german working papers in law and economics · [email protected],edu ∗∗ institute of law and...

German Working Papers in Lawand Economics

Volume Paper

Law and the Poverty of Nations - GivingCredit to Credit

Robert D. Cooter Hans-Bernd SchaferLaw School, UC Berkeley University of Hamburg, Germany

Abstract

Copyright c©2007 by the authors.http://www.bepress.com/gwp

All rights reserved.

Law and the Poverty of Nations

Robert D. Cooter∗

and

Hans-Bernd Schäfer∗∗

Chapter 5: Giving Credit to Credit – Banking and Securities

1st draft

∗ Simon Hall School of Law, Boalt Hall, University of California, Berkeley, CA 94720, USA. [email protected],edu ∗∗ Institute of Law and Economics, University of Hamburg, Rothenbaumchaussee 36, 20148 Hamburg, Germany. [email protected]

1Cooter and Schäfer: Law and the Poverty of Nations - Chapter 5

Produced by bepress.com, 2011

Chapter 5. Banking and Securities -page 2-

2

In Afghanistan the wives of Pashtu herdsmen traditionally wear heavy silver

bracelets to show off their beauty and to store the family’s savings. Robbing a

woman provokes clan revenge feared by thieves, so women are good protectors of

wealth. In India, in contrast, poor people developed another way to store wealth. A

small group of friends, say twelve of them, meet in January, each one contributes

$10 into a pool and gets a chit, one chit is drawn at random, and the winner gets

$120. The winner uses the money for a relatively large purchase – a bicycle for

commuting, seed for planting, a refrigerator, a television, or a wedding. In February

the twelve people repeat this process: each pays $10 into the monthly pool and a

person chosen at random wins $120. January’s winner, however, is ineligible for the

draw in February or any subsequent month. The process repeats itself each month

until December, so everyone wins $120 exactly once.

How do silver bracelets and chits differ? The silver bracelet does not produce

anything. The Pashtu herdsman resembles an Indonesian merchant who buries gold

under the floor or a South American subsistence farmer who stores crops in his

house until he eats them. By contrast, the chit fund creates something, namely

“credit,” just like a commercial bank, mutual fund, investment bank, dealer in stocks

and bonds, or other financial intermediary. With the chit fund, eleven lucky people

get $120 in less than a year and one unlucky person gets $120 at the year’s end. In

contrast, if each individual saved $10 each month for twelve months, then each of

them would have $120 at the year’s end. By advancing access to $120, the chit fund

makes eleven people better off and one person no worse off (a “Pareto improvement”

in economic jargon). Capital in bracelets is economically dead whereas capital in the

chit fund is economically alive.

Why do Pashtu herdsmen store wealth rather than investing in something

productive like a chit fund or a financial instrument? The chit fund involves the risk

that someone in the group who wins the pot will stop paying the monthly fee of $10.

The Pashtu herdsman apparently does not want to risk loaning to someone else.

Credit always involves a promise of future payments and the risk of non-payment.

When property protection is uncertain and promises are not enforced, savings flow to

the best protector and much capital remains as dead as a silver bracelet. Conversely,

when property protection is certain and promises are enforced, savings flow to

borrowers who can good use of the money as in a chit fund.

2 German Working Papers in Law and Economics Vol. 2007, Paper 14

http://www.bepress.com/gwp/default/vol2007/iss2/art14

Law and the Poverty of Nations -page 3-

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The twelve friends who form the chit fund can pressure each other to make

their monthly payments. By personal relationships and group responsibility, the chit

fund overcomes the problem of “deadbeats” - people who do not repay debts. In

terms of Chapter 1, the chit fund is a form of “relational finance” based mostly on

informal social norms. Like chit funds, commercial banks, investment banks, and

other financial intermediaries create credit and channel savings to good uses. These

organizations, however, are forms of “private finance” and “public finance” based on

formal state law as well as social norms. This chapter concerns the informal and

formal legal foundations for financial intermediaries from chit funds to global banks.

Chapter 1 explained that economic innovation must overcome a double-trust

problem in order to unite ideas and capital. This chapter explains how financial

intermediaries confront and solve it. The property principle for growth and the

contracts principle, which the two preceding chapters explained, have their most

important application in finance. Finance does not just move paper money around in

obscure ways that ordinary people resent. Rather, finance is the foundation of

innovation and sustained economic growth. In this chapter we give credit to credit.

I. Lending to the Poor: Relational Banking

More than 20% of the people in poor countries live from less than a $1 per day

and more than 50% live from less than $2 dollars per day.1 If these people had

capital, some of them would invest in agriculture, small business, or education, where

the rate of return is high.2 For example, the private rate of return for investment in

schooling is higher in poorer countries than in richer countries or the stock market.3

People with little capital can ideally finance profitable investments by borrowing. The

1 World Bank, World Development Indicators, 1005, Table 2.5. 2 Empirical evidence on the rate of return for credits given to the poor is still scanty, but shows high average rates. A field survey based on 133 credits to small peasants in the Philippines found an average rate of return of 117 percent. Financing of mobile phones yields a very high return. See Hossain, M. and C.P. Diaz (1999). Reaching the Poor with Effective Microcredit: Evaluation of a Grameen Bank Replication in the Phillipines, International workshop on Assessing the Impact of Agricultural Research on Poverty Alleviation. International Center for Tropical Agriculture, CIAT, Cali, Columbia. 3 Note that the social rate of return on investment in education is somewhat lower than the private rate of return. Apart from education, intelligence increases productivity and commands a wage premium. A school certificate allows the graduate to “signal” that he is intelligent. Even if education does not increase productivity (no social return), schooling that signals intelligence commands a wage premium (private return).




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poorest people, however, cannot borrow from a bank because they have no regular

income and they own nothing to pledge as security.4 Between 65 and 85 percent of

Latin America’s people are outside the banking sector and have no access to credit.

Like chit funds in India, organizations in many poor countries solve the

problem of loaning to the poor by personal relationships and group responsibility.6

Personal relationships improve credit evaluations, so deadbeats never get loans.

Group responsibility improves debt collection by relying on social pressures rather

than on state courts. As a result, chit funds, cooperative banks, and similar

organizations that rely on group responsibility create credit for the poor more

efficiently than banks in some circumstances. These organizations played an

important historical role in rich countries and they continue to play that role in poor

countries, as we will explain.

A. Chit Funds Evolve In the preceding example of a chit fund, the monthly winner is chosen at

random. As chit funds developed, some of them changed the way to pick the winner.

Instead of a random draw, some chit funds auction the pot. To illustrate, if the pot is

$120 in January, members can bid to for it by offering to take less than $120. The

member who offers to take the least from the pot wins it. The winner in January

might offer to take $108, in which case $12 remains. The $12 can be divided among

the members with each receiving $1, like interest on a loan. With chit fund winners

chosen by auction, some members join primarily to become borrowers and bid for the

pot, while other members join primarily to become lenders and receive interest.7

Chit funds have increasingly stretched beyond close friends to encompass

more people, which creates more credit. If 24 people paid $10 per month to

participate in a 24 month chit fund, then 23 people would each get $240 in less than

2 years and 1 person would get $240 at the end of 2 years. Thus 23 out of 24 people

could buy something substantial sooner rather than each one saving for 2 years. 4 “Money, says the proverb, makes money. When you have got a little, it is often easy to get more. The problem is to get that little” Smith, A. (1776). The Wealth of Nations, reprinted 1983, p.195 6 A general name for these organizations is “rotating savings and credit associations” or “roscas.” 7 India’s Chit Fund Act of 1982 set a limit of 30% on the amount that could be bid for the pot. This is the equivalent of a maximum amount of interest on a loan (“prohibition of usury”). See Eeckhout, J. and K. Munshi (2002). Institutional Change in the Non-Market Economy: Endogenous Matching in Chennai's Chit Fund Auctions, Working Paper, University Pennsylvania, Department of Economics.




