Financial Sector Assessment:A Handbook Box 4.1 Quantitative Indicators for Financial Structure and Development Assessment The meas penetration indicat y with d and s 4 (M2)for lude some more detailed analysis ontract ento of the a ourt systems such as the dof judicial co tion),spee ctiveness of it and loan sie distribution,as well as rights,presence of a credit registry,and fimm entry -c an be drawn from e World Bank nents from the World Business Environment number of banks, ally th ment-owned banks are also relevant.Eficienc overhead costs c off by relevant s mmary economic and the informal cco nomy.illit arate total popul services include cash-to-GDP ratio lags in check c h can be World Bank. umber and more de able for aa oof countries,thus allow sources.is contained in chapter 2. Ideally,given data availability,it may be possible to use the results of research studies that have identified causal factors for cross-country differences in depth,efficiency,and other dimensions of financial development.For example,several studies have attempted in average bank margins-key indicators of the price effici banking in terms of policy,institutional,and macroeconomic variables.Those variable include the bank's size,a measure of property rights protection,and other bank-and country-level characteristics.such as bank concentration.output gap,and interest rate level Ifthose policy and for the tion,the results of the studies can be used to throw light on potential improvements that could be achieved through better policies and better institutions.The residual between the expected value of average bank margins in the country predicted by the study and the actual margins,if positive,will point to the need for closer analysis of idiosyncratic ures in the country-fearures that may be contributing to the gap.(For an illustratior of this technique in practice in Kenya,see appendix E.)A similar approach can be used
74 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 Ideally, given data availability, it may be possible to use the results of research studies that have identified causal factors for cross-country differences in depth, efficiency, and other dimensions of financial development. For example, several studies have attempted to explain differences in average bank margins—key indicators of the price efficiency of banking in terms of policy, institutional, and macroeconomic variables. Those variables include the bank’s size, a measure of property rights protection, and other bank- and country-level characteristics, such as bank concentration, output gap, and interest rate level.4 If those policy and institutional variables are available for the country in question, the results of the studies can be used to throw light on potential improvements that could be achieved through better policies and better institutions. The residual between the expected value of average bank margins in the country predicted by the study and the actual margins, if positive, will point to the need for closer analysis of idiosyncratic features in the country—features that may be contributing to the gap. (For an illustration of this technique in practice in Kenya, see appendix E.) A similar approach can be used Box 4.1 Quantitative Indicators for Financial Structure and Development Assessment The measures chosen as quantitative indicators for financial structure and development assessment will naturally include basic indicators of financial depth expressed as a percentage of gross domestic product (GDP). The indicators are proxies for the size of the different components of the financial sector and could include credit to the private sector and broad money (M2) for banking; number of listed equities and bond issues, market capitalization, and value traded of financial markets for financial markets; and insurance premium income and asset size for insurance. Data on breadth and penetration—which are proxies for the population’s access to different segments of the financial sector and, thus, for outreach—of financial markets include bank branch and outlet intensity and deposit and loan size distribution, as well as number of clients in the banking, nearbanking, and insurance sectors. The data gauge the share of the population with access to financial services. Data on market structure—number of banks, concentration in banking, and share of foreign-owned and government-owned banks—are also relevant. Efficiency measures include interest margins, overhead costs or asset indicators, and turnover ratios for capital markets. Indicators of efficiency and quality of payment services include cash-to-GDP ratio, lags in check or payment order clearing, volume and value of checks or payment orders processed in retail and large value payment systems, and number and density of ATMs. Indicators for size, depth, and efficiency are available for a large cross-section of countries, thus allowing comparison; however, the assembly of breadth and penetration indicators on a cross-country basis is in the beginning stages. There is a clear ranking of cross-country data availability among different sectors, with data on banking, insurance, and stock markets more readily available than on bond markets and microfinance. Quantitative benchmarking may also include some comparisons over time within countries where feasible and should serve as basis for more detailed analysis. Infrastructural