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The Political Economy of Financial Sector Reform - Andrew Sheng.ppt

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					Tsinghua University Course on Financial Regulation
                   Lecture 1/08

The Political Economy of Financial
           Sector Reform

                Andrew Sheng
                 Adjunct Professor,
    Graduate School of Economics and Management
                    12 March 2009

                   Lecture Series
• Lecture 1: The Political Economy of Financial Sector
  Reform (2009)
• Lecture 2: The Global Financial Meltdown (2009)
• Lecture 3: Theory and Practice of Governance (2007)
• Lecture 4: Leadership in Regulatory Environment (2007)
• Lecture 5: Money, Property Rights and Markets (2006)
• Lecture 6: Practice of Financial Regulation (2006)
• Lecture 7: A Property Rights Framework (2007)
• Lecture 8: Practice of Bank Supervision (2006)
• Lecture 9: Asian and International Financial Markets (2006)
• Lecture 10: The Regulation of Listed Companies (2006)
• Financial System is an Institutional Arrangement to
  protect property rights, reduce transaction costs
  and improve social welfare, including through
• According to Nobel Laureate Douglass North,
  economic development is a process of change.
• How do we achieve financial system reform?
• Objectives of Financial Sector Reform
• The Strategy and Execution of Reforms
• Chinese and International Experience
• Using Mancur Olson: Power and Prosperity to

           Mancur Olson: Key Questions

1.   What is it that makes some market economies rich
     whereas others are poor?
2.   What policies and institutions does a country need
     to change from a low-level market economy to a
     rich market economy?
3.   Why was economic performance so much better,
     especially in relation to expectations, after the
     defeat of fascism than after the collapse of
4.   Why do the formerly communist countries suffer so
     much from official corruption and organized crime?
        What is a property right?

• Property right
   – There is a property right when it is possible for someone
     to decide, without any significant threat of interference
     from others, on a particular use of an asset or resource
     (including services, physical yields, environmental
     phenomena, intellectual achievements, etc.).
• Contracts and rights of transfer
   – Contract means all kinds of voluntary agreements
     between two or more persons to exchange property
     rights, or property rights for a payment
   – Rights of transfer are “second-level” rights that concern
     what the person can do to with his property rights.
     Rights of transfer exist automatically unless deliberately
     abolished or restricted by law or custom.

Property rights are defined legally and
enforced by regulators/market forces
• Property right
   – Property rights are normally defined legally by law or by
     contract between various parties.
   – Property rights normally comprise both rights (claims)
     as well as obligations (liabilities, either defined or
• Contracts and rights of transfer
   – The rights to contracts are either enforced by agreement,
     or enforced by law. There are costs to defining a
     contract (eg legal costs and stamp duty) as well as
     enforcement costs.
   – Although rights of transfer exist, they are subject either
     to contract, law or taxation in order to protect such
     rights of transfers.

       The Reciprocity Theorem

• If A holds certain property rights and doing
  so is to the detriment of B, then if the holding
  is transferred to B, B’s holding is to the
  detriment of A
• Example
  – Pollution
• Implications:
  – Changes and fine-tuning of property rights are
    likely to involve redistribution of benefits and
    costs, which may not be so obvious when the
    changes are first considered but it is the root of
    resistance to changes
          Transaction costs
      (associated with contracts)
• Transaction costs are the costs of search,
  information, bargaining, decision, policing and
  enforcement associated with contracts
   – More specifically, transaction costs comprise the costs
     parties to a contract incur in order to find each other,
     exchange information, delineate the property rights to
     be transferred, draw up the conditions of the contract,
     signal preparedness to fulfil their obligations, monitor
     each other’s performance and otherwise see to it that
     obligations are fulfilled
• Transaction costs will include taxes and are
  sometime used for all kinds of man-made costs in
  organizing interactions among people

               The Coase theorem
• If, in a two-party framework, a property right is well
  defined and the holding clear, and if there are no
  transaction costs and no wealth effects, then the
  right will end up with the party able to achieve the
  highest net wealth, regardless of whether it is the
  initial holder or someone who buys it from the initial
  holder. It follows that the use of the assets to which
  the property right pertains will be the same,
  irrespective of the initial holding

   – If transaction costs prevent or seriously impede a transfer by
     contract, who the initial holder is matters for the way a
     property right will be used and for the wealth achieved.