5

Many people, however, do not have 24 relatives and close friends willing to

participate in a chit fund. To reach this scale, they must deal with acquaintances, so

the danger increases that someone will refuse to make his monthly payments. To

solve this problem, people form something resembling a club whose members screen

applicants for trustworthiness before allowing them to join. The club may hire a

professional to organize and operate the chit fund in exchange for a commission. In

this way, the chit fund reaches beyond relatives and close friends.

The evolution of chit funds did not stop at this point. Companies that organize

chit funds have become so large that they resemble commercial banks. Chit funds

are used to buy cars and houses. A large company offers different chit funds with

different terms, determines credit-worthiness of applicants, charges a commission,

and assumes responsibility for non-paying members.

According to our theory in Chapter 1, the three stages of finance in Silicon

Valley are relational, private, and public. The movement from friends to clubs

represents the transition in chit funds from relational to private finance. The

movement from club to competitive market represents the transition from private to

public finance. As in Silicon Valley, all three types of chit funds depicted in Figure 5.3

co-exist as living parts of India’s credit system.

Chit funds developed spontaneously without state approval, encouragement,

or subsidies. Social norms originally controlled them, without state law. This

Figure 5.3. Evolution of Chit Funds

Friends

Club

Market




6

evolution illustrates a process that we call “market modernization”: The legal system

modernizes itself by following business practice, not by leading it.8 Specifically, chit

funds developed first and then laws regulated them. The laws ideally improve chit

funds by increasing the trust that consumers have in them. The polar opposite of

market modernization is legal centrism: Laws are made from the top down, in the

same way that central planning controls production.

Legal centrists sought to modernize India’s commercial banks by

nationalization and heavily regulation, which drove users out of banks and caused a

surge in the activities of non-bank financial institutions like chit funds. In recent years,

however, the reversal of these policies has shifted activity back from non-banks to

banks. But India’s banks continue to suffer from bureaucratic sclerosis and political

intrusion, which increases the space for chit funds. Chit funds lend to people who

cannot borrow from banks, charge lower interest to borrowers, and pay higher

interest to depositors than state banks.9 In 2005 non-banking financial institutions

counted for 6.5 percent of total assets in the financial sector, which is a lot of

activity.10 And this number only counts registered chit funds. India has created a

registration process and imposed minimal regulations on the activities of chit funds,

allegedly to curb abuse and fraud. But chit funds in the informal economy, which

especially serve the poorest people, are unregistered, unknown in numbers, and

uncontrolled by state law.

Much like chit funds, small cooperative banks developed in 19th century

Europe to pool funds, finance development, and share responsibility. On of the most

successful was the Raiffeisen Bank in Germany in the late 19th century and early 20th

century. Friedrich Wilhelm Raiffeisen was a conservative catholic who gave up his

military career for health reasons and eventually became the mayor of several

villages in Prussia. In the winter of 1846-47 a famine struck the village of

Weyerbusch where he was in charge. Raiffeisen founded a bread cooperative

8 See Cooter, R. (1996), The Theory of Market Modernization of Law, International Review of Law and Economics. 16: 141-172; a version of this paper was reprinted as Market Modernization of Law: Economic Development Through Decentralized Law with a comment by W. Kovacic (1997), in: Jagdeep S. Bhandari, Alan O. Sykes and (eds.), Economic Dimensions in International Law. Cambridge: Cambridge University Press: 275-317; 317-323. 9 Other advantages over banks are that people enjoy the element of gambling, and chit funds in the informal sector have more ability to avoid taxes. 10 Reserve Bank of India (2005) Non Banking Financial Institutions, Part 1, www.rbi.org.in/scripts/PublicationsView




7

funded with money from a charity. The members of the cooperative built a bakery

and received credit from the cooperative to buy bread.

Later he transformed this organization into a cooperative bank, which became

a runaway success in rural Germany. It grew into a network of affiliated banks, many

of which still exist today. Here is how it worked. Each Raiffeisen bank was organized

as a cooperative in which old members nominated and screened new members. The

members bought shares in the bank, made a deposit, and then they were entitled to

borrow. Friends and relatives co-signed loans for individual borrowers. All of the co-

signers were responsible to the cooperative for repaying the loan (“sureties”).

Collective responsibility for debts and shared profits made every member interested

in admitting only reliable members, and the members monitored loan-making and

debt-collection.11 The central Raiffeisen bank pooled funds of the member banks,

served as lender of last resort, and supplied an outside professional to supervise and

audit the member banks.

The Raiffeisen banks needed legal innovations to succeed. The system

began as charitable relief of the poor by the rich. The first innovation allowed these

charities to accept deposits and lend money against interest to poor people. This

innovation shifted activity from charity to commercial lending. Originally each of the

members was liable for the debts of the whole cooperative. In technical terms,

cooperative banks were joint stock companies with unlimited joint and several liability

of the members. The second innovation replaced group liability for everything with a

new rule limiting each member’s liability to a multiple of his share value. Thus a

member’s liability depended on how much he invested in the bank, not on the total

amount of his wealth. Limited liability triggered explosive growth of Raiffeisen banks

in Germany. Numbering several hundred in 1885, they grew to 14,500 in 1910.

They helped to finance many agricultural improvements, and they replaced village

moneylenders.

In Germany, Raiffeisen banks succeeded in villages and rural areas where

enduring relationships made collective responsibility feasible, and they mostly failed

in larger towns where people have more anonymity and mobility. Raiffeisen banks

were transplanted to Holland, the Austrian-Hungarian Empire, Switzerland, and Italy,

11 Hollis, A. and A. Sweetman (1989). Microcredit, What Can We Learn from the Past, World Development. 26 (10): 1875-91




8

but they failed in Ireland and India in the early 1900s.12 In the 1960s and 1970s,

development agencies tried to transplant cooperative banking to developing

countries, but they mostly failed. Cooperative banks failed due to corruption (big

loans to the families of their managers) and political interference (big loans to

politicians as demanded by regulators). The cooperative banks found in developing

countries today are mostly conduits for charitable and subsidized lending, not self-

sustaining commercial organizations. Many countries have forms of group finance

that we cannot discuss, such as the mutual insurance organizations in Islamic

countries called a "takaful." These organizations originally pooled funds to aid a

member of the group who suffered a calamity.13 Much like mutual insurance

companies that developed from the cooperative movement in the west in the late

19th and early 20th century, takaful currently operate increasingly like for-profit

insurance companies.

As an alternative to cooperative banking, many developing countries have set

up rural development banks run by the state. Commercial banks in India are legally

obliged to channel some of their liquid assets into rural development banks. These

banks give credits to small farmers. Unfortunately, the borrowers often regard the

loans as gifts exchanged for political loyalty. If the borrower defaults, the bank does

not enforce repayment.14 Unlike chit funds or Raiffeisen banks, rural development

banks in most of the world are not commercially viable and their lending is politically

motivated.

Many development experts who favor rural development banks regard

cooperative banking as an outdated model.15 The foundation of cooperation

banking, however, is the same principle that succeeded dramatically in chit funds --

12 Ghatak, M. and T.W. Guinnane (1999). The Economics of Lending with Joint liability: Theory and Practice, Journal of Development Economics. 60 (1):195-2

13 We wish to thank Haider Ala Hamoudi for explaining the takaful to us. He says that the rhetoric of mutual aid continues unabated, although many of these organizations actually function as profit-making institutions. 14 These problems have been extensively discussed in the Narashimham report. This report shows how gradual improvement is possible. It proposes to restrict obligatory lending to rural development banks to a fixed and moderate quota of total saving accounts of commercial banks and to end the political influence to finance sick corporations. 15 We owe this information to Klaus Glaubitt, Director for micro-finance at the Kreditanstalt fuer Wiederaufbau, the German development agency for capital transfers.




9

collective responsibility. Next we turn to another variation on cooperative banking that

has multiplied faster than the rabbit in Australia.

B. The Grameen Bank In 1976 Muhammad Yunus, an economics professor in Bangladesh, went out

of his office into the street and tried to help someone. He began a project that grew

into the Grameen Bank of Bangladesh, which reported in 2006 that it has 6.23 million

borrowers in 2121 branches serving 67,670 villages covering 99.51 percent of the

total villages in Bangladesh.16 His efforts won him the Nobel Peace Prize in 2006.

