.66 260.07 9282.73 9642.76 227.33 9870.09 9554.85 194.25 9749.10 9515.24 161.33 9676.57 11608.91 2128.03 13736.94 13361.16 2094.57 15455.73 16717.32 2060.68 18778.00 25041.78 2000.96 27042.74 32720.38 2000.08 34720.46 51386.03 9059.42 60445.45 60355.60 7937.00 68292.60 66257.00 8063.58 74320.58 81851.63 623.32 82474.95 96395.82 623.32 97019.14 83783.24 78346.82 162130.06 84809.48 363554.76 448364.24 91032.10 358930.55 449962.65 703943.25 91381.65 489305.44 580687.09 610111.27 62095.15 50825.80 112920.95 490738.86 56230.00 92576.88 148806.88 367117.50 56156.10 82219.42 138375.52 366042.67 90902.92 292096.65 382999.57 366663.18 138121.61 302138.37 440259.98 377729.03 77878.20 279773.70 357651.90 372460.26 74986.26 236588.74 311575.00 411803.19
334
CPI (1982 = 100) 15.0 15.5 16.2 16.5 16.6 17.0 17.5 18.0 18.8 21.7 27.6 31.2 35.4 39.7 44.7 53.2 66.4 82.7 100.0 120.2 142.4 169.9 209.9 243.3 276.2 314.1 378.3 452.1 524.0 599.4 664.7 723.8 783.1 826.2 865.9 888.4 916.8 948.0 982.1
Table 8B: ETBA: Loans and Investments (in Million Drs.) Constant 1982 Prices Investme nts in Bonds, Total Treasury Investme Long & Deflation Long and Investme Bonds & nts in Short Term Coefficie Medium nts in Mutual Securitie Loans nt Term Loans Shares Funds s (after 1994) 0.15 0.00 0.00 0.00 0.00 0.155 28359.68 11881.35 446.71 12328.06 0.162 28770.37 11973.33 477.59 12450.93 0.165 30120.91 12064.73 462.00 12526.73 0.166 34113.25 12158.31 446.33 12604.64 0.17 41631.53 11948.29 415.59 12363.88 0.175 52770.17 12356.74 382.74 12739.49 0.18 65072.83 12474.28 394.72 12869.00 0.188 74841.06 13823.30 306.49 14129.79 0.217 76534.98 18939.26 0.00 18939.26 0.276 68381.78 15514.31 158.91 15673.22 0.312 66983.27 18935.90 128.46 19064.36 0.354 63384.27 17546.67 798.31 18344.97 0.397 58839.77 18362.19 665.04 19027.23 0.447 60657.90 20184.92 581.81 20766.73 0.532 62202.95 18125.49 427.31 18552.80 0.664 66397.83 14389.83 292.55 14682.38 0.827 67117.01 11505.73 195.08 11700.81 1 65700.28 11608.91 2128.03 13736.94 1.202 67033.50 11115.77 1742.57 12858.34 1.424 71293.18 11739.69 1447.11 13186.80 1.699 71325.38 14739.13 1177.73 15916.86 2.099 67696.91 15588.56 952.87 16541.43 2.433 75257.23 21120.44 3723.56 24844.00 2.762 85928.54 21852.14 2873.64 24725.78 3.141 101178.69 21094.24 2567.20 23661.44 3.783 103536.03 21636.70 164.77 21801.47 4.521 104600.85 21321.79 137.87 21459.66 5.24 104931.37 15989.17 14951.68 30940.85 0.00 5.994 100441.72 14149.06 60653.11 74802.18 0.00 6.647 13695.22 53998.88 67694.10 105903.90 7.238 12625.26 67602.30 80227.56 84292.80 7.831 7929.40 6490.33 14419.74 62666.18 8.262 6805.86 11205.14 18011.00 44434.46 8.659 6485.29 9495.26 15980.54 42273.09 8.884 10232.21 32878.96 43111.16 41272.31 9.168 15065.62 32955.76 48021.38 41200.81 9.48 8215.00 29511.99 37726.99 39289.06 9.821 7635.298 24090.09 31725.38 41930.8818
