Deregulation can set the stage for chaos---or it can complement the development of an increasingly productive market system. Here are some guidelines
During the 1980s, many experts promoted financial deregulation as a key to economic growth. But in reality, it was a decade of re-regulation. Policymakers swapped one set of rules for another, often with good results, finds World Bank economist Dimitri Vittas.[1]
For many industrial and developing countries, out went the idea of directing banks to subsidize certain industries. And out went efforts to keep interest rates low, often below the rate of inflation.
In came a desire to let banks and other financial institutions find and underwrite the most potentially productive projects and companies. To do this, many governments discovered they would have to devise rules for creating a financial structure that is stable, fair, efficient, and transparent.
Without stability, financial markets become volatile, investors flee, and business confidence plummets. Without fairness, the users of financial services are not protected, and the playing field for competing institutions is not level. And without efficiency, a country's banking system is out of step with its level of development. Large, universal banks might make sense in industrial countries but not in developing nations.
Because of the damaging effects of financial repression, there is now less emphasis on direct credit controls and on structural restrictions that dictate where banks can do business or in what they can invest. Instead, there is growing emphasis on organizational, protective, and, especially, prudential controls. These highlight creating contestable markets with easier entry and exit, protecting the interests of small savers and investors, and promulgating rules that safeguard the financial soundness of individual institutions and the stability of the financial system.
In banking, developing nations are increasingly adopting standards formulated by the Basle Committee of Bank Supervisors. These standards spell out the amount of capital banks should retain based on ratios that take account of the riskiness of assets---both on and off the balance sheet.
Limits on exposure to a single borrower or related groups of companies are essential, because credit advanced to insiders is a frequent cause of problems. Such exposure should be limited to a percentage of a bank's capital. There should also be rules governing whether banks can engage in nonbanking financial activities or own equity stakes in nonbanking firms.
One of the most difficult problems is recognizing problem assets. Governments can press banks to do this by requiring them to classify assets and take the necessary steps to write off poorly performing loans. Bank regulators should also require external audits and establish rules for examination of asset portfolio quality, valuation standards, and adequacy of loan-loss reserves.
On a national level, bank supervisors should have the right to intervene to prevent losses from escalating, to manage ailing institutions, and to resolve bank failures.
The re-regulation of financial systems in the 1980s took a number of forms, from cautious to radical. Some countries developed new systems in response to economic growth or to lay the groundwork for quicker development. Others acted to ward off crisis. Some examples.
In the second half of the 1970s, there was an increase in government borrowing, a drop in demand for industrial investment funds, and growing internationalization. In response, the government gradually dropped controls on foreign exchange and interest rates and allowed a modern bond market to develop.
Some experts think that maintaining an open foreign exchange account imposed healthy restraint on Indonesia's fiscal and monetary policy. They note that such an approach to financial reform works best when a government has the political clout to enforce good macroeconomic management.
Inadequate supervision, widespread fraud, and inconsistent regulations can open the door to financial collapse. Losses are determined by the ability of a government to respond quickly and effectively.
Malaysia's experience in the mid-1980s is seen as an example of decisive corrective action. Facing a serious recession, with many banks on the brink of failure, the government stepped in to bolster distressed institutions and inject badly needed capital. The country's strict banking supervision, with its stiff requirements against carrying bad debts, forced banks to put new capital to good rather than just easy use. The government quickly assessed the extent of losses and dealt promptly with problems of incompetent management.
In contrast with Malaysia is Norway's prolonged distress and repeated interventions, culminating in a virtual government takeover of the banking system in 1991. Authorities are not blamed for failing to take action---they tried a number of remedies. But some say that Norwegian officials failed to assess the extent of bank losses and exposure to firms in difficulty.
These problems were due to the extensive deregulation of banking in the mid-1980s after a long period of tight restrictions, to the failure to introduce adequate prudential regulations, and to a spate of high-risk lending by commercial banks.
The savings and loan crisis in the United States is a perfect example of problems caused by deregulation without rules to supervise the expansion of the financial system. Thrift institutions were given the right to make risky loans drawing on deposits insured by the federal government.
With little to lose, they did just that, resulting in billions of dollars of losses. Much of the political establishment was aware of the problem for years, but took no action as the crisis grew. In the end, the government was forced to take over insolvent institutions and make good on insured deposits.
Over the past decade a consensus has emerged on several regulatory issues. In particular, there is general agreement that governments should build a framework that allows banks to respond to market conditions.
But what about deposit insurance? That remains a source of debate. It protects small savers but presents hazards for regulators.
Then there is the question of universal banking. There is a worldwide trend toward universal banks and financial conglomerates that combine banking, insurance, and securities business. But there are concerns about the difficulties of regulating institutions with complex structures, especially in developing countries.
Another issue is the widespread phenomenon of imprudent and uncritical expansion of financial institutions in countries with deregulated systems. If this were to persist, imposing portfolio or growth limits on banks and other financial institutions for prudential purposes might merit detailed consideration.