The Grameen Bank continues to expand geographically (e.g. projects in Bosnia-

Herzegovina) and functionally (e.g. a new program of loans to beggars).

The Grameen (“gram” + the word for “village”) Bank works roughly as follows.

A bank employee, who believes in the Bank’s philosophy, attracts members from

poor people, each of whom buys a share for approximately $2 and receives a loan.

A typical loan might equal $75 and extend for 1 year at 20% interest, with repayment

in weekly installments. The loan might go for fertilizer on a farm or handcraft

materials for a small business. Early in its history, the Grameen Bank found that

women repay debts more reliably than men, so it mostly recruits women as members.

In 2006 the Grameen Bank proclaimed that 97 percent of its borrowers are women.

The members are organized into groups of 5. The bank employee works

intensively with the group to assure prudent use of loans and timely repayment. If

someone in the group fails to repay, the bank will not loan to anyone in the group in

the future. Individuals, however, are not liable for the debts of others. Thus the

Grameen Bank principle is group responsibility and individual liability. The Raiffeisen

bank’s original principle was group responsibility and group liability for everything

(later modified to a multiple of individual liability).

What about commercial versus charitable lending? Chit funds never received

subsidies, so they had to be commercially viable from the beginning. The Raiffeisen

banks began as charities and became commercially viable within 25 years of their

founding. Is the Grameen Bank a charity or commercially viable? A study

16 Grameen Bank of Bangladesh (2006). Report. http://www.grameen-info.org/bank/index.html.




10

commissioned by the Grameen Bank in the late 1980s calculated that its subsidy on

operations was between 39% and 51%.17 A more recent study calculated that, for

the period 1983-1997, the subsidy per dollar-year borrowed was $ 0.22. In recent

years its annual reports claim a modest profit (but not in 1996 when it went bankrupt).

This claim is probably misleading because organizations like the International Fund

for Agricultural Development give it credits at below market rates. Grameen Bank

loans are mostly commercial and partly charitable, or so it appears.

Private commercial banks seldom voluntarily lend to the poor, who cannot

offer collateral, so the state often requires or pressures private banks into making

charitable loans, or the state extends loans directly through state banks. State banks

in India, the rural development banks, are required to make social loans to farmers.

The lucky recipients, who are often selected for their political connections, usually

have no real obligation to repay, so these loans are actually subsidies. Rural

development banks in many countries are plagued with high proportions of overdue

debts, which they roll over. They avoid bankruptcy only because they do not have to

meet commercial accounting standards. A political loan by a state bank is a form of

corruption. Forcing private banks to make charitable loans distracts them from their

core function of commercial banking.

Subsidized lending through organizations like the Grameen Bank is probably a

better way to combat poverty, so long as they continue to benefit poor people at

modest cost.18 However, its philosophy deserves critical scrutiny. According to the

philosophy of micro-finance, the solution to poverty is to turn the poor into micro-

capitalists. The poor in Bangladesh, according to this view, have investment

opportunities and will take advantage of them if they have credit. The poor will borrow

and then buy-and-sell their way out of poverty. No country in history has become rich

nor has any country removed its poor people from poverty by this path. If this

philosophy is correct, then poor people in countries like Bangladesh will follow a very

different path out of poverty compared to Europe, North America, Japan, or recent

17 Hossain, M. (1988). Credit for Alleviation of Rural Poverty: The Grameen Bank in Bangladesh. Research Report 65, Washington D.C.: International Food Policy Research Institute and the Bangladesh Institute of Development Studies. 18 A recent study concluded dryly that, for Grameen Bank lending, “...the consumer surplus probably exceeds the subsidy... [so Grameen Bank subsidies are] probably a worthwhile social investment”. Schreiner, M. (2003). A Cost-Effectiveness Analysis of the Grameen Bank of Bangladesh, Development Policy Review. 21(3): 357-382.




11

progress in China. In Europe and North America, rising wages lifted most people out

of poverty in the 19th and 20th centuries, and the same is true more recently in East

Asia. Workers in these countries mostly use credit to buy cars or houses, not to

invest in production and raise their incomes. Investment by workers is marginal like

repairing a house, growing vegetables in the backyard, or contributing to a pension

fund.

Instead of using micro-finance to help most poor people become micro-

capitalists, another approach seeks out the small fraction of poor people who have

the ability to develop tiny businesses into larger ones, and lends money to them.

Lending money to the entrepreneurial poor may spur new businesses that will employ

other poor people and raise their productivity and wages. Instead of creating a not-

for-profit organization like the Grameen Bank or Pro Mujer in Bolivia, the alternative

approach creates for-profit organizations to supply microfinance to the poor. The

discipline of having to make a profit focuses these organizations on making loans to

poor people whose businesses will flourish and grow. The for-profit approach has

attracted some organizations in developing countries such as Acción International,

some high tech billionaires in California including Google.org and Omidyar Network

(Pierre Omidyar helped to found eBay), and Citigroup which is the world’s largest

banking network.19 A recent magazine article contrasted the two approaches as “not-

for-profit-do-gooders” and “for-profit-do-gooders.” The world needs more contests in

which the winner is the one who does the most good.

C. How to tell a banker from a moneylender

For-profit lenders hustle to find new opportunities to make money. In contrast,

subsidized lending necessarily creates more demand than supply, so charitable

lenders do not need to hustle. If some poor individuals have investment opportunities

and entrepreneurial ability, why don’t for-profit businesses hustle to find them and

loan them money? This question brings us to the oldest, most pervasive lender on

earth - the village moneylender. In rural villages or poor urban districts, these lenders

live among their borrowers and know who is thrifty and who is profligate, who works

19 Bruck, C. (2006). Millions for Millions, New Yorker Magazine. October 30, 2006: 62-73.




12

regularly and who works episodically, who keeps his word and who breaks his

promises. With this information they can make loans to people who lack collateral or

steady income, and extend loans in response to misfortunate, thus acting as insurers

as well as lenders. Moneylenders generally make relational loans and insure based

on local knowledge.

Moneylenders profit most when reliable people stay forever in debt. Instead of

helping customers to pay off their loans, they prefer for people to pay only the interest

on their loans, and to pay it forever. Some borrowers fall farther and farther into debt,

so more and more of their income goes to interest payments, until they eventually

lose everything.20 Whether in Bangladesh or Baltimore, collecting debts from poor

people who cannot make their loan payments is a heartless business. When the legal

system is weak, gangster lenders who profit from distress assault or maim

recalcitrant debtors as a lesson to others.

Modern social critics describe moneylenders in scathing terms, like Christians

described Jewish bankers in medieval times. The scathing rhetoric is one-sided. For

each defaulting debtor in Bangladesh who is thrown into the street by a moneylender,

how many others who suffer a temporary setback escape being thrown into the street

by a loan from a moneylender? For every debtor whose interest payments grow and

grow, how many successful businesses began by borrowing from a moneylender?

The scathing critics have no information on this point.

Alas, neither do we, but development economists increasingly propose that

modern finance should encompass moneylenders.21 Compared to other lenders,

moneylenders have superior information on their debtors. Moneylenders are more

flexible than micro-credit organizations that insist on fixed repayment installments to

boost discipline. Moneylenders provide flexible terms of repayment in cases of

financial shocks. They can use social networks to enforce debt servicing. Traditional

moneylenders outsmart others when lending to the poor and the vulnerable.

20 For a model of emiserations by moneylenders, see Ligon, E. (2005). Formal Markets and Informal Insurance, International Review of Law and Economics. 25 (1): 75-88. 21 For a survey of the literature see Garg, A.K. and N. Pandey (2006). Making money work for the poor in India: Inclusive finance through bank-moneylender linkages, Agricultural Financing Corporation (working paper), available at http://dlc.dlib.indiana.edu/archive/00002110; See also Hoff, K. and J. E. Stiglitz (1998). Moneylenders and bankers: price-increasing subsidies in a monopolistically competitive market, Journal of Development Economics. 55 (2): 485-518.




