The blurring of boundaries between banking and the rest of the financial network has placed an upper bound on the effectiveness of banking regulation and supervision. Network externalities call for corrective action, but the redundancy and complexity of networks make successful interventions hard to design. So, a degree of modesty is appropriate in designing banking policy.
Current issues in banking policy range from the need to construct basic institutions and incentive structures in transition economies -- to the challenges posed by the increasingly complex interactions involved in contemporary banking.
Honohan and Vittas outline the basic regulatory framework needed to reduce bank failures. Without measures that ensure risk diversification and adequate capital reserves, for example, you get bank failures, as recent experience shows.
Dissatisfaction with the diminishing effectiveness of postwar banking regulation led to substantial deregulation. Before adjusting to deregulation, bankers seemed vulnerable to a contagious euphoria, often manifested in overlending to property developers. Given the historic recurrence of carbon-copy banking failures, clearly private learning will not end all bank failure. And the disappointing performance of both regulated and unregulated financial sectors leaves a vacuum that theoreticians have been trying to fill.
Theoreticians note that banking increasingly displays network characteristics that, on the one hand, may call for corrective action but that, on the other, make policy intervention ineffective or counterproductive. For one thing, networks are susceptible to externalities, redundancy (ensuring that flows cannot be obstructed by blocking just one path), and a tendency to adapt to disturbances in a complex manner. Regulation is justified, but the complexity of the network makes successful interventions hard to design.
Supervision has a role, and Honohan and Vittas outline the basic regulatory measures needed. But the blurring of boundaries between banking and the rest of the financial network has placed an upper bound on the effectiveness of supervision. So, a degree of modesty is appropriate in designing banking policy. We have to put up with bank failures (mitigated by deposit insurance to protect small savers) but, they argue, partly because of network redundancy, the social cost of bank failure is not as high as is sometimes thought.
This paper -- a product of the Financial Sector Development Department -- was an invited paper for the World Congress of the International Economic Association, held in Tunis, December 1995. Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Priscilla Infante, room G8-115, telephone 202-473 7642, fax 202-522-3199, Internet address pinfante@worldbank.org. (43 pages)
The full report is available on our FTP server.