Financial liberalization stimulates competition and thereby supposedly increases
the efficiency of investment. A simple credit market model is developed to show that such
efficiency improvements may be disturbed by competition-induced incentives for banks to
accept higher default rates, which result in instability of the financial system. Thereby we
offer a complementary explanation to the relationship between competition and stability in
financial markets. Consequently we argue that government intervention, in the form of
intelligent regulation, is necessary to ensure the development of sustainable financial
markets.
Table of Contents
1. Introduction
2. The Case of Bolivia
3. Theoretical Framework
3.1. Macroeconomic effects of financial liberalization
3.2. Microeconomic effects of domestic financial liberalization
3.3. Research question
4. The Model
4.1. Entrepreneurs
4.2. Banks
4.3. Credit default
4.4. Optimal strategy
5. Discussion
5.1. Heterogeneous banking technologies
5.2. The distribution of the individual cost to default
5.3. Involuntary loan default
5.4. Monitoring
5.5. Provisioning
5.6. Credit Bureaus
5.7. Stylized Facts
5.8. Limitations
6. Conclusion and Policy Recommendations
7. References
Research Objectives and Themes
The research examines the relationship between financial liberalization, increased market competition, and systemic financial instability in developing economies. It aims to answer whether the pursuit of cost-efficiency by financial intermediaries incentivizes a shift toward riskier lending methodologies, thereby undermining the stability of the financial system.
- Theoretical analysis of information asymmetries in credit markets
- Evaluation of the "risk-shifting" and "margin" effects in banking
- Case study of the 1999 Bolivian indebtedness crisis
- Development of a credit market model linking interest rates, screening intensity, and default rates
- Policy recommendations for intelligent financial regulation
Excerpt from the Book
3.2. Microeconomic effects of domestic financial liberalization
Joseph Stiglitz and Andrew Weiss (1981) pointed out another series of peculiarities of financial (and labor) markets that would lead to credit rationing even in perfectly competitive markets: asymmetric information. In standard economic theory it is assumed that all agents are perfectly informed about the market and other agents. The distinctiveness of financial markets is that interest rates, which take the function of prices in normal markets, do possess sorting and incentive effects that may lead to opportunistic behavior of better-informed agents (Capasso, 2003). This is especially true in the absence of functioning equity markets as was and is the case in many developing countries, as these markets may serve those underserved in the credit market (Cho, 1986). Recent research also introduces the role of better-informed lenders rather than borrowers that may, as Roman Inderst (2008) argues, lead to excessive lending with adverse impacts on the economy by the promotion of moral hazard.
Auerbach and Siddiki (2004) give an excellent overview of microeconomic effects associated with financial liberalization. They conclude that the mixed empirical evidence shows that efficient governments as a result of high accountability are crucial to assess the benefits on economic growth. Efficient government institutions can constrain the financial sector where needed to avoid adverse effects as a result of information asymmetries through prudent regulation, thereby increasing the efficiency of investment. Gibson and Tsakalotos (1994) come to a similar conclusion; they assert that instead of an unconditional full-blown liberalization, it should be recognized, “…what markets are good at, where institutions are needed and what type of institutions, and how these markets and institutions can be combined” (p.620), in order to assure an effective channeling of funds to investment purposes. It is our goal in this paper to analyze this question in more depth, to do so it is eminent to analyze the effects financial liberalization has on financial intermediaries in order to identify areas where regulatory institutions need to step in.
Summary of Chapters
1. Introduction: Outlines the historical context of financial liberalization since the 1980s and introduces the debate regarding its impact on economic growth and financial stability.
2. The Case of Bolivia: Uses the Bolivian financial sector and its 1999 indebtedness crisis as a primary example to illustrate the risks of unregulated competition and changing lending methodologies.
3. Theoretical Framework: Provides an overview of macroeconomic and microeconomic literature concerning financial liberalization, focusing on information asymmetries and credit rationing.
4. The Model: Introduces a mathematical model of a credit market with risk-neutral agents to demonstrate how interest rate changes influence bank screening intensity and default risks.
5. Discussion: Explores model limitations and potential extensions, including banking technologies, credit bureaus, and the impact of provisioning requirements on risk management.
6. Conclusion and Policy Recommendations: Synthesizes findings and argues that intelligent regulation is necessary to balance market efficiency with the mitigation of systemic risks in developing countries.
7. References: Lists the academic sources and empirical data utilized throughout the study.
Keywords
Financial Liberalization, Credit Market, Competition, Stability, Information Asymmetry, Screening Intensity, Default Rate, Bolivia, Indebtedness Crisis, Moral Hazard, Risk-Taking, Banking Technology, Regulation, Financial Intermediaries, Economic Development
Frequently Asked Questions
What is the core focus of this master thesis?
The work investigates the negative consequences of financial liberalization on system stability, specifically focusing on how competition influences the risk-taking behavior and lending methodologies of banks.
What are the primary thematic areas covered?
The paper covers the theoretical underpinnings of financial liberalization, the role of information asymmetries in credit markets, the dynamics of bank competition, and the practical implications observed during the Bolivian financial crisis.
What is the main research question?
The study asks whether the increased cost-efficiency of financial intermediaries, driven by liberalization, incentivizes a shift toward riskier lending methodologies that heighten financial market instability in developing countries.
Which scientific methods are employed?
The author uses a theoretical credit market model involving monopolistic competition to derive propositions, which are then analyzed against historical case study data from Bolivia and existing academic literature.
What does the main body of the work treat?
The main body treats the construction of a mathematical model where banks choose their optimal screening intensity, followed by a discussion on factors like credit bureaus, provisioning, and heterogeneous banking technologies.
Which keywords characterize the work?
The work is characterized by terms such as financial liberalization, credit market imperfections, information asymmetry, screening intensity, and systemic stability.
Why is Bolivia chosen as a case study?
Bolivia is utilized because its relatively isolated financial market and documented experience with the Washington Consensus provide a clear example of the positive and negative consequences of domestic financial liberalization.
How does the model explain bank risk-taking?
The model shows that as competition lowers interest rates, banks face declining margins. Consequently, they may reduce their "screening intensity" (due diligence) to cut costs, which inadvertently leads to higher default rates and greater systemic instability.
What are the implications for policy makers?
The author suggests that regulators must move beyond merely lowering interest rates; they should implement intelligent regulations, such as rigorous provisioning requirements and improved information sharing via credit bureaus, to ensure that competition does not undermine the financial system.
- Quote paper
- Tim Niepel (Author), 2013, Financial Liberalization, Credit Market Imperfections and Financial System Stability, Munich, GRIN Verlag, https://www.grin.com/document/300068