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Instead of suppressing moneylenders, a better policy is to compete with them

through cooperative banks, micro lending, and chit funds. Competition among

lenders is sure to benefit borrowers. Another important approach uses law to coax

moneylenders to become bankers. First, the state must suppress strong-arm debt

collection and separate the moneylenders from gangsters. Second, the law must

allow consumers to escape their creditors through effective bankruptcy proceedings,

so that a defaulting consumer suffers no more loss than destruction of the ability to

borrow in the future. Third, he state should protect consumers from manipulation and

fraud in lending, which is no easy task.22

II. Bankers and Brokers

Having discussed relational loans to the poor, we turn to conventional banks.

Relational lenders and conventional banks finance investment in capital. To

understand the role of banks in economic growth, we first consider the connection

between capital and productivity. In construction sites in Germany, machines

resembling dental drills for dinosaurs bore the foundations of buildings, and other

machines carry away the dirt without human hands touching it. Germans substitute

capital for expensive labor on construction sites. In India laborers with picks and

shovels dig the foundations of some buildings and women remove the dirt in baskets

balanced on their heads. Indians substitute cheap labor for capital on construction

sites. Rich countries like Germany have more capital per person than poor countries

like India. If Indians accumulated as much capital per worker as Germans, would

Indians be as rich as Germans?

To answer this question, we define terms more precisely. If a country needs

$4 in capital to produce $1 in wealth on average, its capital-output ratio is 4/1. The

capital-output ratio measures efficiency in using capital. If the country becomes more

efficient, it might need only $3 in capital to produce $1 in wealth, and its capital-

output ratio would fall to 3/1. Excavation on a construction site uses more capital in

Germany than India, and the speed of excavation is much higher. If we form the ratio

of capital to output measured in dollars, does the German construction site use

capital more or less efficiently?

22 In the United States, the Truth in Lending Act protects consumers from exploitation by lenders, but it is a cause of massive litigation against banks that many observers call nuisance suits.




14

Two important reasons point to opposite answers. A well-run construction

company first acquires machines that boost productivity the most, and later acquires

machines that boost productivity less. Getting more machines without any

improvements in them is called “capital deepening.” It is subject to the “law of

diminishing returns,” which implies that the German construction site should have a

higher capital-output ratio than the Indian construction site. Conversely, innovation

improves machines or their use, so the construction company’s newer machines

should be more productive than its older machines, or the old machines are better

used. When machines improve, buying newer machines or better using old ones can

increase productivity, rather than decreasing it as predicted by the law of diminishing

returns. Innovation implies that the capital-output ratio can remain equal or even

decrease in spite of capital accumulation.

We have explained that capital deepening causes the capital-labor ratio to

rise, and innovation causes the capital-output ratio to fall. Which effect dominates in

fact? Britain was much richer than Algeria or Tunisia in 1960. The ratio of capital to

output, however, was about the same in all three countries. So Britain was using

capital more efficiently than Algeria and Tunisia. Over the next 30 years, Britain and

Tunisia grew steadily richer, and the ratio of capital to output changed little. Thus

Britain and Tunisia sustained its efficient use of capital while it accumulated more of

it. Savings in these countries apparently flowed to innovative businesses. In

contrast, income stagnated in Algeria during this period, and the ratio of capital to

labor grew significantly. Thus Algeria used capital less efficiently as it accumulated

more of it. Instead of financing innovations, savings in Algeria deepened capital and

the returns to investment decreased. These observations of three countries suggest

what an analysis of many countries confirms: There is no general tendency for

countries to have a higher capital output ratio as they acquire more of it per worker.23

Savings can finance innovation and produce sustained growth, or savings can

deepen capital and yield diminishing returns. An important historical case of the

latter concerns communist Russia in the 1940s and 1950s. Stalin and Khrushchev,

who were successive chairmen of the Soviet Communist Party, forced the savings

and investment rate of the economy to unprecedented levels, and forced the women 23 King and Levine find no strong positive correlation between the capital-output ratio and capital per capita for 129 countries in the 1980s.




15

into the workforce. Growth rates were spectacular until the 1950ies but less so from

the 1960ies to 198724. The weakness of the Soviet economy contributed to the

downfall of communism in 1991. Russian communism’s downfall is apparently a

story of diminishing returns from capital deepening in an economy with little

innovation. Even during the Stalin era the main motivation behind economic policy

was not growth or efficiency but the establishment of a command and control

economy. To gain loyalty from the party establishment, the budget constraint for

socialist firms and their managers was softened. This punished efforts to reduce

costs and work efficiently and it rewarded shirking, stealing and lying, thus increasing

the capital-output ratio.

A conventional wisdom about financing development in poor countries is the

idea of a “savings gap”. A low income level does not allow people to save much. To

reach high growth, the overall investment rate must be increased well above the

overall savings rate, especially by development assistance. But this idea is not

supported by facts. Since 1970 the savings rate in poor countries was not lower than

in rich OECD countries. Savings in poor countries are adequate to finance growth. In

recent years, people in low-income countries have even saved a larger fraction of

their income than people in high-income countries.26 The main problem is not saving,

but to channel the savings into productive use.

Banks attract savings and invest them creatively. Good finance causes growth in

poor countries. Bank development and stock market liquidity are good predictors of

future economic growth in a developing country. To unite new ideas and capital,

banks have to overcome the double trust problem described in Chapter 1. To explain

how banks accomplish this, we will first describe their most relevant activities.28

24 M. Harrison and K.B.-Ye (2006). Plans, Prices, and Corruption: The Soviet Firm under Partial Centralization, 1930 to 1990, The Journal of Economic History 66 (1): 1-40. 26 See World Development Indicators (2007). 28Beside banking and brokerage, financial services also includes insurance and payments instruments (credit cards, checks, electronic funds transfers, notes). In recent years, the financial services industry has found lucrative new ways to package risk, such as derivatives, swaps, letters of credit, and mortgage-backed securities.




16

A. Portrait of Banking The traditional core of the financial services industry includes commercial

banking, investment banking, and brokering. Figure 5.1 characterizes these activities

according to the sources and uses of funds. First, banks take deposits from savers

and make loans to borrowers, which is called “commercial banking.” Commercial

bankers mostly require collateral from the borrower to secure the loan, such as land

and buildings (mortgages), movables such as machines, inventories, or financial

claims (pledges of movables), If the borrower defaults, the lender seizes the collateral

and sells it to satisfy the debt. Banks also make loans unsecured by collateral

(personal loans). To obtain an unsecured loan, most borrowers need wealth or a

steady cash flow or income like a government job.

Second, banks sell their own stocks and bonds, and then use the money to

buy the stocks and bonds of other companies. This is called “investment banking,”

as depicted in Figure 5.1. Banks invest in various funds such as the “technology

stock fund”, the “emerging markets fund,” the “municipal bond fund,” the “venture

capital fund”, or the “hedge fund.” The profits from these funds are divided between

the bank that manages them and the bank’s customers who invest in them. Different

funds carry different risks, but lending to an investment bank is generally more risky

than depositing funds in a commercial bank.

Figure 5.1. Three Core Banking Activities

Source of funds Use of funds Commercial banking deposits loans Investment banking bank’s stocks and bonds corporate stocks and bonds Brokering client’s orders execute orders

Third, brokers get money from their clients for executing orders to buy and sell

stocks and bonds in public markets. The clients pay commissions to their brokers,

who act as intermediaries in a market for shares and bonds, in which the lenders are

private persons.

Chapter 1 explained that innovation creates a double trust problem: The

innovator is afraid that the investor will steal his idea, and the investor is afraid that




17

the innovator will steal his capital. Each of the three banking activities solves the

problem differently, and thus contributes to economic growth in a different way.

Instead of a business plan, some innovators give the financier collateral for a

loan. When collateral secures a loan, the lender does not need to know the details of

the borrower’s business. Secured creditors let borrowers keep most of their

innovative ideas and trade secrets. Commercial banking with fully secured credits

thus reduces the double-trust problem to a single-trust problem. When a borrower

defaults, the bank will seize the collateral. To seize collateral legally, commercial

banking requires laws and institutions for debt collection. The first line Figure 5.2

depicts these facts.