quality measures—contract enforcement (including measures of the effectiveness of the court systems such as the speed of judicial conflict resolution), speed and effectiveness of insolvency procedures, creditor and minority shareholder rights, presence of a credit registry, and firm entry regulations—can be drawn from the World Bank’s Doing Business Database. Also informative are user assessments from the World Business Environment Survey. Finally, the quantitative indicators for financial structure and development assessment can be rounded off by relevant summary economic and social indicators such as GDP per capita, share of the informal economy, illiteracy rate, total population size, and so forth, which can be selected from the World Development Indicators published by the World Bank. A more detailed presentation of financial structure indicators, including definitional issues and data sources, is contained in chapter 2
Chapter 4:Assessing Financial and Financial Development for banking depth where macrovariables,such as inflation and the level of gross domestic product(GDP)per capita,are key determinants along with institutional variables,such as shareholder and creditor rights (e.g.,see Beck,Demirguc-Kunt,and Levine 2003). There are also some cross-country studies of other dimensions.including insurance penetration,stock market capitalization,and turnover,although those studies may not yet be sufficiently well established for heavy reliance to be placed on them for bench marking purpos es.Along with other dimensions,including ess to fina cial se not yet sufficieny developed o t this ki 4 ing.In those cases,simple cross-cou comparisons against peers can,nevertheless,be informative and can point to areas of deficiency. 4.3 Review of Legal,Informational and Transactional Technology Infrastructures for Access and Development The major cross-cutting infrastructures can be grouped under the three headings of legal informational,and transactional technology.The robustness of legal infrastructures is universally acknowledged as crucial to a healthy financial system.Creditor protection entral,as is bankruptey law and its impleme ation.In e areas,re rm of the co rt system is often att art c ance law and e can also b hiomataalinfiaicesne&indeacontingandadingTiesandpacice,phsth see as co legal and organizational requirements for public or private credit registries and property registries.Other aspects,such as the ratings industry,may be relevant in more-advanced middle-income countries.Internationally recognized accounting and auditing standards exist,and assessments of their observance,when available,can be useful for both stability and development assessments.The nost important transactional technology infrastruc relat g holesale pay and nay already be mpo nt Payment Syste s (CPS (See S) e chapte s of CPSI nt purp is the functioning of the retail payments system:although it is not vulnerable to sudder failure on a large scale,it is not considered"systemically important"in the sense of the CPSIPS.The efficiency with which the legal.information.and transactional technol. ogy infrastructures support financial intermediation in the country plays a critical role ir access and development.Detailed assessments of those areas are described in chapters 9, 10,and 11 of this handbook,and they provide information on the quality of the infra ed below 4.3.1 Legal Infrastructure 1997,1998,and Levine Although discussed in more detail in chapter 9 of this handbook,the following discus sion highlights the aspects of the legal system that are important for development assess- ment. 75
75 Chapter 4: Assessing Financial Structure and Financial Development 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 for banking depth where macro-variables, such as inflation and the level of gross domestic product (GDP) per capita, are key determinants along with institutional variables, such as shareholder and creditor rights (e.g., see Beck, Demirgüç-Kunt, and Levine 2003). There are also some cross-country studies of other dimensions, including insurance penetration, stock market capitalization, and turnover, although those studies may not yet be sufficiently well established for heavy reliance to be placed on them for benchmarking purposes. Along with other dimensions, including access to financial services, cross-country research is not yet sufficiently developed to support this kind of benchmarking. In those cases, simple cross-country comparisons against peers can, nevertheless, be informative and can point to areas of deficiency. 