On the (de)merits of small banks in developing countries | FT Alphaville

On the (de)merits of small banks in developing countries

Over at the Economist’s Free exchange blog, a handful of top-flight economists (as one would expect) have been engaged in a lively debate on the optimal size and complexity of developing countries’ financial systems.

Mark Thoma has been keeping track of the roundtable, which is hosted by Justin Lin, the chief economist at the World Bank and which kicked off with a guest essay by Lin in the print edition of the Economist and migrated online. [As an aside, clever integration there guys]

The roundtable has featured commentary from Tyler Cowen (he of Marginal Revolution), MIT economics professor Abhijit Banerjee  and Thoma himself, among others. In his opening salvo, Lin argued that low-income countries “need to make small, local banks the mainstay of their financial systems” (emphasis ours):

The size and sophistication of financial institutions and markets in the developed world are not appropriate in low-income markets. Small local banks are the best entities for providing financial services to the enterprises and households that are most important in terms of comparative advantage-be they asparagus farmers in Peru, cut-flower companies in Kenya or garment factories in Bangladesh.

The experiences of countries such as Japan, South Korea and China are telling. Those countries managed to avoid financial crises for long stretches of their development as they evolved from low-income to middle- and high-income countries. It helped greatly that they adhered to simple banking systems (rather than rushing to develop their stockmarkets and integrate into international financial networks) and did not liberalise their capital accounts until they became more advanced.

In short, small is beautiful – particularly in those economies which are further down on the developmental scale. Lin also makes an interesting point about the legacy of ‘colonial’ banks:

In Africa and other parts of the developing world, relatively large foreign banks that were set up in the colonial era have long played a role. But these institutions tend to serve relatively wealthy customers. Smaller domestic banks are much better suited to providing finance to the small businesses that dominate the manufacturing, farming and services sectors in developing countries. There is evidence to suggest that growth is faster in countries where these kinds of banks have larger market shares, in part because of improved financing for just these kind of enterprises.

As one would expect, not everyone agreed. Asim Khwaja, associate professor of public policy at Harvard’s Kennedy School of Government, urged caution before jumping on the “small is beautiful” bandwagon:

Financial intermediation is difficult because of challenges it poses in screening (identifying good borrowers) and monitoring/enforcement (ensuring that they can and should repay). To the extent that smaller banks can perform these roles more effectively, particularly for smaller borrowers, then indeed small is beautiful. But this is by no means obvious.

Theoretically, arguments have been made that smaller lenders may be more responsive to “soft”/localized information since they have fewer (vertical) hierarchies. Yet it is not clear why large banks can’t also have more decentralization decision making. After all, even the strongest proponents of decentralization reforms would unlikely argue that countries should be split up into mini-nations. Empirically, while there is some evidence that small/domestic banks have more smaller/local (profitable) clients or, as Justin mentions, growth is higher in countries with a greater share of small banks, neither evidence is entirely convincing. Small/domestic banks may have more small clients simply because they have no choice but to do so as larger banks “cream-skim” the readily identified good borrowers i.e. the large, established firms. If so, the counterfactual of having fewer large banks may not be more lending to smaller borrowers, but that some of the (better) smaller banks will now also cream-skim. Similarly, higher growth countries may create room for more (smaller) banks and thus it is growth that produces an increase in the small bank share and not vice versa.

Cowen was torn between extremes, a state he blamed on Lin’s “bureaucratese”:

I CAN’T decide whether I agree with everything in this essay or disagree with everything in this essay.

I see Mr Lin using the words “should”, “need to”, and phrases like “what matter most” or “not the way to go”. But who or what is the active agent here? The country’s home government? The World Bank? When it comes to all these banking systems, are we simply rooting for particular paths and outcomes-such as small and simple banks-or is Mr Lin making policy recommendations about how to get there? We never know.

We can all agree that smaller countries and developing countries should eschew the notion of using government to subsidise big banks or equities trading. That’s putting the cart before the horse, as Mr Lin explains very well. But what if those institutions start to arise naturally, from market forces, as indeed they will at some point? Should they be discouraged or shut down or somehow taxed at disproportionate rates? I searched his essay in vain for an answer or even a hint regarding this question.

Cowen ultimately dismissed Lin’s essay as “sound, but non-committal”. In contrast, Luigi Zingales, professor of entrepreneurship and finance at the Chicago Booth Graduate School of Business, praised Lin “for his position in favor of a more fragmented and competitive banking sector” – even as he disagreed with him on everything else:

It is not true, however, that developing countries could not benefit from a stock market. When Germany and Japan were developing in the late 19th and beginning of the 20th century, they relied heavily on public securities issuance. But their institutional development was more advanced. Thus, I agree that in most developing countries today the goal should not be to push for an immediate development of stock markets, but it should not be to ignore their future development, either.

I disagree with Dr Lin’s overreliance on microfinance. Microfinance is a great instrument to alleviate the most severe needs, but it is an unproven one to promote development. Even in developing countries it is not easy to build valuable businesses with $100 loans. To get the engine of growth in motion we need more capital deployed and there are very few substitutes for good traditional banking.

Thoma, for his part, thought small was good, but insufficient:

But while small and simple banks can help to overcome many problems, by themselves they may not be enough fully serve the financial needs within developing countries.

The entire series of posts is available at the Lin Roundtable, and the debate is ongoing. As yet no sign of Martin Wolf, however.

Related links:
Big institutions learn to think small – FT
A once-in-a-lifetime opportunity has come to sustainable banking” – FT