Figure 5.2. Solving Double Trust Problem

Device Law Commercial banking collateral debt collection Investment banking insider profit sharing contracts & corporate Brokering outsider profit sharing corporate & securities

Some banks in Silicon Valley specialize in lending to startup firms. The loan

agreement may require the startup to open a checking account with the bank for its

everyday transactions, and to maintain a stipulated balance. The bank stays

informed about the borrower’s financial health by monitoring the transactions in its

checking account. Silicon Valley banks finance innovation directly by lending to

businesses. Other commercial banks contribute indirectly by freeing the borrower’s

savings for use in business. Thus an entrepreneur may borrow money from a

commercial bank to purchase a house, which frees his accumulated savings to invest

in his business. The amount of commercial lending in a country depends partly on the

cost of debt collection. As we will explain, obstacles to debt collection in poor

countries limit the pool of commercial loans.

Unlike commercial banking, investment banks mostly get money by selling

their customers participation rights in its different lines of investment. A bank

organizes its different lines of investment into funds -- “technology stock fund”, the

“emerging markets fund,” the “municipal bond fund,” the “venture capital fund,” or the

“junk bond fund.” These funds buy stocks and bonds from companies whose




18

success or failure determines whether the investment fund profits or loses. The

bank’s customers who participate in a fund share its profits or losses. Different

investment banks follow different investment strategies in different funds. Some

strategies rely on mathematical models that respond quickly to public information, so

the investment bank has no relationship with the companies whose stock it buys.

Other strategies rely on working relationships between the investment bank and the

companies whose stock it buys.

In such a relationship, the investor often wants to know the plans of the target

business in order to assess future profits, and the business often wants to keep its

secrets. As explained in Chapter 1, investment banking is a form of private finance

that solves the double trust problem through contracts, so contract law underpins

investment banking. In addition, corporate law protects the interests of different

parties entitled to a share of a company’s profits, so corporate law also underpins

investment banking. As we will explain, ineffective contract and corporate law in poor

countries limit investment banking. However, this limitation can be overcome

because investment banks can protect themselves even when law is ineffective. As

a condition of investing in a company, an investment bank often places its

representatives on the company’s board of directors or similar executive position.

Thus the investment bank is an insider that can use its power to protect its interests.

In contrast, the clients of brokers are usually outsiders who play a passive role

in the company’s management. Outsiders are more easily cheated out of their fair

share in the company’s profits than insiders. Protecting outside investors who buy

stocks requires corporate law and also securities laws with a specialized enforcement

agency. The last row of Figure 5.2 summarizes these facts about brokers. As we will

explain, ineffective contract and corporate law in poor countries restrict the

development of public securities markets and increase the relative importance of

banking.

B. Napoleon’s Problem Napoleon possessed almost absolute power, including the power to cancel his

own debts. As a consequence, his subjects would not buy his bonds. His excessive

power thus deprived him of an ability that he strongly depended on to fight his wars --

the ability to borrow money. The British king, in contrast, had less power – he shared




19

it with Parliament – and he had to repay his debts. His subjects would buy his bonds,

and he sold them in London to finance his wars. The British king thus outspent

Napoleon in the wars between Britain and France, and England’s debt grew to more

than two times the British GDP by the end of the Napoleonic wars.29

State law in developing countries does not force some people to repay their

debts, so, like Napoleon, they cannot borrow much money. In Brazil the law forbids a

creditor to seize the debtor’s collateral without first obtaining a valid court order,

which makes debt collection expensive and time consuming. Peru has more than 20

different registries for different types of loans (one registry for collateral of farmers,

another registry for collateral of industrialists, etc.), and the registries in one part of

the country are unconnected to those in another part of the country.30 The World

Bank identified 40 countries where legal devices allow debtors to drag out the

process of seizing collateral.31 In Germany, however, the creditor can repossess the

debtor’s collateral within weeks or months of default without a court proceeding, so

many people in Germany can borrow money that could not do so otherwise.

Another legal problem for secured loans, which adds to the Napoleon problem is, that

substantive property law often imposes overly formalistic conditions for pledging

movables. Especially poor countries with a civil law system often suffer from the

“fallacy of concreteness” in movable collateral. Suppose that a bank wants to lend

against a herd of 100 cattle worth $100,000. In Kansas, the rancher would pledge

cattle worth $100,000 in a specific herd. In Uruguay the individual cows must be

enumerated in a closed list and the list must be continuously updated in order for the

court to accept the pledge as collateral. Similarly, in Kansas a dealer in wool can

pledge wool worth $100,000 in a warehouse, and the pledge remains good as the

particular wool in the warehouse turns over through sales. In Uruguay a dealer in

wool can only pledge the particular wool in the warehouse, so the collateral will

29 Ferguson, N. (1999). Wars, Revolutions and The International Bond Market from the Napoleonic Wars to the First World War. http://icf.som.yale.edu/pdf/NF.pdf. p. 13. And F. Mc Donald (2004). Is Public Indebtedness Essential to Democracy and Freedom? GMU History News Network. 1-19-04 30Salaverry, F. C. (2004). Accesso al credito mediante la reforma de la legislacion sobre garantias reales. Latin American and Carribean Law and Economics Association (ALACDE), Lima, Peru. 31 World Bank, Doing Business around the World (2005), p. 44. India has revised its law to accept credit agreements on the repossession of movable collateral without court involvement.




20

dissipate as the wool in the warehouse turns over through sales. Uruguay’s civil law

system suffers from the fallacy of concreteness.32

A silver candlestick, barrels of beer in a warehouse, or bonds in a drawer are

easier to hide than land and buildings. And it gets easier the more time the creditor

needs to repossess the collateral. Creditors in poor countries consequently prefer

real estate as collateral, provided that they can repossess it.33 In many developing

countries, the creditor can evict a business and seize its real estate to satisfy a debt.

A recent study of secured loans in 60 developing countries found that corporations

secure 70% with mortgages and only 30% with movable capital.34

We have discussed some legal obstacles to debt collection. (There are

others.35) Higher obstacles yield greater rewards for overcoming them. One of

Mexico’s richest businessmen, Ricardo Salinas, first built his fortune by finding an

effective way to collect consumer debts. His “Elektra” stores, which now number over

600, sell televisions, refrigerators, washers, etc. Many of the buyers are poor people

who purchase on credit. When deciding whether or not to make a loan, the account

manager in the store obtains the names of the borrower’s relatives. If the borrower

subsequently falls behind in his monthly payments, the account manager will enlist

the help of relatives to collect the debt. This approach to debt collection relies on

reputation and group responsibility, similar to a Raiffeisen bank or Grameen bank.36

Inefficient debt collection raises the bank’s cost of loaning money, so it will

charge higher interest rates to borrowers. The bank, however, need not pay a higher

interest rate to its depositors. Inefficient debt collection thus causes the difference

between the interest rate that a bank charges to borrowers and the interest rate that it

32 See Fleisig, H. (1996). Secured Transactions, The Power of Collateral, Finance and Development. 33(2): 44-46. 33 The creditor wants the collateral’s value to stay as high as the remaining debt. "... Basically, the bank wants to ensure a rough balance between the value of the debt outstanding and the value remaining in the project, including the value of the collateral, at all times." Hart, O. (1995). Firms, contracts, and financial structure. Oxford and New York: Clarendon Press and Oxford University Press: 8-9.

34 This is true even though the study found that land accounts for only 22% of the value of corporate assets. Safavian, M., H. Fleisig and J. Steinbucks (2006). Unlocking Dead Capital, How Reforming Collateral Laws Improves Access to Finance, Public Policy Journal. 307 35 Another obstacle to collateral in the civil law tradition is that the pledge of a movable requires the creditor to take possession of it. If a shop in Germany sells a television on credit and lets the buyer take it home with him, the shop cannot have the television as collateral for the loan. To circumvent this problem, the shop in Germany retains title of the television until the debt is paid. 36 Ricardo Salinas explained these facts to Cooter.




