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Optimal financial structure of finance companies in a regulated environment of a developing country
Journal of Banking and Finance 8 (1984) 443--457. North-Holland
OPTIMAL FINANCIAL STRUCTURE OF FINANCE COMPANIES IN A REGULATED ENVIRONMENT OF A DEVELOPING COUNTRY* Jorge R. C A L D E R O N - R O S S E L L The World Bank Group, Washington, DC 20433, USA
Received August 1982, final version received December 1983 Little is known about the regulatory framework for financial institutions in developing countries. In this paper, the effect of regulations in the financial structure of finance companies in a developing country is examined. The analysis suggests that regulations are so restrictive that they are reducing competition, limiting the mobilization of local resources, and indudng credit rationing in the financial system. The application of simple programming techniques to evaluate the regulatory framework is also demonstrated. Some policy recommendations and suggestions for further research are presented at the end.
i. Introduction The goals and effects of regulations for financial institutions in industrialized countries has been a frequent subject of discussion [e.g., Edwards and Scott (1979), Heggestad (1979), Leavitt (1973), Maisel (1981)]. Little is k~own, however, about the regulatory framework for financial institutions in developing countries. In this paper the effect of regulations in the financial structure of development finance companies in a developing country is analyzed. While all the implications of financial regulations in developing countries are beyond the scope of the present work, in comparing the actual versus the theoretical optimal financial structure of finance companies, several inferences are made regarding the effect of both pricing and institutional regulations on financial institutions of developing countries. In particular, the actual functions of finance companies compared to their original expected role are examined, highlighting the operations and risks that are induced and neglected by regulations in developing countries. The goals and behavior of private and government-owned companies are also contrasted. As a corollary, the effect of regulations on the efficiency, effectiveness, and development of financial systems, including credit rationing and capital flights, are also briefly discussed. *The comments of Jerome L. Kreuser, The World Bank, his computer assistance, and those of two anonymous referees are gratefully acknowledged. The views in this paper are solely of the author and do not necessarily reflect those of the World Bank Group. 0378-4266/84/$3.00 9 1984, Elsevier Science Publishers B.V. (North-Holland)
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J.R. Calder6n-Rossell. Financial structure of finance companies in DCs
The traditional underlying principle of regulations, now rapidly changing [e.g., Fair and L6onard de Juvigny (1982) and Verheirstraeten (1981)-I determined product segmentation and the specialization of financial institutions. The interdependency and conflicts of those regulations are, however, c o m m o n for a wide variety of financial institutions. Thus, without losing generality, the effect of regulations on the behavior of financial institutions through that of development finance companies is examined, t Development finance companies, or finance companies, are basically financial institutions whose primary function is to provide medium- and long-term financing to firms in the productive sectors. 2 The basic thrust of the regulatory conflicts in developing countries is exemplified by studying a specific country. In order to keep the confidentiality of the data and avoid other policy implications, its identity is kept anonymous. The regulatory environment in which financial institutions operate is usually the result of historical developments, industry norms, and subjective evaluations. Regulations in developing countries which appear to be excessive are basically modeled after the regulatory framework of industrialized countries not yet clearly understood. Nevertheless, the controversy on the reasons for regulation and their interdependenCy are accentuated, a Issued without a clear economic or managerial rationale, most of these regulations might be hindering the development of more efficient and effective financial systems. With varying degrees, developing economies are simpler and smaller than those of industrialized countries. The financial system and the sophistication of the population in financial and economic affairs is still in the process of being developed. The paper is organized as follows: In section 2, the use and advantages of a simple p r o g r a m m i n g technique, the model, for assessing the effect of regulations is demonstrated. In section 3, the theoretical optimal financial structure is discussed and compared to the current structure of finance companies. Finally, some conclusions are provided in section 4. 1A similar study regarding commercial banks was developed by the author confirming the commonality of the regularity problems in developing countries. The reduced number of finance companies' functions, however, permits in a simple way to highlight the main issues. 2In most developing countries, finance companies are financial institutions not receiving demand deposits, and lending mostly to agriculture, industry, tourism and mining. Resources are obtained mainly from equity increases, local market borrowings, and foreign sources. Some banks which are not included in this work, are also classified as development finance companies due to the nature of their operations. Although equity investments are permitted by law, in practice they are relatively small and were excluded from the analysis. Besides finance companies and subsidiaries of foreign banks, the organized financial systems of developing countries basically include local commercial banks, mutual savings institutions, pension funds, c o operatives and insurarice companies. 3In industrialized countries, it is widely recognized [e.g., Heggestad (1979)] that at least three are the basic goals for regulations. First, the need to maintain the soundness of the financial system is believed to be the most important. The second goal is to enhance the efficiency of financial institutions, preventing failures of a free-market environment. Finally, regulations are aimed to control the levels of specific operations for implementing, among others, government's monetary and credit policies.
J.R. Calder6n-Rossell, Financial structure of finance companies in DCs
445
2. The model An analysis of the effect of regulations on the optimal financial structure of finance companies of finance companies requires a programming model that also reflects its actual behavior. Paradoxically, the restrictive and rigid regulations usually imposed in developing countries permit the use of a simple deterministic one-period linear programming model. Although more complex and sophisticated models had been used mainly for developing management decision models [e.g., Cohen and Gibson (1978), Meyer Zu Selhausen (1977), Sunderland (1974), and Szeg6 (1972)-1 the use of a oneperiod linear programming model has proven to be adequate. The simplicity of this approach enhances its application in the context of the developing countries' environment. For purposes of this analysis, regulations are classified in two main groups. The first group includes regulations regarding the pricing system of borrowing and lending operations, including interest rates and commissions. The second group is composed of institutional regulations, i.e., capital requirements, portfolio ceilings, solvency, reserve requirements, etc. This classification capitalizes on the features of linear programming. 4 Effective interest rates 5 are represented by the coefficients of the objective function while the institutional regulations that, if necessary, could include other financial policies, are identified with the standard set of constraints of the linear programming model. Usually monetary authorities fix effective interest rates claiming that this policy would prevent usury and excessive competition while making available resources for specific economic activities at 'reasonable' prices. This fixed policy permits the application of the deterministic simple linear programming model. In examining the companies' past performance, an estimate of the most frequent interest rate is introduced, if not directly fixed by the authorities. Interest rate forecasts could be made in analyzing their expected behavior. Similarly, a cost of capital estimate is required in determining the necessary level of equity in the optimal solution. 6 Finance companies' asset portfolios consist basically of cash deposits; lending operations, most of which are expected to be medium- and longterm, adjusted by provisions for losses; 'correspondent banking type' of loans, i.e., operations directly financed with resources provided by other financial institutions, usually foreign banks, and the central bank; and equipment, 4For a review of linear programming techniques, see, for example, Hillier and Lieberman (1969) or Wagner (1969). SEffectiveinterest rates are here defined as the legal interest rate plus commissions allowed under each transaction, except otherwiseindicated interest rates are effectiveinterest rates. 6In order to have a meaningful solution, an estimate of the cost of capital needs to be introduced. This estimate need not necessarily be accurate given that the cost of capital is usually higher than the cost of borrowed funds. Under this condition, the optimal solution would not change if the actual cost of capital is higher than the estimate.
