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Deepening and broadening financial system: A taxonomy of policies

To understand the role and impact of different government policies on deepening and broadening financial systems, Beck and de la Torre suggest a taxonomy that builds on the concept of the access possibilities frontier—the maximum commercially viable outreach of a country’s financial system given certain “state variables” that do not change in the short term, such as market size; macroeconomic fundamentals; available technology; the quality of the transport and communication infrastructure; the effectiveness of the contractual and informational frameworks; and the degree of general insecurity associated with crime, violence, terrorism, and so on.1 One can then identify the problem of the financial system as being either below or unsustainably beyond the frontier or facing a frontier too low relative to countries of comparable levels of economic development. The types of access problem can be mapped into different policy options that focus on (1) developing, (2) enabling, or (3) harnessing markets. These different policies all contrast with market-replacing policies, which have mostly led to financialsector deepening that is unsustainable, if any deepening at all. If the main problem is that of too low an access possibilities frontier, the policies to highlight would be market-developing policies—that is, those that aim at improving the state variables and moving the frontier and thus involve fundamental reforms such as improving macroeconomic stability, building a privately owned financial system, and improving the contractual framework. In some countries, non–financial-sector policies, such as improving security or upgrading the transport and communication infrastructure, might be the critical areas to push out the frontier.

Changes in the state variables involve changes in fundamental institutions and, thus, take a long time to materialize. To the extent that a financial system is operating below the possibilities frontier, there is room for market-enabling policies that might help deepen and broaden the financial system even in the absence of perceptible changes in state variables. Where the main reason for being below the possibilities frontier is the demand problem of self-exclusion, the appropriate policies would emphasize raising financial literacy, both for households and for enterprises. If—as is more likely—the main problems reside with sub-optimization in credit supply, a wider range of policy options can be considered, starting with competition policy, allowing entry from reputable market players and securing access to the payment system for all financial institutions. This also includes reviewing barriers stemming from bank regulation and AML/CFT regulation that might reduce banks’ appetite for expanding lending and their customer bases. A third category of government policies, defined as market-harnessing, tries to prevent the financial system from moving to an unsustainable equilibrium beyond the frontier because of imprudent lending. Market-harnessing policies therefore aim at keeping banks’ incentives to take aggressive risks in check through a mix of measures aimed at strengthening market and supervisory discipline. Market-harnessing policies are also important on the demand side to avoid predatory lending, which results in unsustainable overborrowing by individual borrowers.

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