21

pays to depositors to increase. The difference between borrowing and lending rates

by banks is roughly three times higher in developing countries than developed

countries.

Source: World Bank, World Development Indicators, 2006

This fact suggests a big difference in the efficiency of bank collections,

although other causes are also at work.37 Improving debt collection is easy legally

and hard politically. People who suffer economic hardship struggle to pay their

debts. The public naturally sympathizes with the poor debtor and antipathizes with

the rich lender. The public does not feel the suffering of the poor who will be denied

loans in the future if poor people do not have to repay their debts. Public sentiment

generally puts greater weight on an ‘identified person” like a defaulting debtor than a

“statistical person” like a future borrower.

Beyond burdening debt collection, many poor countries forbid using some

valuable assets as collateral. A change in law that allows the owners to pledge these

assets can cause a spurt in economic growth. To illustrate, much of the country of

Silesia was devastated following wars that ended in 1763. To finance reconstruction, 37 Rochas-Suarez, L. (2001). Rating Banks in Emerging Markets, Working Paper, www.iie.com/publications/wp/01-6.pdf. Note, however, that low spreads do not necessarily reflect low risk and a better institutional environment. They can be found in banks in crisis, in politically influenced banks, and in banks that can count on a bail out from the state. And high spreads can reflect monopoly power of banks rather than undeveloped creditor rights.




22

the Prussian King Frederick II changed the law in 1770 to allow the nobles to pledge

their manors as collateral. These loans financed the rapid reconstruction of Silesia.38

In the process, manors were thrust into the real estate market, and many noble

families lost their high economic and social position, which changed the social

structure.

Like Silesian nobles before 1770, current law forbids the clans of Papua New

Guinea to pledge their land as collateral, which slows economic development,

especially around cities. Creating a market in rural land, however, would undermine

the clan system of social organization, just like it undermined the manor system in

Silesia.39 Thus economic growth trades off with social stability in the countryside.

Religion poses another obstacle to commercial banking in some countries.

Christianity and Islam traditionally objected to their members charging interest on a

loan. Among Christians the ban against interest disintegrated over centuries and

disappeared, although its language persists in “usury” laws that impose legal caps on

interest rates.40 In Muslim countries, the ban on interest mostly remains in form but

not in substance. To preserve form and circumvent substance, Arab banks re-

characterize interest as profits.41 This makes modern banking possible at the price

of enraging some devout Muslims.

C. Magically Disappearing Profits In a Las Vegas magic show, slight-of-hand makes a beautiful woman

disappear before your eyes. With ineffective law, the same thing happens to

business profits. After 1988 gangster capitalists in Russia made profits disappear

from the books of state companies and reappear in their own pockets. They used

38 Melchers, T. (2002). Preußische Integrationspolitik im 18. Jahrhundert. Oldenburg: Diss. Oldenburg: 550. 39 See Chapter 3 of this book and Cooter, R. (1991). Inventing Market Property: The Land Courts of Papua New Guinea, Law and Society Review. 25 (4): 759. 40 Noonan, J. T. (1957). The scholastic analysis of usury. Cambridge: Harvard University Press. 41 Here is how to make interest in a two-person transaction disappear by using a third person. A has goods that he is sure not to use until next year. A wants to loan $1 to B with repayment of $1.5 in one year, so the interest is $.5. To make interest disappear, introduce C into the transaction as follows: A sells the goods to C for 1, who resells the goods to B for 1, and A promises to repurchase the goods from B for $1.5 in one year. B leaves the goods in A’s possession. The net result is that A receives $1 immediately from B and A promises to pay $1.5 to B in one year, just as with the loan. This ploy was explained by Hamidi, H. (2007) in a lecture, You Say You Want a Revolution: Deviationist Doctrine, Interpretive Communities and the Origins of Islamic Finance (work in progress), Berkeley Faculty Seminar.




23

tactics like this: Seize control of a state company with mineral assets, sell the

minerals to your dummy corporation at low prices, and then resell the minerals on the

world market at high prices.

Worshippers at shrines in East Asia give the gods play money and ask them to

repay in real money. Similarly, in joint with foreigners, Chinese entrepreneurs

sometimes give paper rights to foreign investors who pay with real money. The

assets of the project disappear through connivance between local partners and state

officials.42 In general, outsiders are reluctant to buy stocks in a company unless

corporate insiders can give a credible guarantee that they will not divert the

company’s assets into their own pockets. Statistical analysis shows that when

ineffective laws make outside investors feel insecure, they will not invest, so a greater

proportion of companies must finance themselves internally.43

Members of the public who own a few shares in a company are the most

vulnerable outside investors. After 1989, Russia and the Czech Republic privatized

state companies by distributing shares broadly among the public, but the insiders

quickly appropriated the public shareholders. Instead of equality, the result was

cynicism. In a popular joke, the wife says to her husband, “Play cards if you must,

dear. At least you win sometimes. But don’t buy any more stocks.”

Chapter 1 described three general ways to create trust between investors and

the insiders who manage an enterprise: relationships, private agreements, and

public markets. Most rich and poor countries finance growth by combining relational

finance and private agreements. Thus in India stocks are often sold through informal

networks to people with long-run relationships.44 In Japan and Germany each

manufacturer traditionally had a “main bank” or “house bank” that provided most of its

finance. The main bank might arrange for a manufacturer and one of its suppliers –

say, a car manufacturer and a supplier of specialty steel - to stop trading on the open

market - and deal exclusively with each other. To seal the agreement, the bank

42 A friend of Cooter’s consulted on an aviation deal in which Europeans invested over $40 million, their Chinese partners took all of it, and they wrote off the loss. To protect their interests, foreign investors in China often ally with a strong political or military figure. 43 Demirguc-Kunt, A. and V. Maksimovic (1998). Law, Finance and Firm Growth. Journal of Finance. 53 (6): 2107-2137. 44 Cobham, D. and R. A. J. Subramaniam (1998). Corporate finance in developing countries: new evidence for India.Working Paper, University of St Andrews, St. Andrews, UK Asian Development Bank, Manila, Philippines.




24

arranges for them to exchange their stock. ”In Japan the companies choose who will

buy their stock,” observers say, “and in Britain the buyers choose which stock they

will buy.”

The obvious way to protect bankers against a company’s managers is to bring

bankers inside the company to actively participate in managing it. As insiders,

bankers can detect slight-of-hand and protect their interests much better than

outsiders. To participate in management, bankers can hold board seats, designate

officers, or establish performance goals for managers with material rewards and

punishments.

A less obvious way to protect bankers against insiders rests on the distinction

in Chapter 3 between a firm and its assets. The firm’s market value is measured by

how much a buyer would pay for it, including its name, reputation, good will,

contracts, roles, and relationships. In contrast, the market value of its assets equals

the sum of its parts when sold piecemeal, such as machines, buildings, materials,

and accounts receivable. A successful firm is more valuable than its assets.

Consequently, a person who steals the assets of a successful firm gains less than

the firm’s value.

This fact provides a way to deter managers from stealing a firm’s assets. In

Silicon Valley the founders of a startup company expect to gain much more from its

success than they could gain by stealing the funds invested in it by outsiders.

Complicated contracts create these expectations by using financial arrangements

including collateral for loans, stocks, stock preferences, options to buy, and options to

sell. In general, if the managers stand to gain a significant share of the value of a

successful firm, then they may prefer for it to succeed rather than to loot it.

Chapter 1 explained that private finance requires less law than public finance.

This hypothesis implies that banks should dwarf stock markets in countries with weak

legal institutions. When a country goes through a period of rapid industrialization,

bank finance should predominate if the legal system is weak, and public stock

markets should play a more decisive role if the legal system is strong.

Developing countries often have only a few large banks. Regulating a few

large banks is relatively easy, even when few judges and regulators have economic

expertise. In contrast, markets for stocks and bonds cannot flourish without effective

corporate and securities laws that apply to hundreds or thousands of firms and that




25

are adjudicated in hundreds or thousands of courts. This is especially true where few

judges and regulators have economic expertise. So bank finance may be relatively

successful in earlier phases of economic development because the required laws are

easier to develop compared to securities markets which collect capital from outside

investors.