   Information, risks and the firm

• The existence of transactions costs leads to the
  emergence of the firm…. Coase
• Economic organization, including the firm, must
  reflect the fact that knowledge is costly to
  produce, maintain and use…Stigler
• In a condition of uncertainty, the entrepreneur is
  one who takes residual risks and the firm is an
  institution for risk sharing…Frank Knight

          Types of interaction costs
• Transaction costs
   – in a contract
• Administration costs
   – in non-contractual interactions such as within a firm, in
     a political process, in the government
• Legal costs
   – in running a legal system and in litigation
• Costs of delineating and protecting property rights
   – in activities that are apart from a contract or a legal
     procedure such in establishing and running political
     process, government, regulation, etc.
• Costs of care
   – in avoiding being exposed to legal sanctions when
     hurting others or in avoiding being hurt by other
     people’s acts                                           11
     The basic role of institutions
• The role of market institutions, such as firms,
  markets, judiciary, regulators, police, etc are to:-
   – Facilitate wealth creation while minimizing transactions
   – Establish, protect, fine-tune, and enforce property rights
     and their exchange with least interaction costs
   – Encourage entrepreneurial, socially beneficial, and
     innovative risk-taking while deterring socially costly
     stealing, rent-seeking, and redistribution
• Specialisation of institutions
   – Institutions interact or work through processes, which
     incur costs
   – Different institutions have different knowledge

  Law relating to property rights

• Property rights and restrictions on rights
  of transfer are defined largely by three
  kinds of law:-
  – Judge-made law [precedent] or constitutional
    law which tend to protect property rights of
    individuals and tend to be efficiency-
  – Policy-based or legislative-based law, which
    aim to promote distributional objectives, which
    are not necessarily efficiency-promoting
  – Administrative law, in which bureaucrats
    determine how property rights are affected.
          Kenneth Arrow’s
       “Impossibility Theorem”
• Decisions emerging from voting and other
  political processes cannot be regarded as firmly
  and indisputably derived from the preferences of
  the voters.
• In particular, the decisions are sensitive to
  strategic behaviour and hence in a sense
• In conditions of uncertainty, sometimes arbitrary
  choices and judgements have to be made
• “You can democratically allocate gains, but
  cannot democratically allocate losses”.

      Power and Prosperity-        Mancur Olson

• Chap.1:    The Logic of Power
• Chap.2:    Time, Taking, and Individual Rights
• Chap.3:    Coasian Bargains, Transactions Costs,
             and Anarchy
•   Chap.4: Rational Individuals and Irrational
•   Chap.5: Governance and Economic Growth
•   Chap.6: The Sources of Law Enforcement and
•   Chap.7: The Theory of Soviet-Type Autocracies
•   Chap.8: The Evolution of communism and Its
•   Chap.9: Implications for the Transition
•   Chap.10: The Kinds of Markets Needed for         15
   Chap.1: The Logic of Power
• Narrow interests vs. Encompassing interest
• How does power generate property rights
• Example of the Stationary Bandit
   If the Bandit maximizes public output but steals
    enough to maximize his own takings = Robin
   Bandit has incentive to have Rules amongst
    Thieves to prevent disorder and fights amongst
  = Social Organization.
     The Other Invisible Hand

guides encompassing interests to use
their power, in accord with the social
interest, even when serving the public
good was not part of the intention. p.13
An Autocrat (stationary bandit) will protect his
 territory and maximize social welfare because
 it is in his personal interest to do so
Princely (Government) Consumption helps
 stimulate social income, but so long as social
 revenue>social costs
      Chapter 1: The Logic of Power

• Whenever there is a Superencompassing
  interest, the second invisible hand works
  with Pareto-efficiency, and even those with a
  capacity to take whatever they please, take
  nothing P.20
   Autocracy is stable, so long as:-
     Personal gain>Personal Cost
     Social gain>Social Cost
     Risk of New Leader > Net Social Cost of Status