4.3 Review of Legal, Informational, and Transactional Technology Infrastructures for Access and Development The major cross-cutting infrastructures can be grouped under the three headings of legal, informational, and transactional technology.5 The robustness of legal infrastructures is universally acknowledged as crucial to a healthy financial system. Creditor protection in principle and in practice is central, as is bankruptcy law and its implementation. In both of those areas, reform of the court system is often at the heart of needed reforms. Corporate governance law and practice can also be seen as coming under this heading. Informational infrastructures include accounting and auditing rules and practice, plus the legal and organizational requirements for public or private credit registries and property registries. Other aspects, such as the ratings industry, may be relevant in more-advanced, middle-income countries. Internationally recognized accounting and auditing standards exist, and assessments of their observance, when available, can be useful for both stability and development assessments. The most important transactional technology infrastructures—relating to wholesale payments and settlements—may already be assessed using the Core Principles of Systemically Important Payment Systems (CPSIPS). (See chapter 11 for details of CPSIPS.) The additional dimension required for development purposes is the functioning of the retail payments system: although it is not vulnerable to sudden failure on a large scale, it is not considered “systemically important” in the sense of the CPSIPS. The efficiency with which the legal, information, and transactional technology infrastructures support financial intermediation in the country plays a critical role in access and development. Detailed assessments of those areas are described in chapters 9, 10, and 11 of this handbook, and they provide information on the quality of the infrastructure elements, which are discussed below. 4.3.1 Legal Infrastructure The efficient functioning of the legal system is indispensable for effective financial intermediation (e.g., see La Porta et al. 1997, 1998, and Levine, Loayza, and Beck 2000). Although discussed in more detail in chapter 9 of this handbook, the following discussion highlights the aspects of the legal system that are important for development assessment
Financial Sector Assessment A Handbook In addition to the cro country quantitative evidence mentioned in box 41,underly exerci Systems (World Bank 2001b)and from interviews with banks,enterprises,academics,and other market participants. The effective creation,perfection,and enforcement of collateral is a cross-cutting issue for financial intermediation and requires assessing the appropriate legislation,the 4 property registries (including stamp duties and notary fees),the court system,and the out-of-court enforcement mechanisms.If collateral taking is limited to certain assets or if high collateral-to-debt ratios are equired.this limitation or size gr effectiver sof collateral pr cess can ms of lending,such as interest rates,along with the competitiveness of the lending market. The effectiveness of debt enforcement and insolvency procedures in terms of cost and time it takes,both through and outside the court system,is important for effective and efficient intermediation.Expedited enforcement systems that use private negotiation and out-of-court settlement can be very helpful,if available.The possibility of flexible ways of achieving corporate financial restructuring,albeit without undermining creditors' Position,s A deficient insolvenc restrict the of the c system overalla and can lead to sub ptimal out-of-court settlements or even restrictions or the a sto,and the re ns of,lending The functioning of the court system is crucial.The evaluatior n here could include an assessment of the legal profession along several dimensions,such as education,skills funding,fees,and ethical behavior.The effectiveness of specialized courts in local cir- cumstances can be examined if we bear in mind that those courts can help in situations where complex commercial issues arise and even in situations with less-complex issues. such as loan recovery.The courts may work faster and more consistently than regulat courts-though experience here is mixed,and it may be better in the long run to vork ard an nt in the functioning of the cou The state of corporateg vemance,includi among managemen majority owners,and outside investors,can ct on the ease wi which outi invetor providefnancend the price tro o theuand he practice of corporate governance need to be considered;if a formal corporate governance assessment has been carried out,its findings can be drawn upon here. 4.3.2 Information Infrastructures Asymmetric information between borrowers and lenders and,thus,the transaction costs can be reduced if there is readily available information on the financial condition of bor- rowers and especially on their history of credit performance.In particular,two areas of the information infras should not be glected:(a)tr ency in bo financial sta ents enables lender rs to ss bo reditw h: pas t financial an opera ional performance,and (b readily available cr on borrowers e ables lenders to assess borrowers'creditworthiness according to their past performance within the financial system
76 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 In addition to the cross-country quantitative evidence mentioned in box 4.1, underlying factual information for this exercise can come both from any completed assessments of formal codes such as the Principles and Guidelines for Effective Insolvency and Creditor Rights Systems (World Bank 2001b) and from interviews with banks, enterprises, academics, and other market participants.6 The effective creation, perfection, and enforcement of collateral is a cross-cutting issue for financial intermediation and requires assessing the appropriate legislation, the property registries (including stamp duties and notary fees), the court system, and the out-of-court enforcement mechanisms. If collateral taking is limited to certain assets or if high collateral-to-debt ratios are