In a 1962 book the economic historian Alexander Gerschenkron compared the

industrialization of Germany, Great Britain, and the United States.46 In the United

States and Great Britain, finance for industrialization in the 19th century was provided

more by stock markets than banks. During Germany’s rapid industrialization from

1895 to 1913, in contrast, the ratio of bank deposits to shares of stock increased in

value from 1.5 to 3.4. Large banks financed large firms through a strong credit

market whereas the stock market remained weak.47

As in Germany, the stock market has played an insignificant role in financing

China’s recent explosive growth.48 China grew rapidly in 1977-2003, but the stock

market was did not contribute much to finance until recently.49

46 Gerschenkron, A. (1962). Economic Backwardness in Historical Perspective. Cambridge, MA: Harvard University Press. He based his proposition on observations of the German industrial take off, which gained momentum after the unification of Germany in 1871. Germany industrialized later than most other rich countries. Bank credits played a pivotal role during the industrialization phase in the 19th and early 20th century. 47 Demirgüc-Kunt, A. and R. Levine (1999). Bank-Based and Market-Based Financial System, Cross Country Comparisons, World Bank Policy Research. Paper No. 2143 48 Hoshi, T. and A. Kashyap (2001). Corporate Financing and Governance in Japan. Cambridge: MIT Press. 49 Lau, L. Remarks to the Chinese Reform Summit, National Development and Reform Commission (NDRC), Beijing Diaoyutai State Guesthouse, July 12th-13th, 2005.




26

Source: World Bank Development Indicators 2005

In Japan, the pattern was more complicated. Finance was not bank-based when

industrialization exploded in the early 20th century, but bank finance became

predominant in the 1930s when regulation favored it.50 Statistical evidence indicates

that bank finance has a relative advantage over capital markets in poor countries and

that securities markets surpass the importance of banks when the economy gets

rich.51 The change occurs partly because laws become more effective and outside

investors feel more secure. The statistical evidence is however not quite obvious.

The ratio of the market capitalization of stock listed companies to bank credits given

to private firms in high and low income countries was between 0,3 and 0,5 in both

income groups between 1995 and 2004.52 But this does not tell the whole story. In

poor countries most stocks are held by inside investors, by families and the state.

Inside investors are not dependent on legal protection through company law and

securities regulation. If they hold blocks of for instance more than 50 percent of the

equity capital like in Mexico, or more than 60 per cent like in Kenya or Egypt, this

contributes to the market capitalization but does not say anything about how well the 50 Hoshi, T. and A. Kashyap (2001). Corporate Financing and Governance in Japan. Cambridge: MT Press 51 Demirgüc-Kunt, A. and R. Levine (1999). Bank-Based and Market-Based Financial System, Cross Country Comparisons, World Bank Policy Research. Paper No. 2143 52 Calculated from World Development Indicators (2007)

0 20 40 60 80

100 120 140 160 180

Market capitalization of listed companies (% of GDP) Domestic credit provided by banking sector (% of GDP)

China




27

law protects outside investors in the securities market. Blockholders are inside

investors and need no legal protection. Demirguz-Kunt and Levin (1999) have

constructed an index which shows whether finance is more through bank loans or the

capital market. Their analysis shows a tendency for more market-based systems in

richer countries. In the sample of 57 countries in more advanced countries with a

GNP per capita of more than 10.000 Dollars, 7 out of 17 countries are more market-

based than bank-based, and in countries below this level, only 11 of 40 counties are

more market-based than bank-based.

We have explained that weak legal systems tilt finance away from stock and

towards credit. This proposition, however, seems to contradict an important theory in

finance whose discovery won Nobel prizes for Modigliani and Miller. This theory

asserts that changing the proportion of stocks and credits used to finance a firm

cannot change its value. They define the value of the firm as the market value of its

stocks and credits. To understand their theory, assume that a firm issues more stock

and uses all of the money to pay back some of its credits. Since the money raised

from selling the stock pays for the credit, the amount of capital available for the firm

to invest in developing its business remains unchanged. If the firm’s investment

remains unchanged, its stream of future profits is also unchanged. Modigliani and

Miller prove that, under certain assumptions,53 the firm’s stream of future profits

equals its value, defined as the market value of its stocks and bonds. So changing

the firm’s ratio of bonds to stocks did not change its value.

Now we can explain why our arguments about stock and bond financing do

not contradict the Modigliani and Miller theory. Weak legal systems allow insiders to

make profits disappear from the firm and reappear in their pockets. If stocks held by

outside investors finance the firm, insiders have an incentive to make profits

disappear. If credit finances the firm, insiders do not need to share profits with

outsiders, so they do not have this incentive to make profits disappear. Therefore the

composition of finance between stocks and bonds affects the value of a firm, defined

as the market value of its stocks and credits. The Modigliani and Miller theory

53 Two important assumptions are tax neutrality with respect to bonds and stocks, and discounting of future profits at a rate reflecting the risk of this line of business.




28

implicitly assumes that a strong legal system stops insiders from making profits

disappear from the firm and reappear in their pockets.

Insiders buy stocks and bonds through private deals, and outsiders buy stocks

and bonds in public markets. We have explained that weak law tilts finance towards

private deals and away from public markets. In private deals and public markets,

weak law tilts finance towards credits and away from stocks. Credits of a “main bank”

are easier to enforce than stockholder rights.

Protecting diffuse stockholders against insiders is such a difficult problem that

few countries have solved it. Recent empirical research shows that the widely held

corporation with dispersed ownership plays almost no role in developing countries,

and even in rich countries it is mostly restricted to the USA and the UK. Figure 5.3

shows decisively that stocks are traded far more in rich countries than in low or

middle-income countries. Econometric analysis concludes that better banking law

leads to more activity on bond and stock markets.55

Figure 5.3: Total Value of Stocks Trade as a Percentage of GDP Source: World Development Indicators, 2005.

55 Demirguc-Kunt, A. and R. Levine (1999). Bank-Based and Market-Based Financial Systems: Cross-Country Comparisons, World Bank Policy Research. Paper No. 2143. Data available for 57 countries.

0 20 40 60 80

100 120 140 160 180 200

High income OECD Low & middle income

Fig. É.Stocks t raded, total value (% of GDP) 1971-2003From World Development Indicators 2005




29

. The tilt in finance towards bank credits and away from stocks dampens risk-

taking, slows innovation, and increases business failures. To see why, assume that

an entrepreneur uses his own money to start a company and then obtains additional

funds from bank credit. If revenues do not flow into the business fast enough to

redeem the credits, the business will go bankrupt and the entrepreneur will lose his

entire investment. In contrast, if he were able to sell stocks rather than bonds, he

would not need to make fixed payments, so the company’s revenues could grow

more slowly without precipitating bankruptcy.

This is not the only weakness of a bank-based system. The state can regulate banks

more easily than capital markets, but it can also easier manipulate banks for other

than development purposes as compared with stock markets. A predatory

government can get access to power and resources by controlling banks and

discriminating against the development of decentralized capital markets. It can

influence non-market loan decisions aimed at creating large conglomerates with good

relationships to the government (as in South Korea), channeling credits into sick

industries (as in India) or creating a military industrial complex (as in Germany and

Japan prior to the world wars) or to extract surplus from the economy for the benefit

of the ruling family (as in Soharto’s Indonesia).

D. Soft Budget Constraints

In business, sports, and war, leaders who fail lose their power. Business has

a formal legal procedure prescribed to dispossess a failed leader: Bankruptcy (see

chapter 7). The budget constraint is hard. Bankruptcy quickly transfers resources

from failed managers to new managers with better prospects for profitability

Unlike private businesses, the public sector has a relatively soft budget

constraint. Governments have no procedure like bankruptcy to strip power

automatically from officials who fail to meet quantitative goals.56 When a public

56 To our knowledge, the closest to bankruptcy in the public sector is the procedure that operates in some American school districts that close public schools if they repeatedly fail to meet targets for standardized test score by their students.