446
J.R. Calder6n-Rossell, Financial structure o f finance companies in DCs
furniture and fixed assets. The liabilities include accounts payables, obligations arising form correspondent banking institutions, and debts from issuing medium- and long-term notes and bonds. A special liability of the companies is the equity provided by shareholders which include specific and general reserves. All these assets and liabilities are presented in table 1 in descending order as the maturity increases. 7 To further maintain confidentiality of the information, only a very basic description of the financial operations is presented. Similar to the work of Mazzoleni (1977), under a neoclassical theory of the firm framework, finance companies are assumed to be profit maximizers I-eq. (1)]. Although this traditional assumption might be questioned when firms have monopoly powers [e.g., Heggestad (1979)-I, it appears the profit motives dominate the behavior of finance companies, in particular those of the private sector. The examination of profits before administrative expenses and taxes, however, reduces the effect of inefficiencies that might be derived from concentration or monopoly power. 8 Nevertheless, the study of the goals and the industrial organization of financial institutions in developing countries is a subject for further research. Profits before administrative expenses and taxes, are therefore determined by the difference of total revenue and cost. In turn, total revenue and cost are determined by the level of lending (assets) and borrowings (liabilities) operations, including equity, and their prices and costs. Therefore, the objective function of the finance companies in abbreviated form is assumed to be 16
m a x Z = ~ ijA i j=l
16
~. ~kL k,
k=l
(1)
where Z =total annual profits, ij = effective interest rate of lending operation j (asset accounts), Aj = total value of lending operation j (asset accounts), ctk =effective interest rate of borrowing ope/'ations k (liability and equity accounts), L k = total value of borrowing operations k (liability and equity accounts). 7There are only 16 leading operations (asset accounts}dand 16 borrowing operations, including funds from shareholders. The number of assets and lial~lities is just by accident the same, except otherwise indicated there are no overall matched operations. Although, as suggested by a referee, a mnemotechnical notation could be used, it would make the presentation of the mathematical expressions cumbersome. Thus, a simpler notation was adopted. 8Frequently as an investment incentive in the initial period of operations, finance companies are exempted from income taxes. To eliminate differences due to different tax rates that vary according to the number of years of operation, taxes have not been considered. If needed, taxes could be easily introduced in the model.
J.R. Calder6n-Rossell, Financialstructure offinance companies in DCs
447
In seeking to maximize profits, finance companies are bound by regulations, market factors, and the policies adopted by managers, including a basic balance constraint, 16
16
A j = ~ Z k. j=l
(2) 9
k=l
Frequently, monetary authorities are concerned with the liquidity position of financial institutions, which in the case of banks, is partially monitored through reserve requirements. In this case, finance companies not subject to reserve requirements are also not subject to hold minimum liquidity positions. Sound financial policies, however, require a minimum liquidity position determined by A~>L,
(3)
and 15
A 1 ~0.1 ~ Ai.
(4) l~
j=2
Constraint (3) states that cash should be higher than short-term accounts payable while constraint (4) establishes that cash should be at least 1/10th of the total net loan portfolio. In pursuing its operations, finance companies also need to hold a minimum level of equipment, furniture, and fixed assets, 15
A~6>0.1 ~ Ai.
(5)
j=l
In order to reflect on the quality of the portfolio, managers need to maintain a minimum provision for losses. Monetary authorities in general have been neglecting this aspect of portfolio management. Only recently with the increasing number of bad loans, reschedulings, and bankruptcies, monetary authorities are starting to issue regulations for controlling banks' portfolio quality. Although in the country studied, neither all managers nor monetary authorities were attempting to inform or control potential losses, a minimum provision for losses was introduced to assess its effect on the optimal financial structure, 14-
A15>0.01 ~ Aj. j=2
(6)
9Only assets A15 have a minus sign in all summations. Thus, to keep the nomenclature simple, no additional coefficients are introduced. Also, to simplify the presentation, assets and liabilities are identified by subindices in all summations. 1~ percentage of cash requirements as well as the coefficients of constraints (5) and (6), were determined by finance companies' practices in the country studied.
448
J.R. Calderfn-Rossell, Financialstructure of finance companies in DCs
The operations of finance companies are limited by the supply of and demand for loanable funds. In an environment where interest rates are fixed by monetary authorities, usually below market clearing rates, the operations of financial institutions are limited from the supply side. If the overall size of the finance companies is limited, it is likely that the level of individual transactions would be constrained by regulations rather than the individual demand and supply schedules. In this work, the use of an overall size of the company is proven to be adequate, ~1 16
Aj <$1,000 x 106.
(7)
j=l
Besides the basic balance constraint, market factors, and the financial policies established above, the companies are subject to the following monetary authorities' regulations: (a) 'Correspondent banking type of loans' are financed from specific sources of funds. Thus, there is matching between some assets and liabilities,
Aj=Lk,
j = k = 2 , 3 ..... 6.
(8)
(b) The value of short- and medium-term securities is limited to the total value of the correspondent lending operations, i.e.,
Lk
for (k, j) = (9, 7), (10, 8).... ,(12,10).
(9)
(c) Total value of long-term lending operations j = 1 3 and 14 needs to be financed only from long-term borrowing operations k = 13. Thus, AI3 + A14 <=LI3 .
(10)
Although monetary authorities do not impose an overall limit on the term structure gap between assets and liabilities, constraints (8) and (10) implicitly partially affect this maturity structure. In addition, constraint (9) would partially limit the possibility of financing long-term lending operations with short- and medium-term resources. On the other hand, constraint (10) permits that some short-term operations could be financed from long-term resources, but the resulting profits appear not to be attractive enough to be included in the optimal solution. 11The overall limit was determined by the aggregate of all finance companies. Although eq. (7) is specified in terms of assets, the balance sheet constraint (2) implies the same limit for liabilities.
J.R. Calder6n-Rossell, Financialstructure offinance companiesin DCs
449
(d) Monetary authorities require a minimum base capital to authorize the establishment of finance companies, L14>=$2 x 106.
(11)
(e) A maximum overall leverage is also imposed, 13
15
L k
(12)
k=X4
(f) Although constraint (12) determines a maximum overall leverage, monetary authorities still impose specific limits on some operations. No explicit rationale guiding the country's regulators is known. Without further elaboration, these limits are 15
L l <-~a~ ~
L k,
k=14
where l = 2, 3 . . . . . 6, and a~=0.4,3.5,4.5,0.7,
and
0.5
respectively,
(13)
15
L13=<0.8 ~ Aj, j=2
(14)
Lx5 <0.25 LI4 ,
(15)
12
15
Z Lk <----5 Z
Lk,
(16)
k=14
k=9
and 15
15
Z Ai--<10 ~ j=2
Lk.
(17)
k=14
Finally, the model is completed with the standard non-negative restrictions i.e., Aj>0
and
Lk>O
for j and k = l, 2 . . . . . 16.
(18)
3. The solution x2
The linear nature of all the equations in the model permits to express the 12The linear programming problem was solved using a mathematical programming system (TEMPO) developed by Burroughs Cori~oration and run in the B7800 computer of the World Bank/IMF computer system.A sensitivityanalysischangingbasic constraints,interest rates, and the level of operations was also performedand it is availableupon request.