required, this limitation can ration credit to certain sectors or size groups of borrowers. The effectiveness of the collateral process can also affect the terms of lending, such as interest rates, along with the competitiveness of the lending market. The effectiveness of debt enforcement and insolvency procedures in terms of cost and time it takes, both through and outside the court system, is important for effective and efficient intermediation. Expedited enforcement systems that use private negotiation and out-of-court settlement can be very helpful, if available. The possibility of flexible ways of achieving corporate financial restructuring, albeit without undermining creditors’ position, is important. A deficient insolvency framework can restrict the use of the court system overall and can lead to suboptimal out-of-court settlements or even restrictions on the access to, and the terms of, lending. The functioning of the court system is crucial. The evaluation here could include an assessment of the legal profession along several dimensions, such as education, skills funding, fees, and ethical behavior. The effectiveness of specialized courts in local circumstances can be examined if we bear in mind that those courts can help in situations where complex commercial issues arise and even in situations with less-complex issues, such as loan recovery. The courts may work faster and more consistently than regular courts—though experience here is mixed, and it may be better in the long run to work toward an overall improvement in the functioning of the court system. The state of corporate governance, including the relationships among management, majority owners, and outside investors, can have an important effect on the ease with which outside investors provide finance and the price thereof. Both the rules and the practice of corporate governance need to be considered; if a formal corporate governance assessment has been carried out, its findings can be drawn upon here.7 4.3.2 Information Infrastructures Asymmetric information between borrowers and lenders and, thus, the transaction costs can be reduced if there is readily available information on the financial condition of borrowers and especially on their history of credit performance. In particular, two areas of the information infrastructure should not be neglected: (a) transparency in borrowers’ financial statements enables lenders to assess borrowers’ creditworthiness on present and past financial and operational performance, and (b) readily available credit information on borrowers enables lenders to assess borrowers’ creditworthiness according to their past performance within the financial system.8
Chapter 4:Assessing Financial and Financial Development Credit registries,if they exist,vary widely in the information that is being collece and that is available to financial institutions;hence,they vary in their effectiveness in improving access.The effect on access is influenced by characteristics such as(a)which financial and nonfinancial institutions provide data and have access to the data(the more the better);(b)whether only negative information (i.e.,on defaults and delinquencies) also po ositive information, tion improves the potentia use of the registry for credit appraisal);(c)for what kind of loans is the information collected;and (d)for how long 4 is information kept.While there are reasons to expect privately owned registries to out. perform those operated by public agencies,there are instances of effective publicly owned registries.Local conditions can influence the choice here.Existing credit registries should evaluared not only on their design features,but also on how they have performed in practice.The legal and regularory environment is important fo stence and effective ness of credit registries and other financial information vendors.While protection of con- sumer privacy is important,unduly restrictive rules here can hamper information sharing on borrowers to the detriment of their access to credit. Credit registries may be complemented by other providers of financial information on nmercial infon on endors,such as Bloombergor Reuters,trade associa ts of c ating ag cies,might contrib eto transpar ency in the financial market.Finally,there might be private information-sharing agree ments between financial institutions outside the formal structure of a credit registry. Accounting and auditing standards and practices are important elements of the infor. mation environment in that they govern companies'disclosure of financial information to the public.A full assessment of the accounting and auditing standards (see chapter 10 for further details on these standards)in this a rea n sbe practicable,bu the standards,neverthele ss,represent the overall goa that should be aspired and ca e used as a reference for identifying information-based barriers to enhanced financing for the corporate sector. 4.3.3 Transactional Technology Infrastructures The effective transfer of money between customers of the same and of different institu- tions is one of the main functions of the financial systems.While the stability assessment of the paym nent system is mostly inte ment focuses more on the cost or a nd access to re velopment assessment includes evaluating the effectiveness of the check and money transfer system in terms of time and cost.It also entails assessing the access to those services,either directly through banks or indirectly through other financial institutions that use banks as agents.Indicators to assess the effectiveness of the payment system include the cost and to nsfer money.As alter studies have su the small nu tive indicators mbers of the popula ation an nd of subgrou who ha ve a tr sactions bank account,debit card,or credit card,as well as the distribution of travel time to the nearest ATM or money transmission point.Unfortunately,as yet,there is no cross-country dataset for such access indicators
