“INTEREST BEARING NOTES”: WORLD BANK

July 16, 2008 at 10:33 pm | Posted in Economics, Financial, Globalization, Research | Leave a comment

Interest Bearing Notes July 2008‏

Interest Bearing Notes (ibnnewsletter@worldbank.org)

Thu 7/17/08

Interest Bearing Notes  Vol. 11  No. 4

Contents

I  What’s new on our website
The bifurcated world of microfinance

II  World Bank research
Should we trust our instruments?
Corrupt bureaucrats or innumerate managers?
Good, bad, and ugly colonial activities – and why they matter today
Do microenterprises hold the potential for growth?

III  “FYI”: Our eclectic guide to recent research of interest
Middle class entrepreneurs (or not)
Is private equity destroying jobs?
Two puzzles are better than one: Explaining capital flows to developing countries
Changes in bank regulation and supervision: for better or worse?
Holdings of domestic debt on the rise in developing banking sectors

IV  Upcoming events and miscellanea
Conference & call for papers
All about deposit insurance

The next issue of Interest Bearing Notes will appear in September 2008 so please send comments, suggestions (such as your own or others’ interesting research), and requests to be added to our distribution list, to Agnes Yaptenco (mailto:ayaptenco@worldbank.org) by September 8th.

IBN is a product of the Finance and Private Sector Development Team in the World Bank’s Development Research Group. Our working papers and descriptions of research projects in progress can be found, along with a list of forthcoming seminars and conferences, on our web page (http://econ.worldbank.org/programs/finance).

I What’s new on our website

The bifurcated world of microfinance
Mexico’s Banco Compartamos raised $1.6 billion from a public offering of its stock in April 2007, heralding the commercialization of microfinance on a scale never before contemplated. Not so fast say Asli Demirguc-Kunt, Jonathan Morduch, and IBN co-editor Bob Cull. Using a data set that includes 346 of the world’s leading microfinance organizations and covers nearly 18 million borrowers they find that, while commercialization is a powerful trend, banks like Compartamos and avowedly “social businesses” like Grameen Bank (originated by Nobel Prize winner Muhammad Yunus) are not substitutes. The data show that microfinance is not taking a single path, nor that it should. Click here for eight basic findings that could help frame the debate.

II World Bank research

Should we trust our instruments?
Instrumental variables techniques in empirical research hinge on satisfying the exclusion restriction – that the error term in the equation of interest is uncorrelated with the instrument. And so, many of the landmark papers in recent years develop intricate arguments as to why a given instrument satisfies the exclusion restriction (and is, at the same time, highly correlated with the endogenous regressor). In “Instrumental Variables Regression with Honestly Uncertain Exclusion Restrictions,” Aart Kraay takes a step back to unravel what happens when a researcher is, in fact, uncertain that the restriction is satisfied. He starts by assuming that the uncertainty regarding the correlation between the instrument and the error term can be captured by a well-specified prior distribution centered on zero. He then uses Bayesian updating procedures to demonstrate that even modest prior uncertainty about the validity of the exclusion restriction can lead to substantial loss of precision in the IV estimator. The loss of precision depends on the nature of the sample, and, somewhat counter intuitively, can be most severe when the sample size is large or the instrument is particularly strong. He then adjusts standard errors to reflect this uncertainty for two papers that are familiar to IBN readers: the Rajan and Zingales (1998) study of the relationship between financial development and growth, which uses legal origin and institutional quality as instruments for financial development, and Acemoglu, Johnson, and Robinsion (2001) which examines the effects of institutional quality on development using settler mortality rates in the 18th and 19th centuries as instruments for institutions. Aart finds that moderate uncertainty about the exclusion restriction in the former paper is sufficient to question the significance of its findings, while for the latter only the most severe uncertainty about the restriction renders its results insignificant. On the one hand, it seems to us that arguing about the uncertainty of the exclusion restriction isn’t much different from standard discussions of the validity of an instrument. On the other, by providing a mapping from this uncertainty to the reliability of the estimated coefficients, Aart gives researchers a valuable tool for assessing the extent of the damage we do in a particular sample and for a particular level of plausibility of the instrument. http://go.worldbank.org/T6YAAMNZE0