J.R. Calderdn-Rossell, Financial structure of finance companies in DCs
450
optimal solution in percentage terms in table 1, where the descending order of operations approximately reflects the increasing maturity of operations. The optimal financial structure (table 1) includes mostly short-term operations (82.7Yo), in particular of 'correspondent banking type' operations [eq. (8)]. Nevertheless, a small percentage (8.2~o) of longer-term lending operations is still included in the optimal solution. Under a profit maximization criterion, monetary authorities are favoring short-term operations, in particular correspondent banking type of loans, contrary to the original role of long-term financing envisaged for finance companies. It is evident that finance companies will not intermediate local resources, except those provided by monetary authorities. Thus, finance companies' role in the development of the financial system has been kept minimal. As a consequence, monetary authorities have eliminated competition for local resources penaliz-
Table I Optimal financial structure. Assets
Liabilities and equity
% Cash
% Accounts payable
Lt
3.6 31.8 40.9 6.4 --
Liabilities (LCTL) 1 LCTL 2 LCTL 3 LCTL 4 LCTL 5
L, L3 L.t L5 L6
3.6 31.8 40.9 6.4 --
---
Borrowed funds (BF)I BF 2
L7 La
--i
At
9.0
A2 A3 A4 A5 A6 A7 A8
Correspondent type of lo,qns (CTL) 1 CTL 2 CTL 3 CTL 4 CTL 5
Short-term loans (STL) 1 STL 2
Medium-term loans (MTL) I MTL 2
A9
Securities (S) I
L9
S2
Lt0
--
S3
Lat
--
0.01 --
S4 S 5
L12 L13
-8.2
-
-
Ato
--
Alt
At2
D
Long-term loans (LTL) 1 LTL 2 LTL 3
A13
LTL 4
A,4
8.2
Equity (E) I
Lt4
Provision for losses
AI5
(0.9)
E 2a
LI5
Equipment, furniture, and fixed assets
At6
1.0
E 3b
L16
9.1 __
16
Total ~ j=l
aLegal reserves. bReturned earnings.
Aj
100.0
Total ~ k=l
Aj
100.0
J.R. Calder6n-Rossell, Financial structure of finance companies in DCs
451
ing small savers in favor of financial institutions and their client.s. On the other hand, large savers can obtain better returns in their financial asset holdings by placing their funds abroad, which leads to increased credit rationing in the system. Thus, the monopolistic position of financial institutions induced by monetary authoritie~ vis-~t-vi8 savers, does not help to increase the intermediation of resources while favoring the placement of funds abroad and inducing credit rationing. The larger percentage of 'correspondent banking type' operations on the optimal solution determines that, except between capital and cash, there is no term structure gap between assets and liabilities. The cash position of the company is practically financed from capital. Liberalizing regulations in a developing financial system, however, would require the introduction of an overall term structure gap to avoid a mismatch of cash flows that finance companies may not be able to overcome. Optimally, finance companies are expected to grow to the maximum feasible and to be fully leveraged to the maximum allowed) 3 While reaching the ceilings of the most profitable operations, less attractive operations still contribute to determine the optimal financial structure. 3.1. Optimal versus actual financial structure
In order to compare the optimal solution vis-a-vis the actual financial structure of finance companies, the profiles of the assets and liabilities, including capital, are shown in table 2.14 Examining the optimal with respect to the actual profiles of all private finance companies (table 2), it is evident that in general private companies have a financial structure similar to the optimal financial structure. Thus, under the regulations of monetary authorities, private finance companies appear to be profit maximizers. While slightly exceeding the limits of A4 operations, private finance companies are still short in some assets, particularly h 3 and A14 and long in others, mainly A 7 and As. Regarding liabilities, they appear to be even closer to the optimal liability structure. When the comparison is made with all finance companies, including those owned by the government, the overall actual structure, still similar to that of private companies, deviates somewhat from the optimal. This suggests that government-owned constitutions may not be governed only by a profit maximization criterion. The slight deviations of the whole group with respect to the optimal structure are. due to finance companies' different leverage and liquidity positions and perhaps due to particular 13This leverage is basically determined by the cost of capital which is higher than the cost of borrowed funds. 14Actual profiles of finance companies are slightly below 100yo because after excluding equity investments, s~me deferred and other assets and liabilities are not shown. Actual profiles correspond to the 1980 end of year accounts. J.B.F.--C
452
J.R. Calder6n-Rossell, Financial structure of finance companies h~ DCs
e-,
.=_
eq o~
"d e.
t~ t-3
,-..r
~ ~ _ ~ _ __
v,
I IO~
-
~g ~..,0
0
v~
t-a_~
~
J.R. CaMer6n-Rossell. Financialstructure of finance companies hz DCs
clientele demands. specifically limited The optimal and square error [eq. financial structure
453
Also, it is possible that the d e m a n d for A3 operations, not in the model, is in practice completely satisfied. actual structures were evaluated also based on the m e a n (19)]. 15 The lower the M S E , the closer is the actual to the optimal structure. |
MSE~ ork = -
16
~
[actualjork--optimalio~k] 2.
(19)
llj=l ork-I
The M S E s for all private and g o v e r n m e n t - o w n e d companies are presented in table 3. In addition, the M S E was c o m p u t e d for one of the most profitable private finance companies, c o m p a n y A, and for one of the governmentowned institutions, c o m p a n y B. The M S E s (table 3) c o r r o b o r a t e the visual inspection of the profiles. Private financiers as a whole are closer to the optimal structure while g o v e r n m e n t - o w n e d finance companies are following other goals than profit maximization. Individually, private c o m p a n y A has practically an optimal financial structure. O n the other hand, the g o v e r n m e n t - o w n e d c o m p a n y B has a financial structure far from optimal, m o r e so on the liabilities and equity side. This suggests that g o v e r n m e n t - o w n e d companies m a y not only have other goals than profit maximization but that they also m a y have special sources of funds. Also, having a liability structure closer to the optimal than the asset structure indicates that all finance companies m a y be m a n a g i n g better their borrowing as o p p o s e d to their lending operations. 16 Table 3 Optimal versus actual financial structure, mean square error l-eq. (19)].
Operation Assets Liabilities and equity
All private companies
All private and governmentowned companies
Company A (private)
Company B (government-owned)
29.3
57.6
17.7
217.3
20.2
49.8
13.2
243.2
15The successive application of the deterministic model during several periods or the use of a generalized stochastic linear programming model might permit the assessment of the optimal model by Theil's (1967, pp. 19-67) information gain measurement, as suggested by an anonymous referee. However, this analysis is beyond the scope of the present work. 16This analysis, therefore, can be used to assess the financial structure of individual companies, and also its performance. If the solution is unique and/or if profits are quite sensitive to the financial structure of the company, the MSEs evaluate both how close the actual is to the optimal structure and profitability. If not, the MSEs mainly focus on the financial structure and they would have to be complemented with other standard profitability ratios. In the present case, the MSEs were adequate indicators to evaluate both the structure and the profitability.