77 Chapter 4: Assessing Financial Structure and Financial Development 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 Credit registries, if they exist, vary widely in the information that is being collected and that is available to financial institutions; hence, they vary in their effectiveness in improving access. The effect on access is influenced by characteristics such as (a) which financial and nonfinancial institutions provide data and have access to the data (the more the better); (b) whether only negative information (i.e., on defaults and delinquencies) or also positive information, including interest rate, maturity, and collateral, is collected and provided (positive information improves the potential use of the registry for credit appraisal); (c) for what kind of loans is the information collected; and (d) for how long is information kept. While there are reasons to expect privately owned registries to outperform those operated by public agencies, there are instances of effective publicly owned registries. Local conditions can influence the choice here. Existing credit registries should be evaluated not only on their design features, but also on how they have performed in practice. The legal and regulatory environment is important for existence and effectiveness of credit registries and other financial information vendors. While protection of consumer privacy is important, unduly restrictive rules here can hamper information sharing on borrowers to the detriment of their access to credit. Credit registries may be complemented by other providers of financial information on borrowers. Commercial information vendors, such as Bloomberg or Reuters, trade associations, chambers of commerce, or credit-rating agencies, might also contribute to transparency in the financial market. Finally, there might be private information-sharing agreements between financial institutions outside the formal structure of a credit registry. Accounting and auditing standards and practices are important elements of the information environment in that they govern companies’ disclosure of financial information to the public. A full assessment of the accounting and auditing standards (see chapter 10 for further details on these standards) in this area might not always be practicable, but the standards, nevertheless, represent the overall goals that should be aspired to and can be used as a reference for identifying information-based barriers to enhanced financing for the corporate sector. 4.3.3 Transactional Technology Infrastructures The effective transfer of money between customers of the same and of different institutions is one of the main functions of the financial systems. While the stability assessment of the payment system is mostly interested in wholesale systems, the development assessment focuses more on the cost of and access to retail payment services. Development assessment includes evaluating the effectiveness of the check and money transfer system in terms of time and cost. It also entails assessing the access to those services, either directly through banks or indirectly through other financial institutions that use banks as agents. Indicators to assess the effectiveness of the payment system include the cost and time to transfer money. As alternative indicators of access, some studies have surveyed the small numbers of the population and of subgroups who have a transactions banking account, debit card, or credit card, as well as the distribution of travel time to the nearest ATM or money transmission point. Unfortunately, as yet, there is no cross-country dataset for such access indicators
Financial Sector Assessment a Handbook 4.4 Sectoral Development Reviews Sectoral developmental reviews complement the assessments of regulatory standards Over the past several decades,extensive institutional change and experimentation in advanced economies have led to the emergence of elaborate regimes of regulation and supervision of the banking,insurance,and securities markets.Those regimes are designed 4 to ensure integrity of the functioning within the sectors and to avoid behavior that is likely to contribute to failure.They have evolved largely in response to the rapid develop men of the financial sector in adva nomies r r tha as a m the development of the sco hou gh,in several cases,regulatory liberaliz been influenced by a perceived risk to the competitiveness of domestic financial markets in an increasingly global financial system. The standards and codes used for those sectors essentially codify what has emerged as the common core of what remains a somewhat diverse set of regulatory institutions. While the standards and codes represent a fairly firm and widely agreed framework for essment on the prudential side,the mechanics of over oming ba ers to development