Corrupt bureaucrats or innumerate managers?
No one likes to admit to corruption, which means that estimating the size and the impact of corruption on economic activity is a difficult task for development researchers. Surveys attempt to circumvent the problem of underreporting and lying by asking managers to estimate “typical bribes for a firm like yours” and to report numbers as percent of sales, rather than a nominal amount. But are these estimates accurate? In “How Petty is Petty Corruption? Evidence from Surveys in Africa,” George Clarke demonstrates that estimates of corruption are much higher when reported as a percentage of sales than as a nominal amount in local currency. The same holds for estimates of security costs, losses from crime and losses due to power outages: when managers estimate those as a percentage of sales, the averages are much larger, even after controlling for observable firm characteristics. George explores several plausible explanations for this phenomenon, such as outliers and selection issues, however, the puzzle remains. He suggests that managers simply overestimate the numbers when they scale them by sales. Perhaps, the researchers could test managers’ basic math skills, such as their fluency with fractions, along with the question on corruption. An easier solution might be to ask them to report these in nominal amounts.
http://ssrn.com/abstract=1117631

Good, bad, and ugly colonial activities – and why they matter today
There is now more and more evidence indicating that institutions matter for economic development. Some have argued that the origins of these institutions date far back in history, to colonial times, and that the colonial experience can be used to explain income differences across countries (See Acemoglu, Johnson, and Robinson 2001 discussed above). In “Good, Bad, and Ugly Colonial Activities: Studying Development across the Americas,” Miriam Bruhn and Francisco Gallego show that this argument also holds within countries in the Americas. The authors collect data on the type of economic activity that the colonizers performed in 332 regions within 16 American countries. They then label the activities as “bad” if they depended heavily on the exploitation of labor, thereby creating extractive institutions, and as “good” if most people engaged in them stood on an equal footing, creating inclusive institutions. The results show that areas with bad colonial activities have 15% lower GDP per capita today than areas with good activities. Moreover, the authors construct a measure of pre-colonial population density and show that areas with high pre-colonial population density have significantly lower GDP per capita today than areas with low pre-colonial population density. Interestingly, the positive effect of good activities goes away in areas with high pre-colonial population density. The authors attribute this to the “ugly” fact that colonizers used the pre-colonial population as an exploitable resource, thereby also creating extractive institutions.  Additional evidence suggests that the intermediating factor between colonial activities and economic development today is indeed institutions, and not income inequality or the current ethnic composition of the population.
http://go.worldbank.org/2L3UE6BQW0

Do microenterprises hold the potential for growth?
In recent years, microenterprises have received increased attention from policy makers. They have been targeted through a number of government sponsored programs, such as microcredit and business training, with the hope that these programs would help them grow into larger firms. Hernando de Soto is a prominent advocate of the view that microenterprises have the potential for growth, but that they are being held back by various constraints. However, there is also an opposing view, promoted by Victor Tokman, which claims that microenterpise owners are engaging in these marginalized activities only while they are waiting for a better opportunity in wage work. In their paper “Who are the microenterprise owners?: Evidence from Sri Lanka on Tokman v. de Soto” Suresh Del Mel, David McKenzie, and Christopher Woodruff assess which of these two views applies to microenterprises in Sri Lanka. They collected a unique dataset on own account workers (non-employers), wage workers, and owners of larger firms, which, apart from covering standard variables, such as age, gender, and education, also includes more innovative measures of entrepreneurial ability, such as cognitive ability tests, family background characteristics and entrepreneurial attitudes. Based on these variables, the authors apply a tool from biology – discriminant analysis – to classify own account workers either as wage workers or larger firm owners. The results show that 70% of own account workers are more similar to wage workers in terms of their characteristics and 30% are more similar to larger firm owners, suggesting that a significant number of microenterprises do hold the potential for growth. http://go.worldbank.org/N5D5VXSJ10