454
J.R. Calder6n-Rossell, Financial structure o f finance companies bz DCs
3.2. Redundant constraints
Examining the constraints bounding the optimal solution, it is found that with the exception of constraints (3), (11), (13) (L6), (14), (15), (16) and (17), the rest are determining the optimal solution. Therefore, under ceteris paribus conditions these constraints [(3), (I1) .... (17)] are redundant. The level of cash (A,), for example, is determined as a function of the net value of the loan portfolio [constraint (4)] which dominates the current ratio limit [constraint (3)]. Also, the minimum capital limit [constraint (11)] is redundant because finance companies under optimal conditions would have a base capital higher than the minimum required by law. 17 Maximizing profits, finance companies would grow as much as possible, hence, under the allowed leverage position, the base capital is higher than the minimum required. Constraints (13) (L6), (14) and (15) are redundant also because the finance companies can obtain higher profits in other operations whose limits are exhausted. The limit of legal reserves Lls [constraint (15)] is redundant because reserves L~5 can be a substitute for equity L~4. Finally, the limit on maximum net loan portfolio [constraint (17)] is irrelevant because it is dominated by the overall leverage limit [constraint (12)]. The size of the portfolio is ultimately determined by the maximum leverage. In summary, monetary authorities could eliminate, among others, finance companies' regulations regarding minimum capital (not to be confused with the leverage position), legal reserves and the total net portfolio ceiling. On the other hand, liquidity considerations should be based also on the total net portfolio [constraint (4)] in addition to the current ratio [constraint (3)]. Not having an economic or managerial rationale, monetary authorities should also eliminate ceilings on individual operations [including constraints (13) (L6) , (14) and (16) and adopt free market interest rates. /
3.3. htterest rates
Under the monetary authorities' regulations, the profit maximization criterion, the assumptions of financial policies [constraints (3)-(7)] and the cost estimates on some borrowed funds, the optimal average lending effective interest rate of a company is 18.8~ p.a. (private companies' actual structure would yield 16~o) which is higher than the legal rate. However, under the optimal structure, most clients of the finance companies would receive a substantial amount of these loans subject to a foreign exchange risk, mostly vis-a-vis the US dollar. Thus, the equivalent rate in terms of local currency 17Minimum capital requirements, however, might result in oligopolistic markets, and hence reduced competition. Furthermore, if there are economies of scale, these would be a natural barrier to entry, thus making this requirement unnecessary. If economic barriers are low, entry would be subject to the expected return on investment; low expected profits would discourage the establishment of additional finance companies.
J.R. Calder6n-Rossell, Financial structure of finance companies hi DCs
455
would be around 23.6% p.a. (private companies' actual rate estimated at 19.4%). On the liabilities side, the optimal cost of borrowed funds would be 15.5% (private companies' actual structure would yield 13.0%) that is also higher than the rate stipulated by regulations. However, this rate is also subject to foreign exchange risk vis-fi-vis the US dollar, thus equivalent to 20.1% (private companies' actual rate estimated at 16.7%) in local currency. As a result, the m a x i m u m return on investment before administrative expenses and taxes is around 31% p.a. Nevertheless, if finance companies are able to operate with a lower liquidity position, obtain resources on better terms, particularly those on accounts payable, or further reduce actual losses, the return on investment would be higher. A reexamination of the optimal solution and a revision of the cost of some of the funds could show how changing some cost estimates could yield higher profits. The stated legal interest rates, as shown above, have not been attained in practice, la The optimal lending rate, however, is a closer approximation to the actual rate than the optimal borrowing rate compared to the correspondent actual. The latter could be lower depending upon the sources and the terms of finance companies' borrowings, particularly of accounts payable. Thus, regulators should recognize what is happening in the market place 19 and let market forces determine the equilibrium level of interest rates. While m a x i m u m rates would be held down by international rates, a temporary floor for borrowing operations of financial institutions should be set to protect small savers. 2~ This temporary floor could be eliminated subject to the further development of the financial system and the increasing sophistication of savers. 4. Conclusions In conclusion, regulations are so restrictive that they are reducing competition in the services offered by finance companies, restraining adequate financing of the companies' clientele, limiting the mobilization of local resources, and inducing credit rationing on the system. In sum, the regulations are not helping to develop effective and efficient financial systems. In developed financial systems regulations can be more easily substituted laThe average rates reported here are close indicators of the practices of finance companies. However, it appears that finite companies in some operations are apparently charging interest rates slightly higher than the legal rates allowed by regulations. 19Ceilings on interest rates in developing countries have encouraged Euro-market type of transactions. Paper finance companies have been established abroad whereby interest rate ceilings are circumvented. 2~ savers m'ay be a captive market in developing countries. Lacking financial sophistication and not having other investing alternatives, they are exposed to the market power of financial institutions. Nevertheless, the floor rate still needs to be flexible to reflect market conditions. The mechanism for determining this rate, however, needs not to be further discussed here.
456
J.R. Calderfn-Rossell, Financial structure of finance conlpanies in DCs
by the controls of the market place, in developing systems, however, basic regulations still might be required. Nevertheless, the basic regulations should only be related to the overall leverage, liquidity position, provision for losses, and perhaps, a limit on the term structure gap between assets and liabilities. Monetary authorities need to reconcile the regulations with the market place and adopt market oriented interest rates. However, given the lack of development in the market and to protect savers, a floor for borrowing operations of financial institutions could be adopted. Also, in order to prepare the staff of financial institutions to operate in a more fluid and competitive environment, monetary authorities need to promote professionalism of the staff of financial institutions as well as those of regulatory bodies. The application of simple linear p r o g r a m m i n g techniques to evaluate the regulatory framework in a developing country has been demonstrated. Extension of this work can include, a m o n g others, changes in the objective function, use of non-linear relations, introducing random variables, and making explicit d e m a n d - s u p p l y functions. Similar techniques c o u l d b e applied in several developing countries, as well as for evaluating the effects of regulation on other types of financial institutions. The possibilities of these models for evaluating the performance of financial institutions and as an educational tool is also worth considering. Finally, the changing nature of financial systems and the importance of financial institutions for an efficient allocation of resources calls for further analysis and recommendations for improving the regulatory framework of developing countries.
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457
Meyer Zu Selhausen, H., 1977, Commercial bank balance sheet optimization; A decision model approach, Journal of Banking and Finance 1, 119-142. Sunderland, Neil, V., 1974, Bank planning models (Haupt, Berne, Zfirich). Szeg6, G.P. and K. Shell, eds., 1972, Mathematical methods in investment and finance (North-llolland, New York). The Federal Reserve Bank of Boston and the National Science Foundation, 1979, The regulation of financial institutions, Proceedings of a conference held at Melvin Village, NH, Oct. 1979, The Federal Reserve Bank of Boston Conference Series no. 21. Theil, Ilenri, 1967, Economics and informationtheory (North-Holland, Amsterdam). The World Bank, 1976, Development finance companies, Sector policy paper (Washington, DC). UNIDO (United Nations Industrial Development Organization), 1981, Financial resources for industrial projects in developing countries II, 2nd ed. (Vienna). UNIDO/World Bank, 1980, Development banking in the 1980s, Selection from the proceedings of the UNIDO/World Bank Symposium, Zurich, June 1979 (United Nations, New York). Verheirstraeten, Albert, ed., 1981, Competition and regulation in financial markets (St. Martin's Press, New York). Wagner, Harvey, M., 1969, Principles of operations research with applications research with applications to managerial decisions (Prentice-Hail, Englewood Cliffs, N J).