YEAR 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
335 Table 9A: ETBA: Capital and Borrowed Funds (in Million Drs.) Current Prices Local Foreign Total Capital and Provision Borrowed Borrowed Borrowed Reserves s Funds Funds Funds YEAR 1964 0.00 1965 5567.34 443.01 497.43 206.73 704.16 1966 5776.56 442.98 771.39 157.56 928.95 1967 5903.64 441.84 1011.54 388.11 1399.65 1968 6086.76 444.21 1444.98 371.13 1816.11 1969 6232.68 438.75 2958.57 298.11 3256.68 1970 6385.59 439.98 4894.53 336.75 5231.28 1971 6435.13 778.70 7626.98 342.33 7969.31 1972 6463.13 909.86 10258.00 343.68 10601.68 1973 8005.82 1070.72 0.00 1974 8219.40 1432.22 14860.34 390.09 15250.43 1975 8968.74 1856.85 15759.76 703.38 16463.14 1976 9102.80 2045.91 18268.82 1056.35 19325.17 1977 9577.43 2010.27 20115.14 1360.27 21475.41 1978 9930.04 2258.44 24601.19 2177.75 26778.94 1979 11299.07 2615.85 29394.41 3905.45 33299.86 1980 13246.73 3485.88 36390.11 10433.90 46824.01 1981 14294.20 3236.59 44502.89 15324.87 59827.76 1982 16318.71 3253.69 53908.30 21840.41 75748.71 1983 16964.77 4059.33 66467.98 31206.86 97674.84 1984 21065.89 5222.73 95751.23 43142.59 138893.82 1985 26038.21 5588.11 127001.59 50488.71 177490.30 1986 38394.90 5128.26 172773.03 65369.91 238142.94 1987 41415.93 3038.03 192604.19 69753.70 262357.89 1988 47778.68 1580.70 243905.69 76260.07 320165.76 1989 55564.32 4489.64 302945.68 138422.33 441368.01 1990 62513.32 15009.65 386409.41 148196.02 534605.43 1991 67008.09 17641.49 429926.13 208244.90 638171.03 1992 119739.94 8597.24 498830.36 281724.71 780555.07 1993 145114.00 1858.07 533460.20 359420.13 892880.33 1994 55355.88 8801.15 1995 149062.38 9323.95 1996 75438.53 16323.95 1997 66253.23 16981.66 1998 235835.11 16207.58 1999 376341.86 11300.44 2000 399920.89 8449.78 2001 344357.21 5920.06 2002 345664.49 10497.15
336
CPI (1982 = 100) 15.0 15.5 16.2 16.5 16.6 17.0 17.5 18.0 18.8 21.7 27.6 31.2 35.4 39.7 44.7 53.2 66.4 82.7 100.0 120.2 142.4 169.9 209.9 243.3 276.2 314.1 378.3 452.1 524.0 599.4 664.7 723.8 783.1 826.2 865.9 888.4 916.8 948.0 982.1
Table 9B: ETBA: Capital and Borrowed Funds (in Million Drs.) Constant 1982 Prices Deflation Capital Local Foreign Total Coefficie and Provision Borrowed Borrowed Borrowed nt Reserves s Funds Funds Funds 0.15 0.00 0.00 0.00 0.00 0.00 0.155 35918.32 2858.13 3209.23 1333.74 4542.97 0.162 35657.78 2734.44 4761.67 972.59 5734.26 0.165 35779.64 2677.82 6130.55 2352.18 8482.73 0.166 36667.23 2675.96 8704.70 2235.72 10940.42 0.17 36662.82 2580.88 17403.35 1753.59 19156.94 0.175 36489.09 2514.17 27968.74 1924.29 29893.03 0.18 35750.72 4326.11 42372.11 1901.83 44273.94 0.188 34378.35 4839.68 54563.83 1828.09 56391.91 0.217 36893.18 4934.19 0.276 29780.43 