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August 2004 Big Banks Can Expedite Emerging Markets
In the world of American business, anything that stays too big for too long is likely to get the sledgehammer. "Oligopoly" and "monopoly" have become nearly profane terms in the lexicon of most U.S. economists. But big is not necessarily bad, argues Business School professor Thomas Hellmann, particularly when it comes to banks in developing countries. In fact, most of Europe might never have industrialized without the influence of large universal banks that gave national economies the financial support they needed. Policymakers also should rethink the notion that government intervention is the only viable mechanism for promoting large-scale development. Private banks played a large role in Europe's growth. Hellmann, assistant professor of strategic management, and Marco Da Rin, assistant professor at the University of Turin, come to these controversial conclusions in a study of why banks seem to play a creative role in some but not all emerging markets. Hellmann's work leverages previous research showing that various parts of an economy must rise up simultaneously if a country is to avoid the underdevelopment trap. "In other words, you can't just have one industry—such as coal mining, steel, or railroads—because any one of these is useless without the other," he says. "You need coal to make steel, and railroads to transport them all. To develop successfully, therefore, a newly industrializing economy needs a 'big push,' and the financial system might be key in providing that." Hellmann examined early industrialization in several Western countries, notably Belgium, Italy, and Germany. He found that the ability of such countries to move into a phase of rapid and coordinated industrial growth was due to the financial muscle provided by large universal banks, which were able to engage in both commercial and investment banking activities. Countries that were not able to industrialize successfully, such as Russia and Spain, he discovered, lacked such banks—generally because there was a legal impediment to their formation. "The U.S. and the U.K. developed by means of a stock market, but our historical analysis clearly shows that the stock market is not the only financial system for promoting a healthy economy," Hellmann says. The study by Hellmann and Da Rin is the first to demonstrate from a game-theoretical perspective the conditions under which banks may succeed in catalyzing economic development. First, they must be large enough to finance a critical mass of industries that can work in concert, such as the mining, steel, and railroads example above. Such monetary flexibility is particularly important given that banks will initially incur losses before industrialization is up and running. Second, such banks must have the right incentives. Naturally, these come from the pursuit of profits, and this requires market power, the freedom to charge above-market interest rates. "Banks need to be in a position in which competition does not dissipate all profits," Hellmann says. "Market power allows them to charge loan interest rates or rates on return of equity that are higher than those the market would otherwise bear. Only this will give them the means of eventually recouping their losses from jump-starting the economy. Market power is, at least in the beginning, a necessary evil." Previous studies have typically concluded that government intervention may provide the only viable means for catalyzing economic development. "Given the inefficiencies of government, however, this solution has been problematic," says Hellmann. "We show that private instruments can provide the necessary mobilization. You don't need the government to coordinate a big push." Acknowledging the aversion most American theorists have for anything that limits competition, Hellmann says: "We're arguing that oligopolistic banks may actually be useful in helping to mobilize industrialization. They're not the only answer, but they do have their usefulness. We're simply putting in a word of caution about the blind trust that many economists seem to have in competition as the only solution to all development problems." Hellmann and Da Rin's paper, titled "Banks as Catalysts for Industrialization," won the Journal of Financial Intermediation's best paper prize in 2002 for bringing new insights to an old debate. —MARGUERITE RIGOGLIOSO |
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Further ReadingBanks as Catalysts for Industrialization
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Big
Banks Can Expedite Emerging Markets