OPTIMAL FINANCIAL STRUCTURE OF FINANCE COMPANIES IN A REGULATED ENVIRONMENT OF A DEVELOPING COUNTRY* Jorge R. C A L D E R O N - R O S S E L L The World Bank Group, Washington, DC 20433, USA
Received August 1982, final version received December 1983 Little is known about the regulatory framework for financial institutions in developing countries. In this paper, the effect of regulations in the financial structure of finance companies in a developing country is examined. The analysis suggests that regulations are so restrictive that they are reducing competition, limiting the mobilization of local resources, and indudng credit rationing in the financial system. The application of simple programming techniques to evaluate the regulatory framework is also demonstrated. Some policy recommendations and suggestions for further research are presented at the end.
i. Introduction The goals and effects of regulations for financial institutions in industrialized countries has been a frequent subject of discussion [e.g., Edwards and Scott (1979), Heggestad (1979), Leavitt (1973), Maisel (1981)]. Little is k~own, however, about the regulatory framework for financial institutions in developing countries. In this paper the effect of regulations in the financial structure of development finance companies in a developing country is analyzed. While all the implications of financial regulations in developing countries are beyond the scope of the present work, in comparing the actual versus the theoretical optimal financial structure of finance companies, several inferences are made regarding the effect of both pricing and institutional regulations on financial institutions of developing countries. In particular, the actual functions of finance companies compared to their original expected role are examined, highlighting the operations and risks that are induced and neglected by regulations in developing countries. The goals and behavior of private and government-owned companies are also contrasted. As a corollary, the effect of regulations on the efficiency, effectiveness, and development of financial systems, including credit rationing and capital flights, are also briefly discussed. *The comments of Jerome L. Kreuser, The World Bank, his computer assistance, and those of two anonymous referees are gratefully acknowledged. The views in this paper are solely of the author and do not necessarily reflect those of the World Bank Group. 0378-4266/84/$3.00 9 1984, Elsevier Science Publishers B.V. (North-Holland)
444
J.R. Calder6n-Rossell. Financial structure of finance companies in DCs
The traditional underlying principle of regulations, now rapidly changing [e.g., Fair and L6onard de Juvigny (1982) and Verheirstraeten (1981)-I determined product segmentation and the specialization of financial institutions. The interdependency and conflicts of those regulations are, however, c o m m o n for a wide variety of financial institutions. Thus, without losing generality, the effect of regulations on the behavior of financial institutions through that of development finance companies is examined, t Development finance companies, or finance companies, are basically financial institutions whose primary function is to provide medium- and long-term financing to firms in the productive sectors. 2 The basic thrust of the regulatory conflicts in developing countries is exemplified by studying a specific country. In order to keep the confidentiality of the data and avoid other policy implications, its identity is kept anonymous. The regulatory environment in which financial institutions operate is usually the result of historical developments, industry norms, and subjective evaluations. Regulations in developing countries which appear to be excessive are basically modeled after the regulatory framework of industrialized countries not yet clearly understood. Nevertheless, the controversy on the reasons for regulation and their interdependenCy are accentuated, a Issued without a clear economic or managerial rationale, most of these regulations might be hindering the development of more efficient and effective financial systems. With varying degrees, developing economies are simpler and smaller than those of industrialized countries. The financial system and the sophistication of the population in financial and economic affairs is still in the process of being developed. The paper is organized as follows: In section 2, the use and advantages of a simple p r o g r a m m i n g technique, the model, for assessing the effect of regulations is demonstrated. In section 3, the theoretical optimal financial structure is discussed and compared to the current structure of finance companies. Finally, some conclusions are provided in section 4. 1A similar study regarding commercial banks was developed by the author confirming the commonality of the regularity problems in developing countries. The reduced number of finance companies' functions, however, permits in a simple way to highlight the main issues. 2In most developing countries, finance companies are financial institutions not receiving demand deposits, and lending mostly to agriculture, industry, tourism and mining. Resources are obtained mainly from equity increases, local market borrowings, and foreign sources. Some banks which are not included in this work, are also classified as development finance companies due to the nature of their operations. Although equity investments are permitted by law, in practice they are relatively small and were excluded from the analysis. Besides finance companies and subsidiaries of foreign banks, the organized financial systems of developing countries basically include local commercial banks, mutual savings institutions, pension funds, c o operatives and insurarice companies. 3In industrialized countries, it is widely recognized [e.g., Heggestad (1979)] that at least three are the basic goals for regulations. First, the need to maintain the soundness of the financial system is believed to be the most important. The second goal is to enhance the efficiency of financial institutions, preventing failures of a free-market environment. Finally, regulations are aimed to control the levels of specific operations for implementing, among others, government's monetary and credit policies.
J.R. Calder6n-Rossell, Financial structure of finance companies in DCs
445
2. The model An analysis of the effect of regulations on the optimal financial structure of finance companies of finance companies requires a programming model that also reflects its actual behavior. Paradoxically, the restrictive and rigid regulations usually imposed in developing countries permit the use of a simple deterministic one-period linear programming model. Although more complex and sophisticated models had been used mainly for developing management decision models [e.g., Cohen and Gibson (1978), Meyer Zu Selhausen (1977), Sunderland (1974), and Szeg6 (1972)-1 the use of a oneperiod linear programming model has proven to be adequate. The simplicity of this approach enhances its application in the context of the developing countries' environment. For purposes of this analysis, regulations are classified in two main groups. The first group includes regulations regarding the pricing system of borrowing and lending operations, including interest rates and commissions. The second group is composed of institutional regulations, i.e., capital requirements, portfolio ceilings, solvency, reserve requirements, etc. This classification capitalizes on the features of linear programming. 4 Effective interest rates 5 are represented by the coefficients of the objective function while the institutional regulations that, if necessary, could include other financial policies, are identified with the standard set of constraints of the linear programming model. Usually monetary authorities fix effective interest rates claiming that this policy would prevent usury and excessive competition while making available resources for specific economic activities at 'reasonable' prices. This fixed policy permits the application of the deterministic simple linear programming model. In examining the companies' past performance, an estimate of the most frequent interest rate is introduced, if not directly fixed by the authorities. Interest rate forecasts could be made in analyzing their expected behavior. Similarly, a cost of capital estimate is required in determining the necessary level of equity in the optimal solution. 6 Finance companies' asset portfolios consist basically of cash deposits; lending operations, most of which are expected to be medium- and longterm, adjusted by provisions for losses; 'correspondent banking type' of loans, i.e., operations directly financed with resources provided by other financial institutions, usually foreign banks, and the central bank; and equipment, 4For a review of linear programming techniques, see, for example, Hillier and Lieberman (1969) or Wagner (1969). SEffectiveinterest rates are here defined as the legal interest rate plus commissions allowed under each transaction, except otherwiseindicated interest rates are effectiveinterest rates. 6In order to have a meaningful solution, an estimate of the cost of capital needs to be introduced. This estimate need not necessarily be accurate given that the cost of capital is usually higher than the cost of borrowed funds. Under this condition, the optimal solution would not change if the actual cost of capital is higher than the estimate.
