Asia’s Growing Pains: The “Crowding-Out” Effect of Financial Regulation

“O$P$”

This was splashed in bright red paint across the staircase wall. Next to it was the surname and a flat number. As I walked past the writing, I did a double take. The surname and unit number were that of a friend I was visiting. More on this later ….

I was recently in India and had the opportunity to be part of a salon session discussing the future of finance. The forum was lively and filled with colorful illustrations and anecdotes about the financial markets. For example, one participant commented, “Risk is like a speedometer in a car — it tells you how much risk you are taking, but it’s the driver who gets into the accident!”

However, throughout the discussion, one common theme emerged. This relates to the consequences of too much regulation, and too soon — particularly important to an emerging economy like India whose financial markets are still developing.

The economic terminology used to describe the above is known as “financial dualism.” What this means is that in most economies, financing occurs in either the formal markets or the informal markets. Germidis, Kessler, and Meghir (1991) call this “an organized urban-oriented, institutional system centering to the financial needs of the modernized modern sector, while the informal sector, itself unorganized and non-institutional, would deal with the traditional, rural, subsistence (non-monetised) spheres of the economy.” In short, formal markets consist of regulated financial entities, while informal markets have the unregulated, and probably illegal, money-lending activities.

Financial regulation is then postulated to have a curved effect (or convexity, as termed by a statistician). The reasoning is that as a country is developing, increased financial regulation draws away credit from the informal markets into the formal markets. A number of reasons are given for this. Better resources and diversity of products to meet funding needs, better logistical support through branches, and greater responsiveness to the needs of these businesses (World Bank Lending to Small Enterprises, by Jacob Levitsky). Anecdotal evidence includes improved control over contractual obligations, lower credit pricing, and even a smaller chance of getting harassed and beaten up in default situations.

The problem is that, as regulation increases, concentration of activities builds up. This can lead to spectacular losses due to fraud or malfeasance. In response to these problems, regulators are often “forced” to tighten control of “problem” areas, leading to more regulation. Financial repression (or some call it frustration) then sets in as marginal lenders and borrowers exit the formal markets and enter the informal ones. The question often asked is “Where is this level?” Mathematically, this is the point of tangency. And how big is this sector?

On the size and share of the informal finance sector, empirical evidence is lacking. This is largely due to the qualitative type of work done in these areas. However, two pioneering surveys by U. Tun Wai (The Role of Unorganised Financial Markets in Economic Development and in the Formulation of Monetary Policy) in 1980, broadly suggest that this informal finance is more important in Africa, Asia, and the Middle East. In terms of its size, it ranged from 53 percent to 75 percent in these countries.

Given its perceived size in the overall financial sector, “where is the turning point?” and “what are the potential problems?” were concerns voiced by numerous participants in the session. Their worry is that, with India catching up quickly on regulatory matters commonly practiced in developed markets, has it had time to digest it? Are participants in the formal markets prepared for the onslaught of changes coming its way, or is it starting to say “all these new compliance requirements are just not worth the effort?” I have heard similar fears in China. I dare say it’s a structural feature in the developing Asian markets.

Is this trend worth worrying about? I would love to hear from readers out there.

Now, back to the friend I was visiting in Singapore. When I reached his flat, the door was splashed with black paint and the gate locked from the outside. I tried ringing the doorbell to no avail. I then called him on his mobile phone. When he picked up the phone, all he could say was “sorry.” He then continued with a cracked voice, “I borrowed money from the money lenders and I cannot pay.”

“O$P$” means “Owe Money, Pay Money.” This is a technique commonly used by illegal money-lenders in Singapore to embarrass and harass borrowers who have defaulted on their obligations.

Photo credit: @iStockphoto.com/miralex