Responding to the Global Financial Crisis Public Disclosure Authorized Strengthening Financial Systems in Developing Countries Public Disclosure Authorized The Case for Incentives-Based Financial Sector Reforms Biagio Bossone and Larry Promisel Public Disclosure Authorized Public Disclosure Authorized Strengthening Financial Systems in Developing Countries: The Case for Incentives-Based Financial Sector Reform iii Foreword he East Asian crisis has underscored the importance of strong domestic policies and institutions in enabling countries to integrate successfully Tinto the global financial community. From the crisis, a debate has emerged on the structural policy reforms needed at both the national and international levels to restore financial stability and to avert and mitigate future crises. These reforms include strengthening financial sectors, establishing a sound business environment and adopting adequate mechanisms for social protection. To advance the dialogue on these issues among a broad group of stakeholders, Bank Group staff have prepared the following five papers: • Corporate Governance: Emerging Issues and Lessons from East Asia • Strengthening Financial Systems in Developing Countries: The Case for Incentives-Based Financial Sector Reforms • Systemic Bank and Corporate Restructuring: Experience and Lessons for East Asia • The Business Environment and Corporate Governance: Strengthening Incentives for Private Sector Performance • Social Consequences of the East Asian Financial Crisis These papers will provide background for discussions during the World Bank’s 1998 Annual Meetings Program of Seminars (website http://www.worldbank.org/html/extdr/pos98/). They were prepared in tandem with East Asia: The Road to Recovery, which assesses the evolution of the crisis and sets out the agenda for stimulating an early recovery. The papers are not intended to reflect the Bank Group’s policies, but rather to stimulate debate and solicit the views of the development community at large. Masood Ahmed Vice President The World Bank Strengthening Financial Systems in Developing Countries: The Case for Incentives-Based Financial Sector Reform v Acknowledgements he paper was written by Biagio Bossone and Larry Promisel. Amar Bhattacharya, Gerard Caprio, Stijn Claessens, Patrick Honohan, Millard TLong, and Dimitri Vittas provided extensive comments and inputs and reviewed several drafts. Joseph Del Mar Pernia, Khalid Siraj, and Richard Zechter also provided useful comments. Specific inputs were received from Asli Demirgüç-Kunt, Edward Kane, Michele Lubrano, Maria Soledad Martinez Peria, Sergio Schmukler, and Mary Elizabeth Ward. Rose Vo was crucial in preparing the manuscript for publication. The paper does not necessarily represent the views of the World Bank. Strengthening Financial Systems in Developing Countries: The Case for Incentives-Based Financial Sector Reform 1 Executive Summary Whenever commerce is introduced into any country, probity and punctuality always accompany it . A dealer is afraid of losing his character, and is scrupulous in observing every engagement. Adam Smith n international cooperative effort has been focused on the need to reduce financial fragility and systemic risks in global financial markets. AWork is proceeding in three different areas: enhancing financial market transparency, improving the international financial architecture, and strengthening financial systems. Strengthening financial systems (the focus of this paper) means cooperating to promote principles and sound practices for financial stability through development of well-functioning financial systems and market discipline. Financial sector reform and development is much more than setting rules, articulating standards, approving legislation, and creating new institutions. All are important but ultimately behavior must be changed if there is to be meaningful and lasting financial reform. For that reason, this paper emphasizes the role of incentives to induce appropriate behavior. Given all that needs to be done, financial sector development will take a long time. The fact that the process will take years, probably decades, to complete should not reduce the sense of urgency. It means, rather, that we should not have unrealistic expectations and that we must be patient. Empirical research suggests that the effect of financial sector development on economic growth is significant. Banks are one but not the only important part of a healthy financial system. Markets for bonds and equities, too, have an independent effect on growth. But banking and capital markets seem to complement each other throughout most stages of development. The international approach to financial sector reform Developing countries have made important progress toward improved financial supervision in the past few years. Reforming financial sectors is a lengthy and complex process of institution building and incentive reorientation, whose success requires full ownership of, and participation in, the process by society and its government. Beginning in the early 1980s, financial sector reforms in developing countries were rooted in the premise that liberalized economic relationships, macroeconomic stability, and competitive price setting would lead to high and stable economic growth. While most people understood that there was a crucial role for government (prudential supervision of the financial system, for instance), it was not seen as coincidence that, in the countries that pursued strong macroeconomic adjustment and financial liberalization, growth improved markedly. 2 The World Bank Group Since the early 1990s, market volatility and crises, as well as a better understanding of how financial markets work, have led economists and policymakers to re-examine their policy framework. Those financial crises were costly and the risk of systemic repercussions is seen to have risen sharply in recent years. Greater emphasis is now placed on market rule- making that should be consistent across national boundaries. Also, more international policy cooperation is required for managing rules effectively in the new global marketplace. Financial sector reform requires writing effective rules and addressing the question of how to make financial market participants and supervisors respond to those rules adequately, in a timely fashion, and consistently with the objective of maintaining efficiency. It is now more widely accepted that the government, in cooperation with the private sector, can help markets perform better by providing appropriate financial regulations and infrastructure. Rules should be designed to promote more efficient and open markets, importantly by improving the availability of information and mutual trust. Appropriate incentive mechanisms, though difficult to devise, are crucial. The case for incentive-based financial sector reforms is especially compelling for developing economies. The scarcity of government resources for monitoring and enforcement, recognition that there are greater profit opportunities in producing information where information is relatively scarce, and improvements to be gained in both efficiency and stability when honest and prudent behavior is appropriately rewarded, all point to the benefits of incentive mechanisms that induce good conduct and self-policing in the behavior of those operating in the market. A strong emphasis must be placed on the microeconomic and institutional dimensions of financial systems, which are linked. Competition and prudential supervision need to be consistently integrated into financial sector reforms. Redressing structural weaknesses relating to distorted incentives, inadequate information, inappropriate allocation of responsibilities, and poor market infrastructures is now regarded as a prerequisite to achieve good governance of financial institutions and establish a solid credit discipline across the markets. The international community recognizes the need for arrangements that minimize moral hazard, sequencing liberalization consistently with the overall pace of market development, and supporting liberalization with policies aimed at ensuring that there are appropriate incentives and effective market discipline. Another distinctive feature of international strategy is recognition that financial stability requires strong market regulation and supervision of financial institutions. Current strategy seeks to strike a balance between principles to ensure good institutional governance, mechanisms for inducing effective market discipline, and regulatory and supervisory regimes that are market-friendly and mimic the market in driving agents’ action through incentives. Strengthening Financial Systems in Developing Countries: The Case for Incentives-Based Financial Sector Reform 3 Financial sector reform: incentives and strategies To make financial markets stronger and more efficient (and therefore less vulnerable to systemic crises), emphasis must be placed on incentive-based financial sector reforms, that is, on setting up a system of rewards and penalties such that market participants perceive (correctly) that it is in their own best interest to behave in efficient and prudent ways. To support such a system, infrastructure (including the legal, regulatory, and supervisory frameworks) should be the responsibility of government. Reform will be lengthy, however, and require input from both the private and the public sectors, and policy choices involving tradeoffs of one kind or another will be necessary along the way.