Challenges posed by underdeveloped financial markets and instruments

Challenges posed by underdeveloped financial markets and instruments Kevin Davis Professor of Finance, University of Melbourne Research Director, Australian Centre for Financial Studies (and Professor, Monash University) University of Melbourne 1

Outline • • Finance and Growth – the relationship Finance – channels of influence Impediments to financial development Policy Options University of Melbourne 2

Financial Development and Economic Growth • Research indicates financial development causes faster economic growth – Although economic development also stimulates financial sector growth University of Melbourne 3

Financial Sector Functions Market frictions • Information costs • Transactions costs Financial markets and Intermediaries Financial Functions • Mobilise savings • • Allocate resources • • Exert corporate control • Facilitate risk management • Ease trading of goods, services, contracts Channels to growth Growth Capital accumulation Technological innovation Source: Adapted from Levine (1997) University of Melbourne 4

Functions of the Financial Sector • Mobilize and pool savings for investment • Ease the exchange of goods and services • Create liquidity – reconciling long term needs of users with short term preferences of savers • Facilitate risk management – across participants and across time • Create price signals and information to guide decisions on capital allocation • Monitoring / disciplining recipients of funds to ensure efficient and proper use of funds University of Melbourne 5

Long run consequences: Finance and Growth 500 450 400 350 300 250 200 150 100 50 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 GDP (2% growth) GDP (5% growth) Cons (2% growth) Cons (5% growth) • Improved finance sector can increase growth through • productivity growth by better allocation of funds • encourage savings and investment • (example shows effect of higher investment rate and productivity) University of Melbourne 6

Impediments to Financial Development • Look at impediments to overcoming information and transactions (including contracting) costs. Market frictions • Information costs • Transactions costs Financial markets and Intermediaries Financial Functions • Mobilise savings • • Allocate resources • • Exert corporate control • Facilitate risk management • Ease trading of goods, services, contracts Channels to growth Growth Capital accumulation Technological innovation University of Melbourne 7

Impediments to Financial Development • Legal Systems – Property rights and certainty of contract – Access to courts and redress • Information, Education, Financial Inclusion • Accounting / Auditing and information reliability • Economic Stability – Redistributive effect of unexpected inflation • & contracting problems when high inflation – Macroeconomic fluctuations and default risks • Financial Institution Safety / Prudential Regulation • Regulation and Vested Interests University of Melbourne 8

Regulatory Impediments • Example: interest rate ceilings – Imposed to “protect” borrowers – Consequences: • less funds available for borrowers • Poorer borrowers rationed out • Social loss Interest rate Supply Ceiling Demand Loans Lost opportunities University of Melbourne 9

Regulatory Impediments • Example: Capital account restrictions – Consequences: • less funds available for borrowers – At higher interest rate • Social loss from foregone profitable investments Interest rate Domestic Supply rd “world” Interest rate rw Domestic Demand Loans Lost opportunities University of Melbourne 10

Vested Interests Marginal Cost = Monopoly Supply • Financial system evolution Interest rate shaped by influence of existing vested interests Average rm • Example: existing Cost = monopolies lose profits if rc Competitive Supply competition allowed – Lobby to influence legislators and protect Demand position – Social loss – in addition Loans Lost opportunities to redistributive effects University of Melbourne 11

Retirement Financing Challenges or As economies become wealthier, family sizes shrink And mortality improvements mean larger share of aged University of Melbourne 12

Retirement Financing Challenges or • Less reliance on family support for aged • Need for retirement savings – but individuals generally don’t! • Increased call on government safety nets / pensions • when aged dependents / working age population falling • Rationale for tax incentives/compulsion/defaults for long term retirement income saving • Higher saving generates a pool of investable funds • Potentially available for longer term investments University of Melbourne 13

The Importance of Financial Consumer Protection • Economic development generates increasing household involvement with the financial sector • Financial development leads to increasing complexity of financial products and services • Financial literacy is generally low • Opportunities for miss-selling, overcharging are significant, particularly given individuals’ gullibility and greed University of Melbourne 14

Gullibility and Greed A fundamental challenge of Financial Consumer Protection - Protecting individuals from themselves - As well as from others! If it’s too good to be true it probably is! Fools and their money are easily parted University of Melbourne 15

The Importance of Financial Consumer Protection • Economic development generates increasing household involvement with the financial sector • Financial development leads to increasing complexity of financial products and services • Financial literacy is generally low • Opportunities for miss-selling, overcharging are significant, particularly given individuals’ gullibility and greed • Some providers of financial products, services, and advice may have questionable ethics, governance, incentives • Financial failures, scams, consumer losses reduce confidence and cause sub-optimal use of the financial sector University of Melbourne 16

G 20 Financial Consumer Protection Principles 1 Legal, Regulatory & Supervisory Framework 2 Role of Oversight Bodies 3 Equitable, Fair Treatment of Consumers 4 Disclosure and Transparency 5 Financial Education and Awareness 6 Responsible Business Conduct of Providers and Agents 7 Protection of Consumer assets against Fraud and Misuse 8 Protection of Consumer Data and Privacy 9 Complaints Handling and Redress 10 Competition The World Bank Good Practices for Financial Consumer Protection (2012) provides guidance on practices at a sectoral level Source: OECD University of Melbourne 17

FCP Policy Underpinnings • The legal/regulatory framework is crucial – When can redress be sought? • Strict “terms and conditions” v “reasonable expectations” • Abusive practices definitions • Duty of care – How can redress be sought? • Individual legal action • Class actions (and litigation funders) • Legislated dispute resolution schemes • Government agency (enforcement) role University of Melbourne 18

Financial Development Opportunities • Technological advance is changing (reducing) information and transaction costs – Past financial development patterns may be less relevant – Threats to existing business models • Electronic finance not without its problems – Cyber-crime; potential instabilities University of Melbourne 19

Financial Development Opportunities • Some potential areas of focus – Micro-finance: social networks and incentives – Electronic payments: SMEs and financial inclusion – Information sharing: credit bureaus – Retirement savings programs University of Melbourne 20

Conclusions and Cautions • Government policies for financial development – Need for good “financial infrastructure” • Law, politics, stability, financial system – One size does not fit all • Need to take account of existing social and economic structure / constraints – Need to recognise individuals have behavioural biases – Promoting competition is important • But market imperfections are substantial – Financial stability is not guaranteed • Sound regulation / supervision essential University of Melbourne 21

Thank You Questions? University of Melbourne 22