5189.20 53841.81 1413.37 55255.18 0.312 28745.96 5951.44 50512.05 2254.42 52766.47 0.354 25714.12 5779.41 51606.84 2984.04 54590.88 0.397 24124.51 5063.65 50667.86 3426.37 54094.23 0.447 22214.85 5052.44 55036.22 4871.92 59908.14 0.532 21238.85 4917.01 55252.65 7341.07 62593.72 0.664 19949.89 5249.82 54804.38 15713.70 70518.09 0.827 17284.40 3913.65 53812.44 18530.68 72343.12 1 16318.71 3253.69 53908.30 21840.41 75748.71 1.202 14113.79 3377.15 55297.82 25962.45 81260.27 1.424 14793.46 3667.65 67241.03 30296.76 97537.79 1.699 15325.61 3289.06 74750.79 29716.72 104467.51 2.099 18292.00 2443.19 82312.07 31143.36 113455.43 2.433 17022.58 1248.68 79163.25 28669.83 107833.08 2.762 17298.58 572.30 88307.64 27610.45 115918.09 3.141 17690.01 1429.37 96448.80 44069.51 140518.31 3.783 16524.80 3967.66 102143.65 39174.21 141317.85 4.521 14821.52 3902.12 95095.36 46061.69 141157.05 5.24 22851.13 1640.69 95196.63 53764.26 148960.89 5.994 24209.88 309.99 88999.03 59963.32 148962.35 6.647 8327.95 1324.08 7.238 20594.42 1288.19 7.831 9633.32 2084.53 8.262 8019.03 2055.39 8.659 27235.84 1871.76 8.884 42361.76 1272.00 9.168 43621.39 921.66 9.48 36324.60 624.48 9.821 35196.47 1068.847
YEAR 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
337
Table 10: ETEBA: Comparing Rates of Change
YEAR
1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Rate of Rate of Change Change of Long of Total Rate of Term and Investme GDP Rate Change Medium nts in of of Net Term Securitie Change Profits % Loans % s% % (Constant 1982 Prices) (Constant 1982 Prices) -36.55 197.83 56.72 -4.96 22.28 52.87 7.93 131.17 13.07 -34.38 13.38 59.26 10.49 -8.66 -3.40 47.86 4.26 -18.37 55.07 -25.26 -39.01 -37.07 7.64 -10.45 8.11 138.12 50.42 -49.22 54.45 10.51 2.04 5.86 -31.24 131.93 83.76 -28.28 -6.21
167.35 494.73 142.98 42.85 79.98 77.25 43.68 32.65 10.09 0.59 -1.42 12.97 4.79 -0.39 1.20 -0.88 -3.75 -1.59 -3.30 -8.07 -11.90 -12.99 -7.86 5.48 -0.45 -14.36 -13.96
32.63 271.46 -0.58 -6.21 6.75 30.09 13.61 71.98 35.10 -1.39 18.72 -1.14 -1.42 1.19 -3.13 -6.43 7.04 -3.92 -9.07 -8.78 -4.79 0.01 79.50 -10.13 -17.41 31.24 50.14 -29.84 -9.35 -17.25 12.75 18.03 27.39 49.89 102.78 -20.95 5.49
11.6 6.9 6.0 8.1 12.4 9.8 8.0 10.8 13.2 -9.7 6.4 9.6 4.4 8.4 4.3 -3.8 -3.9 4.0 -0.7 5.0 2.3 -3.3 -2.8 7.2 4.5 0.2 3.3 -0.3 -1.6 2.3 2.9 1.6 4.8 3.4 3.7 5.2 3.9
338 Table 11: Investment Bank: Comparing Rates of Change
YEAR