446
J.R. Calder6n-Rossell, Financial structure o f finance companies in DCs
furniture and fixed assets. The liabilities include accounts payables, obligations arising form correspondent banking institutions, and debts from issuing medium- and long-term notes and bonds. A special liability of the companies is the equity provided by shareholders which include specific and general reserves. All these assets and liabilities are presented in table 1 in descending order as the maturity increases. 7 To further maintain confidentiality of the information, only a very basic description of the financial operations is presented. Similar to the work of Mazzoleni (1977), under a neoclassical theory of the firm framework, finance companies are assumed to be profit maximizers I-eq. (1)]. Although this traditional assumption might be questioned when firms have monopoly powers [e.g., Heggestad (1979)-I, it appears the profit motives dominate the behavior of finance companies, in particular those of the private sector. The examination of profits before administrative expenses and taxes, however, reduces the effect of inefficiencies that might be derived from concentration or monopoly power. 8 Nevertheless, the study of the goals and the industrial organization of financial institutions in developing countries is a subject for further research. Profits before administrative expenses and taxes, are therefore determined by the difference of total revenue and cost. In turn, total revenue and cost are determined by the level of lending (assets) and borrowings (liabilities) operations, including equity, and their prices and costs. Therefore, the objective function of the finance companies in abbreviated form is assumed to be 16
m a x Z = ~ ijA i j=l
16
~. ~kL k,
k=l
(1)
where Z =total annual profits, ij = effective interest rate of lending operation j (asset accounts), Aj = total value of lending operation j (asset accounts), ctk =effective interest rate of borrowing ope/'ations k (liability and equity accounts), L k = total value of borrowing operations k (liability and equity accounts). 7There are only 16 leading operations (asset accounts}dand 16 borrowing operations, including funds from shareholders. The number of assets and lial~lities is just by accident the same, except otherwise indicated there are no overall matched operations. Although, as suggested by a referee, a mnemotechnical notation could be used, it would make the presentation of the mathematical expressions cumbersome. Thus, a simpler notation was adopted. 8Frequently as an investment incentive in the initial period of operations, finance companies are exempted from income taxes. To eliminate differences due to different tax rates that vary according to the number of years of operation, taxes have not been considered. If needed, taxes could be easily introduced in the model.
J.R. Calder6n-Rossell, Financialstructure offinance companies in DCs
447
In seeking to maximize profits, finance companies are bound by regulations, market factors, and the policies adopted by managers, including a basic balance constraint, 16
16
A j = ~ Z k. j=l
(2) 9
k=l
Frequently, monetary authorities are concerned with the liquidity position of financial institutions, which in the case of banks, is partially monitored through reserve requirements. In this case, finance companies not subject to reserve requirements are also not subject to hold minimum liquidity positions. Sound financial policies, however, require a minimum liquidity position determined by A~>L,
(3)
and 15
A 1 ~0.1 ~ Ai.
(4) l~
j=2
Constraint (3) states that cash should be higher than short-term accounts payable while constraint (4) establishes that cash should be at least 1/10th of the total net loan portfolio. In pursuing its operations, finance companies also need to hold a minimum level of equipment, furniture, and fixed assets, 15
A~6>0.1 ~ Ai.
(5)
j=l
In order to reflect on the quality of the portfolio, managers need to maintain a minimum provision for losses. Monetary authorities in general have been neglecting this aspect of portfolio management. Only recently with the increasing number of bad loans, reschedulings, and bankruptcies, monetary authorities are starting to issue regulations for controlling banks' portfolio quality. Although in the country studied, neither all managers nor monetary authorities were attempting to inform or control potential losses, a minimum provision for losses was introduced to assess its effect on the optimal financial structure, 14-
A15>0.01 ~ Aj. j=2
(6)
9Only assets A15 have a minus sign in all summations. Thus, to keep the nomenclature simple, no additional coefficients are introduced. Also, to simplify the presentation, assets and liabilities are identified by subindices in all summations. 1~ percentage of cash requirements as well as the coefficients of constraints (5) and (6), were determined by finance companies' practices in the country studied.
448
J.R. Calderfn-Rossell, Financialstructure of finance companies in DCs
The operations of finance companies are limited by the supply of and demand for loanable funds. In an environment where interest rates are fixed by monetary authorities, usually below market clearing rates, the operations of financial institutions are limited from the supply side. If the overall size of the finance companies is limited, it is likely that the level of individual transactions would be constrained by regulations rather than the individual demand and supply schedules. In this work, the use of an overall size of the company is proven to be adequate, ~1 16
Aj <$1,000 x 106.
(7)
j=l
Besides the basic balance constraint, market factors, and the financial policies established above, the companies are subject to the following monetary authorities' regulations: (a) 'Correspondent banking type of loans' are financed from specific sources of funds. Thus, there is matching between some assets and liabilities,
Aj=Lk,
j = k = 2 , 3 ..... 6.
(8)
(b) The value of short- and medium-term securities is limited to the total value of the correspondent lending operations, i.e.,
Lk
for (k, j) = (9, 7), (10, 8).... ,(12,10).
(9)
(c) Total value of long-term lending operations j = 1 3 and 14 needs to be financed only from long-term borrowing operations k = 13. Thus, AI3 + A14 <=LI3 .
(10)
Although monetary authorities do not impose an overall limit on the term structure gap between assets and liabilities, constraints (8) and (10) implicitly partially affect this maturity structure. In addition, constraint (9) would partially limit the possibility of financing long-term lending operations with short- and medium-term resources. On the other hand, constraint (10) permits that some short-term operations could be financed from long-term resources, but the resulting profits appear not to be attractive enough to be included in the optimal solution. 11The overall limit was determined by the aggregate of all finance companies. Although eq. (7) is specified in terms of assets, the balance sheet constraint (2) implies the same limit for liabilities.
J.R. Calder6n-Rossell, Financialstructure offinance companiesin DCs
449
(d) Monetary authorities require a minimum base capital to authorize the establishment of finance companies, L14>=$2 x 106.
(11)
(e) A maximum overall leverage is also imposed, 13
15
L k
(12)
k=X4
(f) Although constraint (12) determines a maximum overall leverage, monetary authorities still impose specific limits on some operations. No explicit rationale guiding the country's regulators is known. Without further elaboration, these limits are 15
L l <-~a~ ~
L k,
k=14
where l = 2, 3 . . . . . 6, and a~=0.4,3.5,4.5,0.7,
and
0.5
respectively,
(13)
15
L13=<0.8 ~ Aj, j=2
(14)
Lx5 <0.25 LI4 ,
(15)
12
15
Z Lk <----5 Z
Lk,
(16)
k=14
k=9
and 15
15
Z Ai--<10 ~ j=2
Lk.
(17)
k=14
Finally, the model is completed with the standard non-negative restrictions i.e., Aj>0
and
Lk>O
for j and k = l, 2 . . . . . 16.
(18)
3. The solution x2
The linear nature of all the equations in the model permits to express the 12The linear programming problem was solved using a mathematical programming system (TEMPO) developed by Burroughs Cori~oration and run in the B7800 computer of the World Bank/IMF computer system.A sensitivityanalysischangingbasic constraints,interest rates, and the level of operations was also performedand it is availableupon request.