  2: Time, Taking, and Individual Rights

• a long-term view:
   - An economy will generate its maximum income
  only if there is a high rate of investment and that
  much of the return on long-term investment is
  received long after. ..p25
   - To reach the maximum income, a society must
  Impartially enforce contracts and need a stable
  currency p25

• When and how do autocracies become
  replaced by other systems of government?
The Autonomous Emergence of Democracy
      or Representative Government
   Three necessary conditions

     - the absence of the commonplace conditions
    that generate autocracy.

     - rough balance of power in society that does not
    allow autocracies to form [Magna Carta]

     - the area in which democratic arrangements are
    emerging is spared conquest by neighboring
    regimes, whether because of geographical
    barriers, city walls, or other lucky circumstances.

Representative Governments Institute
   Property and Contract Rights
When a peaceful order has been established, social
 good is best served by production and mutually
 advantageous trade:
 Markets basically are representative, since buyers
  and sellers are voting on what is accepted by society
  or rejected in daily trade..
 Mechanisms for defining and protecting property
  rights, enforcing contracts, and resolving disputes
  are in the common interest - this requires third-party
  enforcement, hence a court system. p35

Lasting Representative Government Implies
   Lasting Property and Contract Rights

 • Experience has shown that the longer lasting the
   government, the more secure the property and
   contract rights
 • Therefore, the issue is back to Principal-Agent
   Problem: How to align interests of the people with
   the bureaucrats or policy makers?

3: Coaseian Bargains, Transactions Costs,
              and Anarchy
• The reason why we need government is to
  deal with market failure, e.g. defence,
  pollution, property disputes, externality.
• Can Coasian bargains deal with market
• Bad things often happen, even to rational
  people? p.58
• Therefore, the difference between rich and
  poor states is not due to natural
  resources, but the quality of governance
The Dark Side of the Force .p.60

 Thomas Schelling: it is easier to destroy than to
   If private gains are higher than social costs, then
     coercion, fraud, theft and social disorder will arise
   Governments are inherently compulsory and
     necessary to enforce and protect property rights
 Government Is Needed for Contract Compliance,
  but must be supported by taxation, otherwise
  corruption and abuse of power comes in
   Therefore, Government power to regulate and
     implement laws and policies must also be subject
     to checks and balances

    4: Rational Individuals and Irrational
• Small group can engage in collective action, but Voluntary
  collective action must fail in large groups because of incentive
• E.g. Typical individual gets only a miniscule share of benefit from
  collective action, then no incentive to act in group interest. P77.
  [Chinese Large Number Divide and Multiply problem].
• The difficulties of collective action:
    if a group is sufficiently large, its members will not have any
   incentive to engage in the costly bargaining and strategic
   interaction, instead, they try to be in a coalition of free rider
   obtaining the largest gains. p87
• Two circumstances can overcome the difficulties:
   - when the numbers in the group are few,
   - availability of selective incentives.

   4: Rational Individuals and Irrational
• Small Groups Often Succeed in Voluntary Collective
  -normally, when the number of potential beneficiaries of a
  collective good is small, the interests of each are
  significantly affected by the contributions or non-
  contributions of the others. p73
  - Premises: communication & enforcement of agreements
• The voluntary, unsubsidized provision of anything
  never reach a collectively rational level. p79
    Why Voluntary Collective Action Must Fail in Large
     Groups--- the individual share of benefit is minuscule
    An incentive to be a free-rider                      26
Selective Incentives and Collective Action

• Even When There Are No Transactions Costs…
 - A Game Without a Core(没有核心集的博弈): situations where some
 individuals are better off in a subgroup than in a coalition of the
 whole, even when total gains are greatest from a coalition of the
 whole. P84
 - in large group collective action problems, rational individual
  behavior implies that individuals will try to cut themselves out of
  Coaseian bargains and thereby often prevent the Coaseian
  bargains from occurring, even when transactions costs are zero.