III “FYI”: Our eclectic guide to recent research of interest

Middle class entrepreneurs (or not)
Research has shown that countries with a larger middle class grow faster. One argument that could explain this finding is that entrepreneurs often emerge from the middle class. Abhijit Banerjee and Esther Duflo examine this claim in “What is middle class about the middle classes around the world?” They combine household surveys from 13 developing countries to document how the middle class differs from the poor, where the middle class as they define it roughly spans the 30th to 80th income percentile in each country. The data show that the middle class is not much more likely to be self-employed than the poor. And, surprisingly, the businesses owned by the middle class are only slightly larger in terms of employees than the businesses run by the poor. Even more surprisingly, although the middle class has a larger potential to save and more access to bank loans, they do not invest more in their businesses than the poor. Instead, they spend more on health care, education, and durable assets like a television or radio. The authors find that the biggest occupational difference is that the middle class is more likely to hold a relatively secure, salaried job than the poor (which is what makes them richer). In conclusion, the middle class does not appear to be particularly entrepreneurial. It could be that, even though they have more wealth and better access to banks than the poor, they would need even greater wealth or larger bank loans for being successful entrepreneurs, or they may be lacking another crucial factor for business success: the right connections. http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=6613.asp

Is private equity destroying jobs?
Some policy makers are concerned about the negative impact that private equity buyouts could have on employment in target firms. Empirical evidence on this issue is not very conclusive since most studies suffer from data limitations and are not able to track all establishments that are part of a target firm over time. The studies also often lack a valid counterfactual. In “Private Equity and Employment,” Steven Davis, John Haltiwanger, Ron Jarmin, Josh Lerner, and Javier Miranda try to overcome these two obstacles by using a US Bureau of the Census database that includes all non-farm firms and establishments in the US between 1976 and 2005, allowing the authors to examine 4,500 target firms of private equity transactions, comprised by a total of 300,000 establishments, for several years around the transaction data. The rich dataset also allows them to define 1.4 million comparison firms that were not private equity targets, but that have comparable observable characteristics (there may still be unobserved differences that the study cannot account for). When considering only establishments operated by target firms before the private equity transaction, the data show that post-transaction job creation is similar in target and comparison firms, but job destruction is greater in target firms. However, when also considering new establishments opened by target firms after the transaction, the authors find that target firms engage in more greenfield job creation than comparison firms. Increased job destruction after private equity buyouts in existing establishments is thus at least partially offset by job creation in new establishments.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1107175

Two puzzles are better than one: explaining capital flows to developing countries
Standard economic theory predicts that capital should flow to countries that have higher productivity growth. The data, however, disagree: countries that have experienced lower productivity growth (for example, Madagascar), have received more net capital inflows than countries that have experienced higher productivity growth (e.g. Korea). In their recent paper Pierre-Olivier Gourinchas and Olivier Jeanne refer to this phenomenon as the “allocation puzzle.”  Great! Now in addition to the famous Lucas (1990) puzzle, which is about the small size of capital flows from rich to poor countries, we now have an allocation puzzle – the flows go in the opposite direction. Clearly, we economists have our work cut out for us in explaining these “abnormalities.” If you wonder about aid flows – well, they do not fully explain the puzzle, although they may play a role. To some extent the puzzle might be explained by frictions and inefficiencies in domestic financial markets, which reduce responsiveness of investment to productivity growth, thus reassuring some of us who are involved in research on financial development. The authors lay out several other explanations for this puzzle, but leave much room for future research. Breaking down total flows into different categories might also be interesting to explore. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1140088