unsophisticatedfin ncial systems in low hich a dmiddle-income coun ds an d codes ei presenc of much of what is sought in the goal of developing the financial system and at the same time contain (to some extent)principles that guide institutional development and good practices in financial institutions.Promoting institutional development,however,raises issues of sequencing and absorptive capacity in implementing policy reforms.Because of those considerations,conducting the develop cal,more subjective,ar arguably more assessing the rele ant stan ds ar For most low.and mi ddle ncome countries,a b rief and selective review of deve opment issues provides the information that is needed on the preconditions for a full standards and codes assessment.Where standards and codes for a sector are not being fully assessed,the review of development issues can be accompanied by a less detailed. stability-oriented,regulatory assessment.The assessor should highlight deficiencies in provided and shoul attemp f that have ed to those e deficie well a s any policy policy-that hav contributed to the deficiencies. Although some of the nee data are covered in cro country databases(as mentioned in chapter 2),for many other dimensions in each of the sectors,only noncomparable national sources are currently available,Those dimensions would include aspects such as the stock market free-float,reliance by large firms on inter- national depositary receipts.transactions costs for securities markets.prices of insurance oducts,and maturity structure of intermediary p ortfolios s must use their j ent in evaluating wh ate ation is vailable o such matters Because competitiveness issues have a pervasive influence on sectoral performance the issues need to be analyzed in all sectors.The competitive structure of the industry
78 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 4.4 Sectoral Development Reviews Sectoral developmental reviews complement the assessments of regulatory standards. Over the past several decades, extensive institutional change and experimentation in advanced economies have led to the emergence of elaborate regimes of regulation and supervision of the banking, insurance, and securities markets. Those regimes are designed to ensure integrity of the functioning within the sectors and to avoid behavior that is likely to contribute to failure. They have evolved largely in response to the rapid development of the financial sector in advanced economies rather than as a means of promoting the development of the sector—though, in several cases, regulatory liberalization has been influenced by a perceived risk to the competitiveness of domestic financial markets in an increasingly global financial system. The standards and codes used for those sectors essentially codify what has emerged as the common core of what remains a somewhat diverse set of regulatory institutions. While the standards and codes represent a fairly firm and widely agreed framework for assessment on the prudential side, the mechanics of overcoming barriers to development of what are still unsophisticated financial systems in low- and middle-income countries are not something for which a comprehensive template can be distilled from current practice. Indeed, the standards and codes either explicitly or implicitly assume the presence of much of what is sought in the goal of developing the financial system and at the same time contain (to some extent) principles that guide institutional development and good practices in financial institutions. Promoting institutional development, however, raises issues of sequencing and absorptive capacity in implementing policy reforms. Because of those considerations, conducting the development assessment for any given subsector is necessarily less categorical, more subjective, and arguably more difficult than assessing the relevant standards and codes. For most low- and middle-income countries, a brief and selective review of development issues provides the information that is needed on the preconditions for a full standards and codes assessment. Where standards and codes for a sector are not being fully assessed, the review of development issues can be accompanied by a less detailed, stability-oriented, regulatory assessment. The assessor should highlight deficiencies in quantity (scale and reach), quality, and price of the services provided and should attempt to identify the infrastructural weaknesses that have contributed to those deficiencies, as well as any policy flaws—including flaws in competition and tax policy—that have likely contributed to the deficiencies. Although some of the needed data are covered in crosscountry databases (as mentioned in chapter 2), for many other dimensions in each of the sectors, only noncomparable national sources are currently available. Those dimensions would include aspects such as the stock market free-float, reliance by large firms on international depositary receipts, transactions costs for securities markets, prices of insurance and efficiency of insurance products, and maturity structure of intermediary portfolios. The assessors must use their judgment in evaluating whatever information is available on such matters. Because competitiveness issues have a pervasive influence on sectoral performance, the issues need to be analyzed in all sectors. The competitive structure of the industry