J.R. Calderdn-Rossell, Financial structure of finance companies in DCs
450
optimal solution in percentage terms in table 1, where the descending order of operations approximately reflects the increasing maturity of operations. The optimal financial structure (table 1) includes mostly short-term operations (82.7Yo), in particular of 'correspondent banking type' operations [eq. (8)]. Nevertheless, a small percentage (8.2~o) of longer-term lending operations is still included in the optimal solution. Under a profit maximization criterion, monetary authorities are favoring short-term operations, in particular correspondent banking type of loans, contrary to the original role of long-term financing envisaged for finance companies. It is evident that finance companies will not intermediate local resources, except those provided by monetary authorities. Thus, finance companies' role in the development of the financial system has been kept minimal. As a consequence, monetary authorities have eliminated competition for local resources penaliz-
Table I Optimal financial structure. Assets
Liabilities and equity
% Cash
% Accounts payable
Lt
3.6 31.8 40.9 6.4 --
Liabilities (LCTL) 1 LCTL 2 LCTL 3 LCTL 4 LCTL 5
L, L3 L.t L5 L6
3.6 31.8 40.9 6.4 --
---
Borrowed funds (BF)I BF 2
L7 La
--i
At
9.0
A2 A3 A4 A5 A6 A7 A8
Correspondent type of lo,qns (CTL) 1 CTL 2 CTL 3 CTL 4 CTL 5
Short-term loans (STL) 1 STL 2
Medium-term loans (MTL) I MTL 2
A9
Securities (S) I
L9
S2
Lt0
--
S3
Lat
--
0.01 --
S4 S 5
L12 L13
-8.2
-
-
Ato
--
Alt
At2
D
Long-term loans (LTL) 1 LTL 2 LTL 3
A13
LTL 4
A,4
8.2
Equity (E) I
Lt4
Provision for losses
AI5
(0.9)
E 2a
LI5
Equipment, furniture, and fixed assets
At6
1.0
E 3b
L16
9.1 __
16
Total ~ j=l
aLegal reserves. bReturned earnings.
Aj
100.0
Total ~ k=l
Aj
100.0
J.R. Calder6n-Rossell, Financial structure of finance companies in DCs
451
ing small savers in favor of financial institutions and their client.s. On the other hand, large savers can obtain better returns in their financial asset holdings by placing their funds abroad, which leads to increased credit rationing in the system. Thus, the monopolistic position of financial institutions induced by monetary authoritie~ vis-~t-vi8 savers, does not help to increase the intermediation of resources while favoring the placement of funds abroad and inducing credit rationing. The larger percentage of 'correspondent banking type' operations on the optimal solution determines that, except between capital and cash, there is no term structure gap between assets and liabilities. The cash position of the company is practically financed from capital. Liberalizing regulations in a developing financial system, however, would require the introduction of an overall term structure gap to avoid a mismatch of cash flows that finance companies may not be able to overcome. Optimally, finance companies are expected to grow to the maximum feasible and to be fully leveraged to the maximum allowed) 3 While reaching the ceilings of the most profitable operations, less attractive operations still contribute to determine the optimal financial structure. 3.1. Optimal versus actual financial structure
In order to compare the optimal solution vis-a-vis the actual financial structure of finance companies, the profiles of the assets and liabilities, including capital, are shown in table 2.14 Examining the optimal with respect to the actual profiles of all private finance companies (table 2), it is evident that in general private companies have a financial structure similar to the optimal financial structure. Thus, under the regulations of monetary authorities, private finance companies appear to be profit maximizers. While slightly exceeding the limits of A4 operations, private finance companies are still short in some assets, particularly h 3 and A14 and long in others, mainly A 7 and As. Regarding liabilities, they appear to be even closer to the optimal liability structure. When the comparison is made with all finance companies, including those owned by the government, the overall actual structure, still similar to that of private companies, deviates somewhat from the optimal. This suggests that government-owned constitutions may not be governed only by a profit maximization criterion. The slight deviations of the whole group with respect to the optimal structure are. due to finance companies' different leverage and liquidity positions and perhaps due to particular 13This leverage is basically determined by the cost of capital which is higher than the cost of borrowed funds. 14Actual profiles of finance companies are slightly below 100yo because after excluding equity investments, s~me deferred and other assets and liabilities are not shown. Actual profiles correspond to the 1980 end of year accounts. J.B.F.--C
452
J.R. Calder6n-Rossell, Financial structure of finance companies h~ DCs
e-,
.=_
eq o~
"d e.
t~ t-3
,-..r
~ ~ _ ~ _ __
v,
I IO~
-
~g ~..,0
0
v~
t-a_~
~
J.R. CaMer6n-Rossell. Financialstructure of finance companies hz DCs
clientele demands. specifically limited The optimal and square error [eq. financial structure
453
Also, it is possible that the d e m a n d for A3 operations, not in the model, is in practice completely satisfied. actual structures were evaluated also based on the m e a n (19)]. 15 The lower the M S E , the closer is the actual to the optimal structure. |
MSE~ ork = -
16
~
[actualjork--optimalio~k] 2.
(19)
llj=l ork-I
The M S E s for all private and g o v e r n m e n t - o w n e d companies are presented in table 3. In addition, the M S E was c o m p u t e d for one of the most profitable private finance companies, c o m p a n y A, and for one of the governmentowned institutions, c o m p a n y B. The M S E s (table 3) c o r r o b o r a t e the visual inspection of the profiles. Private financiers as a whole are closer to the optimal structure while g o v e r n m e n t - o w n e d finance companies are following other goals than profit maximization. Individually, private c o m p a n y A has practically an optimal financial structure. O n the other hand, the g o v e r n m e n t - o w n e d c o m p a n y B has a financial structure far from optimal, m o r e so on the liabilities and equity side. This suggests that g o v e r n m e n t - o w n e d companies m a y not only have other goals than profit maximization but that they also m a y have special sources of funds. Also, having a liability structure closer to the optimal than the asset structure indicates that all finance companies m a y be m a n a g i n g better their borrowing as o p p o s e d to their lending operations. 16 Table 3 Optimal versus actual financial structure, mean square error l-eq. (19)].
Operation Assets Liabilities and equity
All private companies
All private and governmentowned companies
Company A (private)
Company B (government-owned)
29.3
57.6
17.7
217.3
20.2
49.8
13.2
243.2
15The successive application of the deterministic model during several periods or the use of a generalized stochastic linear programming model might permit the assessment of the optimal model by Theil's (1967, pp. 19-67) information gain measurement, as suggested by an anonymous referee. However, this analysis is beyond the scope of the present work. 16This analysis, therefore, can be used to assess the financial structure of individual companies, and also its performance. If the solution is unique and/or if profits are quite sensitive to the financial structure of the company, the MSEs evaluate both how close the actual is to the optimal structure and profitability. If not, the MSEs mainly focus on the financial structure and they would have to be complemented with other standard profitability ratios. In the present case, the MSEs were adequate indicators to evaluate both the structure and the profitability.