Changes in bank regulation and supervision: for better or worse?
Seems your IBN co-editors are never too far from the contentious issues surrounding the appropriate design of bank regulation and supervision. And Jim Barth, Jerry Caprio, and Ross Levine (BCL) draw us back to those issues with their recent paper, “Bank Regulations Are Changing: For Better or Worse?” By now, our readers are familiar with their finding that private monitoring mechanisms seem to improve banking sector outcomes more than strengthening capital regulations and empowering official supervisors, neither of which are associated with improved banking-system stability, enhanced efficiency of intermediation, or reduced corruption in lending. Yet, this latest update of the cross-country dataset enables the authors to demonstrate that in the recent past many countries have made capital regulations more rigid and empowered supervisors (in part due to Basel II) while relatively few have strengthened private monitoring, though there are notable exceptions such as Mexico. Countries have also intensified restrictions on banks’ non-lending activities, which BCL have shown is associated with greater instability, slower development, and reduced efficiency in the banking system. One might quibble with whether certain components of the private monitoring index belong in the supervisory index, or whether there are important complementarities between official supervision and private monitoring yet to be teased out, but the authors have clearly struck on an important source of variation in banking sector outcomes. Rather than heed the resulting advice, many governments seem to be headed in the opposite direction. As with past editions of the survey, the data are available on our website and those that have doubts about the sensitivity of the results to the construction of the indices are encouraged to try their hand at deriving their own results.
http://go.worldbank.org/L5FMHM7XK0

Holdings of domestic debt on the rise in developing banking sectors
Government domestic debt went from one-third of government debt in the mid 1990s to two-thirds in 2005 in the 25 largest developing country banking systems, a change that has some important implications for risk and regulation of the financial system. James Hanson puts together these figures on government debt, which include a significant amount of central bank debt in some countries, from publicly available sources.  He argues that the rapid growth of government domestic debt reflected the resolution of financial crises, the growth of central bank debt and the greater attractiveness to governments of issuing domestic debt, as well as the increased demand for it from foreigners in a benign international environment.  However, increased government reliance on domestic borrowing increases risks for the banking system under the standard debt management policies. Typically government debt management tries to extend debt maturities and increase borrowing in domestic currency.  Banks’ liabilities typically do not increase in maturity and become denominated in domestic currency very rapidly, leaving banks with an asset-liability mismatch.  Reducing the risks requires some shifts in bank regulatory and supervisory policy and a debt management policy that takes into account the potential shift in risk from the government to the banks.  In the non-bank part of the financial system, the growth of domestic debt also creates some new risks and burdens. For example there are issues across generations in fully-funded pension systems between those who retire soon after a balance of payments crisis, compared to those who retire later. http://go.worldbank.org/3I0SWWYZZ0

IV  Upcoming events and miscellanea

Conference & call for papers
The program for the Conference on Risk Analysis and Management that will take place at the World Bank on October 2-3, 2008 is now posted here on our website.

As mentioned in the last IBN, Stijn Claessens, Asli Demirguc-Kunt and Fariborz Moshirian are also editing a special issue of the Journal of Banking and Finance on the same topic as the conference. The deadline for submissions to this special issue is approaching fast. Make sure to get your submissions in by July 31.

All about deposit insurance
Regular IBN readers are familiar with the burgeoning empirical literature showing that overly generous, poorly designed explicit deposit insurance schemes can have destabilizing effects on banking sectors, especially in weak institutional environments. Our own Asli Demirguc-Kunt has teamed up with Luc Laeven and Ed Kane to produce “Deposit Insurance Around the World: Issues of Design and Implementation” (MIT Press) that nicely ties this literature together. The book includes an update of the first cross-country dataset on the design of deposit insurance programs and a discussion of the global pattern of adoption of explicit insurance; an overview of the literature linking poorly designed programs with instability and slow development in banking sectors; discussions of pricing issues and the interplay between deposit insurance and bank failure resolution; and a series of instructive country case studies (including the United States, Mexico, and Russia).  The authors then do a fine job of distilling their findings into six guiding principles of good design: limited insurance coverage, compulsory membership, private-sector participation in overseeing the scheme, appropriate pricing, restrictions on the ability to shift losses to the taxpayer, and assigning explicit responsibility for bank insolvency resolution. Sure to become an indispensable reference for policy makers and researchers alike.

Happy Reading!

Your editors Miriam Bruhn (mbruhn@worldbank.org), Bob Cull

(rcull@worldbank.org), and Inessa Love (ilove@worldbank.org).

Interest Bearing Notes July 2008‏

Interest Bearing Notes (ibnnewsletter@worldbank.org)

Interest Bearing Notes  Vol. 11  No. 4

Thu 7/17/08