1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Rate of Rate of Change Change of Long of Total Rate of Term and Investme GDP Rate Change Medium nts in of of Net Term Securitie Change Profits % Loans % s% % (Constant 1982 Prices) (Constant 1982 Prices) -53.19 469.97 -275.07 113.84 7248.27 11.6 152.34 44.31 6.96 6.9 8.66 26.44 27.05 6.0 -28.76 12.68 12.96 8.1 -1.72 25.12 2.75 12.4 180.32 47.39 18.26 9.8 12.52 58.51 -13.39 8.0 2.95 36.07 13.67 10.8 -3.19 28.50 -19.82 13.2 75.54 10.87 45.13 -9.7 6.4 9.6 -100.00 -5.20 -8.05 4.4 0.00 -3.03 42.79 8.4 -1.66 -14.63 4.3 70.72 -6.35 -13.02 -3.8 -93.44 -7.40 -15.58 -3.9 218.04 -7.78 -8.25 4.0 32.27 -1.85 -15.91 -0.7 -1.22 -1.33 -12.45 5.0 -112.09 -6.79 -14.59 2.3 5908.98 -8.57 -11.32 -3.3 -102.43 -4.58 44.83 -2.8 -2194.70 -6.15 -3.21 7.2 -107.63 -9.00 -18.94 4.5 -2662.20 -22.14 -31.77 0.2 19.39 -19.56 -15.20 3.3 28.15 -5.11 -0.3 -1.6 2.3 2.9 1.6 -66.35 -5.35 4.8 3.4 3.7 5.2 3.9
339
Table 12: ETBA: Comparing Rates of Change
YEAR
Rate of Rate of Change Change of Long of Total Rate of Term and Investme GDP Rate Change Medium nts in of of Net Term Securitie Change Profits % Loans % s% % (Constant 1982 Prices) (Constant 1982 Prices)
1964 1965 1966 1967 1968 32.68 1969 1970 1971 -67.92 1972 -57.21 1973 -100.00 1974 100.00 1975 27111.42 1976 -91.24 1977 -83.56 1978 260.74 1979 44.03 1980 122.52 1981 -50.63 1982 -26.00 1983 27.43 1984 10.00 1985 -8.95 1986 -90.94 1987 -25.90 1988 51.68 1989 -100.00 1990 1991 42.96 1992 11.85 1993 86.82 1994 -33.22 1995 -40.69 1996 38.32 1997 32.89 1998 -107.85 1999 256.75 2000 -24.26 2001 -108.91 2002 -587.45
-9.65 4.69 13.25 22.04 26.76 23.31 15.01 2.26 -10.65 -2.04 -5.37 -7.17 3.09 2.55 6.74 1.08 -2.11 2.03 6.35 0.04 -5.09 11.17 14.18 17.75 2.33 1.03
1.00 0.61 0.62 -1.91 3.04 1.02 9.80 34.03 -17.24 21.64 -3.77 3.72 9.14 -10.66 -20.86 -20.31 17.40 -6.39 2.55 20.70 3.92 50.19 -0.47 -4.30 -7.86 -1.56 44.18 141.76 -9.50 18.51 -82.03 24.90 -11.27 169.77 11.39 -21.43 -15.91
11.6 6.9 6.0 8.1 12.4 9.8 8.0 10.8 13.2 -9.7 6.4 9.6 4.4 8.4 4.3 -3.8 -3.9 4.0 -0.7 5.0 2.3 -3.3 -2.8 7.2 4.5 0.2 3.3 -0.3 -1.6 2.3 2.9 1.6 4.8 3.4 3.7 5.2 3.9 6.1
340 Table 13: ETEBA, Investment Bank, ETBA Profitability Ratios ETEBA Investme ETEBA Investme Net nt Bank Return nt Bank ETBA ETEBA Investme Interest Net ETBA Net on Total Return Return Return nt Bank ETBA Margin Interest Interest Assets on Total on Total on Equity Return Return Margin Margin (ROTA) Assets Assets (ROE) on Equity on Equity YEAR (NIM) 1963 0.05 -0.06 -0.07 1964 0.97 0.04 0.02 -0.01 0.02 -0.02 0.01 1965 0.34 0.06 0.01 0.02 0.02 0.03 1966 0.13 0.06 0.03 0.03 0.05 0.04 1967 0.08 0.05 0.04 0.04 0.04 0.03 0.06 0.02 0.04 1968 0.07 0.06 0.05 0.05 0.03 0.03 0.04 0.03 0.05 1969 0.05 0.05 0.00 0.05 0.03 0.04 0.07 1970 0.03 0.05 0.04 0.05 0.05 0.04 0.12 0.04 0.08 1971 0.03 0.03 0.04 0.05 0.06 0.03 0.14 0.01 0.12 1972 0.03 0.02 0.03 0.06 0.06 0.03 0.15 0.01 0.13 1973 0.03 0.02 0.03 0.07 0.07 0.08 0.09 0.00 0.10 1974 0.03 0.03 0.03 0.07 0.08 0.03 0.14 0.00 0.11 1975 0.04 0.09 0.08 0.06 0.08 0.16 1976 0.03 0.03 0.04 0.08 0.08 0.04 0.04 0.01 0.14 1977 0.03 0.02 0.02 0.08 0.08 0.05 0.00 0.00 0.12 1978 0.04 