454
J.R. Calder6n-Rossell, Financial structure o f finance companies bz DCs
3.2. Redundant constraints
Examining the constraints bounding the optimal solution, it is found that with the exception of constraints (3), (11), (13) (L6), (14), (15), (16) and (17), the rest are determining the optimal solution. Therefore, under ceteris paribus conditions these constraints [(3), (I1) .... (17)] are redundant. The level of cash (A,), for example, is determined as a function of the net value of the loan portfolio [constraint (4)] which dominates the current ratio limit [constraint (3)]. Also, the minimum capital limit [constraint (11)] is redundant because finance companies under optimal conditions would have a base capital higher than the minimum required by law. 17 Maximizing profits, finance companies would grow as much as possible, hence, under the allowed leverage position, the base capital is higher than the minimum required. Constraints (13) (L6), (14) and (15) are redundant also because the finance companies can obtain higher profits in other operations whose limits are exhausted. The limit of legal reserves Lls [constraint (15)] is redundant because reserves L~5 can be a substitute for equity L~4. Finally, the limit on maximum net loan portfolio [constraint (17)] is irrelevant because it is dominated by the overall leverage limit [constraint (12)]. The size of the portfolio is ultimately determined by the maximum leverage. In summary, monetary authorities could eliminate, among others, finance companies' regulations regarding minimum capital (not to be confused with the leverage position), legal reserves and the total net portfolio ceiling. On the other hand, liquidity considerations should be based also on the total net portfolio [constraint (4)] in addition to the current ratio [constraint (3)]. Not having an economic or managerial rationale, monetary authorities should also eliminate ceilings on individual operations [including constraints (13) (L6) , (14) and (16) and adopt free market interest rates. /
3.3. htterest rates
Under the monetary authorities' regulations, the profit maximization criterion, the assumptions of financial policies [constraints (3)-(7)] and the cost estimates on some borrowed funds, the optimal average lending effective interest rate of a company is 18.8~ p.a. (private companies' actual structure would yield 16~o) which is higher than the legal rate. However, under the optimal structure, most clients of the finance companies would receive a substantial amount of these loans subject to a foreign exchange risk, mostly vis-a-vis the US dollar. Thus, the equivalent rate in terms of local currency 17Minimum capital requirements, however, might result in oligopolistic markets, and hence reduced competition. Furthermore, if there are economies of scale, these would be a natural barrier to entry, thus making this requirement unnecessary. If economic barriers are low, entry would be subject to the expected return on investment; low expected profits would discourage the establishment of additional finance companies.
J.R. Calder6n-Rossell, Financial structure of finance companies hi DCs
455
would be around 23.6% p.a. (private companies' actual rate estimated at 19.4%). On the liabilities side, the optimal cost of borrowed funds would be 15.5% (private companies' actual structure would yield 13.0%) that is also higher than the rate stipulated by regulations. However, this rate is also subject to foreign exchange risk vis-fi-vis the US dollar, thus equivalent to 20.1% (private companies' actual rate estimated at 16.7%) in local currency. As a result, the m a x i m u m return on investment before administrative expenses and taxes is around 31% p.a. Nevertheless, if finance companies are able to operate with a lower liquidity position, obtain resources on better terms, particularly those on accounts payable, or further reduce actual losses, the return on investment would be higher. A reexamination of the optimal solution and a revision of the cost of some of the funds could show how changing some cost estimates could yield higher profits. The stated legal interest rates, as shown above, have not been attained in practice, la The optimal lending rate, however, is a closer approximation to the actual rate than the optimal borrowing rate compared to the correspondent actual. The latter could be lower depending upon the sources and the terms of finance companies' borrowings, particularly of accounts payable. Thus, regulators should recognize what is happening in the market place 19 and let market forces determine the equilibrium level of interest rates. While m a x i m u m rates would be held down by international rates, a temporary floor for borrowing operations of financial institutions should be set to protect small savers. 2~ This temporary floor could be eliminated subject to the further development of the financial system and the increasing sophistication of savers. 4. Conclusions In conclusion, regulations are so restrictive that they are reducing competition in the services offered by finance companies, restraining adequate financing of the companies' clientele, limiting the mobilization of local resources, and inducing credit rationing on the system. In sum, the regulations are not helping to develop effective and efficient financial systems. In developed financial systems regulations can be more easily substituted laThe average rates reported here are close indicators of the practices of finance companies. However, it appears that finite companies in some operations are apparently charging interest rates slightly higher than the legal rates allowed by regulations. 19Ceilings on interest rates in developing countries have encouraged Euro-market type of transactions. Paper finance companies have been established abroad whereby interest rate ceilings are circumvented. 2~ savers m'ay be a captive market in developing countries. Lacking financial sophistication and not having other investing alternatives, they are exposed to the market power of financial institutions. Nevertheless, the floor rate still needs to be flexible to reflect market conditions. The mechanism for determining this rate, however, needs not to be further discussed here.
456
J.R. Calderfn-Rossell, Financial structure of finance conlpanies in DCs
by the controls of the market place, in developing systems, however, basic regulations still might be required. Nevertheless, the basic regulations should only be related to the overall leverage, liquidity position, provision for losses, and perhaps, a limit on the term structure gap between assets and liabilities. Monetary authorities need to reconcile the regulations with the market place and adopt market oriented interest rates. However, given the lack of development in the market and to protect savers, a floor for borrowing operations of financial institutions could be adopted. Also, in order to prepare the staff of financial institutions to operate in a more fluid and competitive environment, monetary authorities need to promote professionalism of the staff of financial institutions as well as those of regulatory bodies. The application of simple linear p r o g r a m m i n g techniques to evaluate the regulatory framework in a developing country has been demonstrated. Extension of this work can include, a m o n g others, changes in the objective function, use of non-linear relations, introducing random variables, and making explicit d e m a n d - s u p p l y functions. Similar techniques c o u l d b e applied in several developing countries, as well as for evaluating the effects of regulation on other types of financial institutions. The possibilities of these models for evaluating the performance of financial institutions and as an educational tool is also worth considering. Finally, the changing nature of financial systems and the importance of financial institutions for an efficient allocation of resources calls for further analysis and recommendations for improving the regulatory framework of developing countries.
References Cohen, Kalman, J. and Stephen E. Gibson, eds., 1978, Management science in banking (Warren, Gorham and Lamont, Boston, MA). Diamond, William, 1957, Development banks (The John Hopkins Press, Baltimore, MA). Edwards, Franklin R. and James Scott, 1979, Solvency regulation and bank soundness in: Franklin R. Edwards, ed., Issues in financial regulation (McGraw-Hill, New York). Fair, Donald E. and Francois L6onard de Juvigny, eds., 1982, Bank management in a changing domestic and international environment: The challenges of the eighties (Martinus Nijhoff, The Hague). Heggestad, Arnold A., 1979, A survey of studies on banking competition and performance in: Franklin R. Edwards, ed., Issues in financial regulation. Hillier, Frederick S. and Gerald J. Lieberman, Introduction to operations research (Holden-Day, San Francisco, CA). Kane, Joseph A., 1975, Development banking: An economic appraisal (Lexington Books, Lexington, MA). Leavitt, Brenton, C., 1973, The philosophy of financial regulations, Banking Law Journal 8, 632647. Maisel, Sherman, J., 1981, Some issues on bank regulation in: Sherman J. Maisel, ed., Risk and capital adequacy in commercial banks (The University of Chicago Press, Chicago, IL, and London). Mazzoleni, P., 1977, The influence of reserve regulation and capital on optimal bank asset management, Journal of Banking and Finance 1, 297-309.
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