Since the global financial crisis, “banking” has practically become a swear word, but while banks undoubtedly have the capacity to inflict serious damage on economies and livelihoods, a well-run financial system can offer significant benefits. A growing body of evidence, highlighted in the World Bank Group’s recent Global Financial Development Report, shows that financial institutions and markets have a profound influence on economic development, poverty alleviation, the stability of economies worldwide and that a pragmatic assessment of the state’s role in finance is warranted.
On the surface, the most unusual feature of the ongoing financial crisis is that developed economies have been affected much more strongly and directly than developing economies, many of which have learned from previous crises and put their fiscal houses in order, made progress on structural reforms and improved supervision and regulation.
But this distinction misses the key point: The quality of policy matters much more than the level of economic development. Some financial systems in developed economies — for example, in Australia, Canada, and Singapore — have shown remarkable resilience, while others have got into trouble.
The focus on financial reform in developed economies, while warranted, has contributed to complacency in developing economies. For example, many are facing their own version of the “too big to fail” problem — which the crisis reinforced — yet have done little to address it.
Measures taken during the crisis may have helped to mitigate financial contagion, but some do not support robust long-term development of the sector. Many developing economies weathered the crisis at the cost of massive direct state intervention, while their financial sectors lack breadth and access.
The financial crisis has had a particularly profound impact on the supply of finance at longer maturities. To some extent, this is understandable, given the focus on short-term liquidity and capital flows. But the sharply decreased availability of longer-term funding is heightening financial-sector vulnerabilities.
While developing economies’ share of the global economy has risen from roughly one-third to one-half over the last decade, developed economies continue to dominate the supply of long-term funding. The mismatch between the time horizon of available funding and that of investors and entrepreneurs, particularly those in developing economies, is a source of vulnerability that acts as an impediment to growth.
Several factors have diminished investors’ willingness to extend long-term credit. The financial crisis reduced private financiers’ risk appetite, making long-term exposures unappealing.
Net private capital flows, particularly to developing economies, have become more volatile.
Private capital, which accounts for more than 90 percent of capital flows to developing economies, will remain the dominant source of long-term financing. But, the availability of long-term capital appears to have been impaired, as traditional providers of equity to infrastructure projects have become less able or willing to invest. Financing from banks has also been constrained owing to deleveraging, particularly by European banks.
The new Basel III package of global banking reforms could increase funding costs further for some borrowers, while reducing the availability of finance, especially for longer-term debt.