• Selective Incentives help overcome the
  problems of collective action  Reformer must
  “bribe” select groups [vested interests] to
  prevent “blocking action”.                  27
  5: Governance and Economic Growth

• Usually some complementarity between the activity
  that can provide a collective good and that which
  produces income must be found or exploited;
  lobbying power must be used in part to get favorable
  governmental treatment of the business activity. P97

• How do we ensure that representative government
  are controlled and not captive to vested interests or
  lobby groups?
• How can we push through short-term unpopular
  policies [to some parties] that are vital for long-term
  social stability or economic productivity?

  5: Governance and Economic Growth

• Rational Ignorance of Individual:
  As society becomes more complicated, most
  individuals do not understand complex policies and
  decisions that affect their daily lives.
• It takes a long time for a society to accumulate many
  organizations for collective action, and that industry-
  specific, occupation-specific, and other narrow
  organizations for collective action are most harmful
  to economic efficiency and dynamism. p98
    Strong, secure, and relatively well-advised
     autocrats can perform impressive economic
    Question is how to have representative
     government without the costs of lobbying and      29
6: The Sources of Law Enforcement and
• Governments with decent institutions and
  policies can maintain sufficient law and order
  for economic progress at relatively low costs
  because of the self-interest of private parties.
   The encompassing majorities have an incentive to
    choose good economic policies and institutions
    so as to obtain a reasonable degree of law and
    order at modest costs.

  Corruption comes from bad laws and
• Legislation or regulation that is market
  contrary(违反市场规律) must leave all or
  almost all parties with the incentive to evade
  the law, and it is likely to promote criminality
  and corruption in government. p107
  - thus, one reason why many societies have
  a lot of corruption in government is that they
  prescribe outcomes that all or almost all
  private sector has an incentive to avoid, and
  no one in the private sector has an incentive
  to report violations to the authorities.

7: The Theory of Soviet-Type Autocracies

  Soviet-type nationalization enabled regime to:
   Expropriate essentially all of the national stock of
    tangible capital, land, and other natural resources,
    thereby adding the yield of all of these assets to tax
   Avoid the collapse of investment by directly
    controlling the level of consumption and
    investment, getting a high rate of saving and
   Raise taxes on labor income far above revenue-
    maximizing rates by tax-price discrimination.
   Reduce the ratio of marginal to average tax rates.
    How Corruption and Soft-Budget
   Constraint Destroyed Soviet System
• Corruption is equivalent to high rates of implicit tax
  collections that add to transaction costs and cause
  great interference with markets.
• Wealth concentration goes to minority and therefore
  all those subject to high corruption tax has an
  incentive to collude either to maximize private gain
  at social cost or to evade tax altogether.
• Soft budget constraint on SOEs resulted in huge
  losses, so that State had no tax resources except
  through inflation
• Ultimate, government has no resources to finance
  legitimate functions of state, since corruption is tax
  leakage                                                33
  Conflicts between narrow interest and
              social interest
• Each of the vested interests has narrow self-
  interests: little or no incentive to maintain
  social productivity because they obtain very
  little of the society output.
 Therefore, social productivity cannot
 increase or may even decline, so that there is
 less and less to share. Vested interests may
 increase their “taxation”, so that productivity
 declines further and social stability collapses.

   9: Implications for the Transition [to
             Market Economy]
• Transition works well when incentives are
  changed to broaden public encompassing
  interests [e.g. TVE, rural household
  contracting system, commercialization of
  state-owned industry.
• Dangers of slow transition - high inflation,
  Privitization of SOEs, nomenklatura block
  reforms that expose their collusive gains from
  no competition.

