1. The Political Economy of Finance (2014) Enrico Perotti Presentation by Gerard Hertig

2. Presentation Outline 1.Importance of institutions 2.Financial development in emerging countries 3.Great reversals 4.Financial instability 15.01.2015G. Hertig2

3. 1. Importance of Institutions Economic exchange shaped by political, legal and cultural institutions Institutions – Combination of formal norms and informal ‘rules of the game’ – Highly persistent as deeply embedded in social expectations Quality of institutions can explain economic renewal and growth across countries 15.01.2015G. Hertig3

4. Institutions that are Critical for Finance Financial contracting – Separation of ownership and control – Diversification and specialization Protection of investors – Induce investments – Size, composition and allocation of capital Prudential regulation – Containing negative spillovers 15.01.2015G. Hertig4

5. Type of Institutions Political – Formation of capital – Impact on legal framework Legal – Rules of organization, cooperation and conduct – Impact on enforcement framework Cultural – Social norms – Impact on politics and legal framework 15.01.2015G. Hertig5

6. 2. Financial Development in Emerging Countries 2 models – State dominated (less developed capital markets) – Business group (more developed capital markets) Political liberalization is said to facilitate – Moving from state ownership – To concentrated ownership 15.01.2015G. Hertig6

7. Concentrated Ownership 15.01.2015G. Hertig7

8. Why Moral Hazard? Privileged access to finance – Loans, bailouts, etc – Due to political connections Regulatory capture – Barriers to entry for competitors Often very high in emerging markets Allow for high rents – Facilitated by political connections 15.01.2015G. Hertig8

9. Political Institution & Financial Structure Natural Test 1: Chile Business groups close to Pinochet enjoyed remarkable privileges over many years Flawed privatization in the 1970s  Borrowed money enabled many groups to take control over many firms Major bank collapse in early 1980s  forced renationalization of banks Valuation of business groups decline in 1980s- 1990s as return to democracy 15.01.2015G. Hertig9

10. Political Institution & Financial Structure Natural Test 2: Korea Until early 1980s: Government favored allocation of credit to chaebol business groups During these years chaebols enjoy their highest valuations Post 1997 Asian crisis: Public opinion pressure to adopt stronger regulatory and governance standards Korea enjoyed faster recovery than its neighbors and considerable broadening of its financial system 15.01.2015G. Hertig10

11. Can we deal with this via tighter financial regulation? State dominated countries restrict bank entry Less bank stability, more corruption in lending, lower credit market development Evidence that restrictive regulation reflect political opportunism, not optimal response to moral hazard Formal rules do not help when institutions are poor 15.01.2015G. Hertig11

12. Better to Look at the Dynamics of Capture Consequence of family-based ownership structures – Key vulnerability: Heirs to a family firm have less talent than other manager – Dynastic management: Reduces firm value Legal reform aimed at facilitating transfer of ownership – Less opposition than reducing barriers to entry – Improves access to finance Wealthier incumbent did not really need Crucial for newcomers – Open the doors to competition 15.01.2015G. Hertig12

13. Effect of Wealth Distribution on Regulatory and Corporate Governance Regime (Model) Economy with more concentrated wealth  Political support for – Greater role of banks over minority equity investors – Larger over dispersed shareholders – Government role in governance Intuition: – Less wealthy median voter more concerned by labor income risk than financial return – More wealthy median voter support lower labor rents and more financial risk taking = higher financial returns 15.01.2015G. Hertig13

14. Great Reversals Remarkable rise & decline of public capital markets in Continental Europe and Japan in first half of XX th century Civil law countries first more financially developed than common law countries, than less Shift attributed to: – Great Depression (drastic trade barriers, strengthened bargaining power of established firms, increased regulatory capture) – Civil law countries being more vulnerable to capture due to greater reliance on codified regulation 15.01.2015G. Hertig14

15. Inconclusive Code vs. Case Law Debate Evolution of investor protection in common law countries after 1929 driven by legislation in both UK and U.S. (securities regulation) Various civil law countries remained market- oriented (Netherlands, Sweden, Switzerland) It follows that legal explanation is not sufficient – WW II destruction – Public finance deficits, financed via high inflation – Exogenous to legal or political institutions – Middle class was especially affected 15.01.2015G. Hertig15

16. 4. Financial Instability Crises in emerging markets often attributed to short-sighted macro-economic policies – Excessive public spending or borrowing – Excessive monetary creation These choices may be endogenous to political and legal institutions – Banking crisis more likely in countries with weaker institutions or investor protection – Weak corporate governance explain exchange rate drops during Asian crisis better than exchange rate policy, government borrowing or foreign lending 15.01.2015G. Hertig16

17. Impact of Increase in Accountability Theory: Less instability when political accountability and stability increase Not clearly consistent for countries in transition (Chile, Korea, Mexico, Russia) – Financial vulnerability precisely when countries privatize their banks – Due to regulatory inexperience? – Model shows jump in instability at time of privatization Not clearly consistent for highly accountable countries – Limit risk-taking vs. Competition – Supervision vs. Financing marginal borrower – Are laissez-faire and politics more important for instability than poor private governance ? 15.01.2015G. Hertig17