Bank Negara Malaysia and the Tun Ismail Ali Chair (TIAC) have successfully hosted a public lecture by the current TIAC chairholder, Professor Thorsten Beck from Cass Business School, London on 28 November 2017 at Sasana Kijang. The public lecture, titled Looking Beyond Banks: Alternative Finance, Competition and Regulation, was attended by over 60 participants from various local higher learning institutions, private sector analysts, and staff from the Bank.

The following are the summary and recording of the public lecture.

You may access the presentation slides here: Looking Beyond Banks

Summary by Prof. Thorsten Beck

Financial systems across the globe, both in most developed but even in many developed countries, are dominated by banks, with a more limited role of other financial intermediaries and public capital markets in resource allocation. While there might not be an optimal financial structure, a financial system that lacks a diversified and balanced structure might lack the necessary competition and innovation. In addition and as shown by Langfield and Pagano (2015) bank lending is more procyclical than non-bank financing, which might be one of several reasons of why the Eurozone took longer to recover than other advanced countries after the recent crisis wave. Developing non-bank segments of the financial systems, including public capital markets, non-bank private debt and private equity funds, as well as contractual savings institutions (insurance companies, pensions funds, mutual funds) is therefore a challenge. This comes on the backdrop of continuous challenges to expand financial inclusion in many developing countries as well as the dearth of long-term financial intermediation in developing and developed countries alike. Along many dimensions, non-bank intermediaries and markets might be at a better position to intermediate long-term savings into long-term funding for firms, households and governments. But capital markets face size-related challenges in small developing economies, related to the scale and network economies they rely on (see my paper with Jose, Peter and Mathijs; http://voxeu.org/article/nascent-stock-exchanges-explaining-success-and-failure).

Similarly, pension funds and life insurance companies are often engaged in “reverse maturity transformation”, investing long-term resources into bank deposits and government bonds. There is also a broader governance challenge, as developing countries are still heavily relationship-based, but public capital markets require trust in arms-length transactions.

Financial innovation, driven to a large extent by the recent digitalization wave, can be a game changer. Digitalization allows for cheaper transactions, reduces the impact of physical distance, increases transparency and thus addresses governance challenges. Technologically driven financial innovation has shown itself in many different forms – mobile money/digital finance has helped push out the financial inclusion frontier, while lending platforms have opened new funding opportunities for firms.

This brings me a broader topic – financial innovation, controversial in most developed countries since the Global Financial Crisis, as it has been blamed for enabling and incentivizing aggressive risk-taking that eventually led to the perfect crisis. This innovation-fragility hypothesis goes clearly against the innovation-growth hypothesis, which claims that financial innovations help reduce agency costs, facilitate risk sharing, complete the market, and ultimately improve allocative efficiency and economic growth. In work with Tao, Chen and Frank (http://voxeu.org/article/financial-innovation-good-and-bad) we have evaluated these hypotheses in a broad cross-country setting with new measures of financial innovation and found evidence for both. Banks grow faster in countries with more financial innovations, but also become riskier and more fragile and suffered more in terms of losses during the recent crisis. However, when testing the importance of financial innovation for the real economy, we find that countries and industries with higher growth opportunities grow faster in economies with higher levels of financial innovation.

While policy makers like to focus on the lending side of financial markets and institutions, in recent work with Haki, Ravi and Burak (http://voxeu.org/article/mobile-money-trade-credit-and-economic-development) we show that more effective payment services allow small firms in Kenya to access more trade credit as it avoids the risk of theft and thus increases credit worthiness, with important macroeconomic repercussions.

Where does this ambiguous result on the effects of financial innovation leave us in terms of policy conclusions? Policy makers care about stable but also effective and competitive financial intermediaries and markets. Allowing for innovation, while carefully looking for new sources of fragility is important. Many regulators have created regulatory sandboxes over the past years, which allows businesses to test innovative products, services, business models and delivery mechanisms on small scale and a limited time (see, e.g., https://www.fca.org.uk/firms/regulatory-sandbox).

One important challenge in this context is the regulatory perimeter. Over the years, more and more bank-like institutions (e.g., money market funds in the U.S., wealth management products in China) have taken on intermediation functions, which might make them implicitly part of the financial safety net relying on the public back-stop in times of crisis. This could be seen in the Global Financial Crisis, when the Fed had to expand the financial safety net to both investment banks and money market funds. In addition, heavy regulatory focus on banks might push banking activities outside the prudential regulatory perimeter, ultimately turning into a mouse-cat race between regulators and financial sector. This requires a dynamic approach to the financial regulation, regulating on the basis of function rather than institutions, as well as complementing micro- with macro-prudential analysis and regulation.

Regulations can also have an important impact on inclusion, through Know-Your-Customer requirements. The regulatory framework has thus to be structured in a way that allows for a risk-based proportional approach, treats providers of similar services equally and allows for competition, while at the same time providing sufficient incentives for first movers and new entrants. These principles are discussed in more details, with underlying analysis and plenty of examples in this task force report: https://www.cgdev.org/sites/default/files/CGD-financial-regulation-task-force-report-2016.pdf

In summary, building non-bank segments of finance is an ongoing challenge across the globe. Technology can make the task easier, but regulation has to tread a fine line between ensuring stability and allowing for efficiency and competition.

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