0.03 0.03 0.09 0.07 0.05 0.00 0.01 0.13 1979 0.05 0.04 0.03 0.09 0.10 0.07 0.05 0.01 0.14 1980 0.06 0.04 0.04 0.10 0.14 0.08 0.11 0.02 0.17 1981 0.06 0.03 0.02 0.12 0.14 0.09 0.01 0.01 0.13 1982 0.06 0.03 0.02 0.11 0.13 0.09 0.02 0.01 0.20 1983 0.08 0.04 0.03 0.13 0.13 0.09 0.03 0.01 0.16 1984 0.08 0.04 0.03 0.13 0.14 0.09 0.04 0.01 0.11 1985 0.07 0.03 0.03 0.13 0.14 0.11 -0.01 0.01 0.08 1986 0.05 0.00 0.02 0.13 0.11 0.09 -0.24 0.00 0.10 1987 0.04 0.03 0.02 0.15 0.14 0.11 0.01 0.00 0.08 1988 0.04 0.03 0.04 0.15 0.13 0.10 -0.15 0.00 0.08 1989 0.04 0.04 0.03 0.15 0.17 0.10 0.01 0.00 0.13 1990 0.10 0.07 -0.02 0.17 0.20 0.08 -0.49 -0.43 0.20 1991 0.11 0.00 -0.07 0.21 0.42 0.09 -3.67 -0.69 0.10 1992 0.10 -0.04 -0.08 0.21 0.35 0.07 1.47 -0.50 0.17 1993 0.11 -0.09 0.22 0.03 -0.88 0.18 1994 0.17 -0.06 -1.71 0.18 1995 0.15 -0.03 -0.41 0.22 1996 0.15 0.04 -1.60 -1.21 0.16 1997 0.10 0.05 -1.31 -1.93 0.35 1998 0.06 0.08 0.04 0.43 1999 0.02 0.08 0.10 0.28 2000 0.04 0.11 0.08 0.31 2001 0.06 0.06 -0.01 2002 0.04 0.04
341
Table 14: ETEBA, Investment Bank, ETBA Solvency Ratios ETEBA Loss Ratio (LR) 0.00 0.00 0.02 0.03 0.05 0.04 0.04 0.04 0.04 0.04 0.04 0.05 0.05 0.04 0.05 0.06 0.07 0.07 0.08 0.09 0.10 0.11 0.12 0.12 0.11 0.12 0.17 0.15 0.17 0.14 0.02 0.02 0.02 0.01 0.01 0.01 0.01 0.01
Investm ETEBA ent Investm Average Bank ETBA ETEBA ent Bank ETBA Cost of Loss Loss Leverag Leverag Leverag Debt Ratio Ratio e (DE) e e (ACD) 0.00 0.05 0.00 0.00 0.16 0.07 0.00 0.01 0.59 0.13 0.04 0.07 0.00 0.55 1.05 0.16 0.03 0.06 0.00 1.17 1.59 0.24 0.05 0.06 0.01 1.55 1.97 0.30 0.05 0.05 0.02 2.83 2.85 0.52 0.05 0.04 0.03 4.92 4.10 0.82 0.05 0.06 0.03 7.25 7.09 1.24 0.05 0.05 0.03 6.08 9.41 1.64 0.06 0.05 0.03 7.14 6.85 0.00 0.06 0.06 0.03 8.73 6.73 1.86 0.06 0.07 8.06 1.84 0.07 0.07 0.05 8.44 7.17 2.12 0.07 0.07 0.05 6.92 7.36 2.24 0.08 0.06 0.06 6.51 9.40 2.70 0.08 0.06 0.07 7.52 10.91 2.95 0.08 0.06 0.07 5.40 11.38 3.53 0.10 0.05 0.08 6.01 8.12 4.19 0.11 0.04 0.09 5.81 8.45 4.64 0.11 0.04 0.09 6.17 10.58 5.76 0.12 0.04 0.09 6.40 11.81 6.59 0.13 0.04 0.09 7.06 13.26 6.82 0.13 0.03 0.07 8.54 9.84 6.20 0.13 0.01 0.06 8.35 10.21 6.33 0.16 0.01 0.06 6.76 10.62 6.70 0.16 0.01 0.06 5.78 7.53 7.94 0.16 0.03 0.11 3.27 11.14 8.55 0.18 0.03 0.11 3.26 63.14 9.52 0.22 0.05 0.03 3.32 -17.34 6.52 0.24 0.00 2.71 6.15 0.25 0.01 0.01 0.03 0.01 0.03 0.01 0.03 0.02 0.01 0.01 0.01
Investme nt Bank ETBA Average Average Cost of Cost of Debt Debt YEAR 0.04 1963 0.02 1964 0.01 1965 0.01 1966 0.03 0.04 1967 0.03 0.04 1968 0.03 1969 0.04 0.04 1970 0.05 0.04 1971 0.05 0.05 1972 0.07 1973 0.07 0.05 1974 0.06 1975 0.08 0.06 1976 0.09 0.06 1977 0.08 0.06 1978 0.10 0.09 1979 0.14 0.09 1980 0.15 0.11 1981 0.14 0.11 1982 0.13 0.10 1983 0.15 0.11 1984 0.15 0.12 1985 0.14 0.10 1986 0.15 0.13 1987 0.15 0.11 1988 0.19 0.11 1989 0.26 0.14 1990 0.48 0.17 1991 0.41 0.16 1992 0.18 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