30

organization runs out of money, it negotiates for more, again and again. The budget

constraint is soft.

Here is how soft budget constraints work in China. The dinosaurs in the old

industrial core – heavy industries like steel – were re-organized as companies that

issue stocks. The government owns enough shares to retain control over these

enterprises, and the law forbids the sale of these shares. 57 When these enterprises

lose money, as they inevitably do, the government makes state-controlled banks

provide fresh loans to cover the losses. In a summit meeting for China’s top

economic officials in 2005, several speakers identified the soft budget constraints on

state enterprises as China’s biggest economic problem.58

China’s startling economic growth has occurred in export industries outside of

its old industrial core. Many of these new enterprises are privately owned, and others

involve a partnership between private businessmen and local government officials,

especially in China’s many “village enterprises”. In dealing with village enterprises,

the Chinese government shows remarkable toughness: If they do not make money,

they cannot expect subsidies from the central government. The old industrial core,

however, receives the subsidized loans. Ironically, China’s failing enterprises in the

old industrial core pay a lower price for capital than China’s successful new

enterprises.

Earlier we mentioned that India nationalized its banks in the 1970s and they

suffered from bureaucratic sclerosis and political intrusion. Many other developing

countries nationalized banks with the same results. As in China, state banks soften

the budget constraint for state owned enterprises and other politically preferred

borrowers. Instead of losing power, managers in these enterprises go to state banks

for more loans.

57 These companies currently have four classes of stock:

Non-tradable shares held owned by the state. Non-tradable shares with non-state owners (e.g. state officials in their capacity as private persons). Tradable shares on domestic exchanges. (Chinese citizens can own them). Tradable shares on foreign exchanges. (Chinese citizens cannot own them.)

58 This was the theme of a speech by Raghuram Rajan, Economic Counselor and Director of Research of the International Monetary Fund, and also a speech by Charles Goodhart of the London School of Economic. Proceeds of the NDRC Economic Summit, Beijing, China, 11 July 2005.




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If the factories close, these employees will lose their jobs, which is very

painful.59 Besides factories, the large enterprises in China’s industrial core are social

enterprises that supply housing, schooling, recreation, and medical care to their

employees. So plant closing endangers more than jobs. Even so, other citizens may

eventually tire of subsidizing the old industries. To hasten the end of subsidies, the

government could make them overt instead of covert. To make subsidies overt, the

state banks should stop giving soft loans and the subsidies should appear in the state

budget as expenditures.60

In much of the world, the budget constraints on commercial banks are soft.

Banks make risky investments in which they win or else the taxpayer loses. In the

1980s, U.S. regulators in the Reagan Administration allowed government-insured

banks called “Savings and Loans” to try gambling their way out of bankruptcy. If their

highly risky investments succeeded, the bankers would win, and if they failed, the

taxpayers would lose. This gamble delayed the collapse until after President Reagan

left office, when massive failures triggered the government’s liability as insurer of the

depositors in these banks. The federal government apparently lost more money in

reorganizing these banks than in any other bailout or financial scandal in U.S.

history.61 When a bank says to the state, “I’ll wager your money that I am right,” the

state should refuse.

Almost every country regulates banking to control fraud, manipulation, and

recklessness, which can abuse individuals or even destabilize an economy. The

structure of banking regulation, however, differs from one country to another. In the

United States and Japan, the regulations traditionally separate commercial,

59 Econometrics from survey data has proved what people know intuitively: Unemployment makes people very unhappy and damages their self-esteem. Frey, B.S. and A. Stutzer (2000). Happiness, Economy and Institutions, The Economic Journal. 110: 918-938. Frey, B.S. and A. Stutzer (2002). What Can Economists Learn from Happiness Research?, Journal of Economic Literature. 40: 402 – 435. 60 Here are three steps to harden the bankruptcy constraint:

1. Prohibit state banks from making loans to failing enterprises. Put state banks on a commercial basis. 2. If a state bank stops loaning to a state owned enterprise, central or local officials can decide whether to pay the subsidies. 3. Create a reorganization procedure for failing state enterprises similar to bankruptcy under Chapter 11 in the U.S.

Goodhart, C. (2005). Remarks on Chinese Bank Debt. China Reform Summit: Promoting Further Economic Restructuring by Focusing on Administrative Reform, Organized by National Development and Reform Commission, P.R. China, Assisted by USB, July 12-13, Beijing, China. 61 Joe Stiglitz estimated the loss at one to two hundred billion dollars.




32

investment, and brokerage activities by law.62 Germany and most developing

countries, however, allow each bank to engage in all three activities (“universal

banking”). The best pattern of bank regulation remains unclear. No country

recommends itself as an ideal model for baking regulation. International agreements

propose standards and protocols for all countries to follow.63 In spite of business

advantages from conforming to international standards, many countries do not

participate in the international agreements.

The central bank in each country implements policies that affect inflation,

interest rates, and unemployment. Macroeconomic mismanagement can wreck an

economy. In Argentina in the 1980s, inflation undermined the economy. Conversely,

in Argentina in the 1990s, a stable but over-valued currency destroyed exports and

caused unemployment. Mishandling of exchange rates in Thailand in 1988 caused an

economic slump that spread throughout East Asia. Abrupt devaluation of the

Mexican peso in 1994 caused an economic downturn that affected most Latin

American countries (“peso crisis”). Russia defaulted on its debts in 1998 and the

ruble plummeted, which increased the country’s economic distress. If the central

bank must finance excessive government deficits, the sale of government bonds can

crowd out private credits, so growth slows in the private sector. We mention these

examples of disruptive macroeconomic policies, but this book does not analyze them

because it focuses on law.

62 We say “traditionally” because the Glass-Steagall Act, which the U.S. Congress passed in response to the stock crash of 1929, has been eroded in small ways by new laws and court decisions. The current situation in the U.S. mixes the three forms of banking (and insurance) in complex ways. 63 The Asian crisis of 1997 led to the Basel core principles of banking and credit regulation proposed by the World Bank and the IMF. These principles emphasize the autonomy, powers, and resources of the bank regulatory agency, as well as bank reporting, minimal capital requirements, and risk assessment of credits. Under the “Basel II agreements,” banks should retain capital equal to 8% of liabilities or else submit to an “internal rating basis” that requires disclosing their credit evaluations of their debtors to bank regulators. See Hertig, G. (2005). Basel II to Facilitate Access to Finance: Fostering the Disclosure of Internal Credit Ratings, Law and economic Workshop, Hamburg University Law and Economics Center. The Basel Committee on Banking Supervision is an arm of the Bank for International Settlements whose rules apply to the banking regulators in each of 13 participating countries. Additional countries may voluntarily sign on. Some countries like the U.S. traditionally reduced these risks by legislation prohibiting commercial banks from engaging in investment banking or brokering -- The Glass-Steagall Act of 1933 has been eroded but not repealed. Banking law in these countries seem to be evolving to resemble countries like Germany with a tradition of “universal banking” – banks may engage in all of these activities.




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III. Conclusion

The economist Joan Robinson said, “Where investment leads, finance

follows.” This phrase suggests that banks will find their way to innovators like ants

find a picnic. Influenced by this thought, most textbooks on development economics

give little emphasis to finance or financial law.64 This omission is a serious mistake.

It does not give credit to credit. Sustained growth comes from solving the double

trust problem, and finance is half of it. Finance does not come to innovative ideas

like ants to a picnic. Instead, finance comes to innovative ideas like a man and a

woman come to marry. In finance and courtship, the stakes are high and so is the

risk.

Solving the problem requires law and institutions. Applied to finance, the

property principle for growth implies that law and institutions should enable lenders

and investors to keep much of what they contribute to a firm’s profitability. Similarly,

the contract principle implies that financing agreements should be enforced as made

by the parties. The elaboration of these principles in finance develops corporate law,

banking laws, and securities law. As financial laws strengthen, finance supplements

group responsibility with individual responsibility, relational lending with private

lending, private banks with public markets, and bonds with stocks.

64 R. Levine (1997). Financial Development and Economic Growth, Journal of Economic Literature. 35 (2): 688-726.



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