   10: The Kinds of Markets Needed for
• Only two general conditions are required for a market
  economy that generates economic success:
 1) secure and well-defined individual rights.
 2) the absence of predation of any kind.
• To realize all the gains from trade, there has to be a
  legal system and political order that enforces contracts,
  protects property rights, carries out mortgage
  agreements, provides for limited liability corporations,
  and facilitates a lasting and widely used capital market
  that makes the investments and loans more liquid than
  they would otherwise be. P185

      Contribution of Olson Analysis

1. Uses Economic Analysis for Political
   Economy questions
2. Realizes that rational game is being played
   between different interest groups in
3. Questions whether Coasian bargains can
   be reached
4. Reforms require sacrifice [resources for
   bargaining] and good timing, especially
   outcomes that reward reforms

             Why many reforms fail

1.   Lack of clear reform objectives
2.   Under-estimation of Vested Interests that oppose
3.   Lack of resources to implement or deliver reform
4.   Absence of “External Threat or Crisis” that force
     public to questions whether there is need for
5.   Inability to reach Social Bargains by trade-offs or
6.   Inability to communicate and deliver on Reform
     objectives, benefits and necessities
7.   Require sacrifices and good timing, especially
     outcomes that reinforce reforms
    Building Market Economy means building a
    Robust Property Rights Infrastructure (PRI)
1. Delineation of property rights
    – Property rights need to be clearly defined and legally protected
2. Enforcement of property rights
    – Property rights need to be protected and enforced efficiently,
       fairly, and predictably through independent judiciary and
       regulatory systems
3. Culture in respecting law, property rights and contracts
    – Credit culture means respect of law, property rights and
       contracts, and they are rewarded for doing so
4. Reform market institutions that protect rights
    – The accounting, regulatory, judiciary and property registration
       (eg land and equity registration systems) need to brought up to
       international standards in order for markets to perform efficiently,
       fairly and transparently

           Efficient Markets Have Robust
                   PRI Institutions
• Central Registry of property right [e.g. land registry, share
• Trading Engine [e.g. stock exchange]
• Clearing, settlement and payment infrastructure – clearing
  house and payment system
• Regulated intermediaries
• Clear Rules of Game – norms, standards, codes, regulations,
• Enforcement infrastructure – enforcement costs cannot
  exceed benefits to market
• Independent and transparent judiciary to adjudicate property

 Effective judiciary, enforcers [police, regulators, enforcement
  agencies], accounting, legal and financial intermediaries are all
  part of PRI
   Free Markets Systems are prone to
            Financial Crises
• If Soviet type systems are subject to collapse,
  market systems are also subject to financial
• Governments in free market economy use
  monetary policy, fiscal policy and regulation
  to mitigate business cycles
• However, free market philosophy which
  stressed minimal government and minimal
  regulation gave rise to excess greed,
  financial bubbles and eventual collapse,
  including deflation in real economy
    2009 Geneva Report: the regulatory
        system stands accused of:
• Failed to mitigate the recent cycle in leverage, credit
  expansion and housing prices.
• Nothing was done to tighten regulations (e.g. on
  capital, liquidity or remuneration) in the upswing, nor
  to relax the pro-cyclical implications of the
  accounting/regulatory framework in the downturn.
• Provided little or no check, nor barrier, to the
  decisions taken by banks, and other financial
  operators, in their pursuit of (short-term) profit
• It was not adapted to changes in the underlying
  vulnerabilities in the system as a whole, and allowed
  financial engineering to avoid its impact, e.g. SIVs
  and other methods of deconsolidating risks.           42
      Geneva Report: Objectives of
1. to constrain the use of monopoly power and the
   prevention of serious distortions to competition and
   the maintenance of market integrity;
2. to protect the essential needs of ordinary people in
   cases where information is hard or costly to obtain,
   and mistakes could devastate welfare; and
3. where there are sufficient externalities that the social,
   and overall, costs of market failure exceed both the
   private costs of failure and the extra costs of

What Lessons can we draw from Current Financial
          Process to Manage Reform
• Asia has implemented many reforms, but outcomes
  may not always be on target.
• Reform fatigue could have set in resulting in no
  follow through to ensure successful implementation.
• Law of unintended consequences may frustrate
  reform efforts and generate reform resistance.
• Reform is a process, but we need a process to
  manage the reform process so that it stays the
  course and departures from path can be put back on
  track through set procedures.
• Reform needs ownership of the need for change.
• Process to manage change is an important area that
  deserves more attention by policy makers.

       Thank You
Questions to


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