342
YEAR 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Table 15: ETEBA, Investment Bank, ETBA Profitability and Expenses Ratios ETEBA Investme ETEBA Investme Return nt Bank ETBA Operatin nt Bank ETBA on Return Return g Operatin Operatin Earning on on Expenses g g Assets Earning Earning Ratio expences Expences (ROEA) Assets Assets (OER) ratio Ratio -0.31 0.09 0.09 -0.02 0.04 0.02 0.04 0.02 0.04 0.01 0.04 0.03 0.01 0.01 0.06 0.04 0.03 0.01 0.00 0.01 0.06 0.04 0.03 0.01 0.01 0.01 0.05 0.04 0.01 0.01 0.05 0.05 0.04 0.00 0.00 0.01 0.06 0.06 0.03 0.00 0.00 0.01 0.06 0.07 0.03 0.00 0.00 0.01 0.07 0.07 0.03 0.00 0.00 0.07 0.08 0.04 0.00 0.00 0.08 0.06 0.00 0.01 0.08 0.07 0.04 0.01 0.00 0.01 0.09 0.07 0.05 0.01 0.00 0.01 0.09 0.07 0.05 0.01 0.01 0.01 0.09 0.10 0.07 0.01 0.00 0.01 0.11 0.13 0.08 0.01 0.01 0.01 0.13 0.13 0.11 0.01 0.01 0.01 0.13 0.12 0.11 0.01 0.01 0.01 0.16 0.13 0.11 0.01 0.01 0.01 0.17 0.13 0.13 0.01 0.01 0.01 0.19 0.13 0.15 0.01 0.01 0.01 0.20 0.11 0.14 0.01 0.01 0.01 0.20 0.13 0.14 0.01 0.01 0.01 0.18 0.12 0.12 0.01 0.01 0.01 0.17 0.16 0.12 0.01 0.02 0.01 0.19 0.18 0.10 0.01 0.02 0.01 0.22 0.39 0.11 0.01 0.04 0.01 0.25 0.38 0.41 0.01 0.05 0.03 0.27 0.07 0.01 0.01 0.33 0.09 0.03 0.00 0.22 0.11 0.03 0.01 0.14 1.46 -0.01 0.03 0.07 0.02 0.11 0.52 -0.17 0.02 0.06 0.01 0.15 0.08 0.01 0.02 0.14 0.12 0.01 0.01 0.17 0.10 0.01 0.01 0.09 0.04 0.01 0.01 0.06 0.01
343
ETEBA Net Profit Margin (NPM)
0.00 0.01 0.01 0.00 0.01 0.01 0.01 0.01 0.01 0.00 0.00 0.01 0.01 0.01 0.01 0.02 0.01 0.02 0.04 0.05 0.05 0.07 0.04 0.02 0.02 0.01 0.00 0.02 0.02
Table 16: ETEBA, Investment Bank, ETBA Gross and Net Profit Margins ETEBA Investme Investme Gross nt Bank ETBA nt Bank ETBA Net Profit Gross Gross Net Profit Profit Margin Profit Profit Margin Margin (GPM) Margin Margin -0.34 -0.25 -0.04 -0.02 0.01 0.04 0.02 0.02 0.02 0.03 -0.01 0.01 -0.01 0.02 0.02 0.00 0.00 -0.01 0.01 0.01 0.01 0.01 0.01 0.00 0.02 0.00 0.01 0.02 -0.01 0.02 -0.01 0.01 0.02 -0.01 0.01 -0.01 0.01 0.01 0.00 0.01 0.01 0.01 -0.02 0.01 0.01 0.01 0.00 0.01 -0.01 -0.01 -0.02 0.02 -0.01 -0.01 -0.02 -0.02 0.02 -0.01 -0.01 -0.01 -0.02 0.01 0.00 -0.01 -0.01 -0.02 0.01 0.00 0.00 -0.01 -0.01 0.02 -0.01 0.00 -0.03 -0.01 0.03 -0.02 0.01 -0.02 0.00 0.03 -0.01 0.02 -0.01 0.00 0.05 0.00 0.03 -0.01 0.02 0.06 0.00 0.04 -0.02 0.03 0.06 -0.01 0.05 -0.03 0.04 0.08 -0.02 0.02 -0.02 0.01 0.05 -0.01 0.01 -0.03 0.01 0.03 -0.02 0.02 -0.03 0.01 0.03 -0.02 -0.03 -0.08 -0.04 0.02 -0.06 -0.05 -0.09 -0.06 0.01 -0.05 0.27 -0.03 0.25 0.03 0.02 -0.10 -0.11 0.03
YEAR 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
344
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