There are many who argue that the financial crisis proved that we have been wrong about most of our policy recommendations in the financial sector. I am not one of them. For example, consider the renewed fascination with development banks. Given the reluctance of private institutions to lend more during the crisis, many countries used their public banks to expand credit. (But others without such institutions used other innovative ways to do this – such as the US Federal Reserve.) Should we then conclude that government ownership of banks is desirable? Similarly, the crisis was so intense that many governments ended up as large shareholders in their banking systems (which is turning out to be temporary, as expected). Does this mean developing countries should abandon their bank privatization programs? Others interpret the crisis as a vivid example of market failure and wonder if much more aggressive regulation is a good idea.
You may have guessed already that my answer to these questions is no. Research is seldom conclusive, but in the area of state ownership of banking the evidence is as overwhelming as it gets. When it comes to lending, it appears that the state banks are the best at lending to cronies. Government officials face conflicts of interest that go against efficient allocation of resources – such as securing their political bases and rewarding supporters. Overall, greater state ownership of banking is associated with less financial sector development, lower growth, lower productivity and even less stability – and it is more damaging at lower per capita income levels where there are typically fewer checks and balances. So it is no wonder that many countries embarked on privatization programs and ought to continue with them. Surely this is a difficult process – but there is again plenty of evidence that well-designed privatization can significantly increase bank performance.
It is true that finance is prone to excesses and crises. But just because governments sometimes find themselves as bankers as a result of crises, this does not mean government ownership is the answer: they still need to focus on their exit strategy as part of the rehabilitation plan. Where governments have a very important role to play is rather in regulation and supervision.
Did the crisis expose market failures? Yes, just as it exposed weaknesses in the underlying incentive frameworks and the regulation and supervision systems that are supposed to reinforce them. After all, if we expect to be bailed out when we go bust, most of us would take on more risk than we would otherwise. It is also true that those expectations were reinforced during this crisis – through generous guarantees, bail-outs etc. – making the task of prudential regulation much more difficult in the future.
The solution is not more of the same type of regulation, but better regulation. We need to recognize finance is risky business and we should not expect regulation and supervision to completely eliminate the risk of crises. But we certainly expect effective regulation and supervision to make crises less frequent and less costly. Ultimately the goal of regulation and supervision is not to reduce risk-taking; but to make sure it is neither taxed nor subsidized.
So far I have argued that this crisis has reinforced some of our well-established policy positions. But what are some of the most important policy reforms this crisis revealed as necessary? I will mention three main areas of significant policy interest:
- The above discussion makes it clear that one of these areas is the reform of regulation and supervision. As the debate continues - mostly driven by the developed world- what will be the implications for low income countries?
- Financial literacy is another policy issue that has come to the fore as a result of the recent crisis. The ability of consumers to make informed financial decisions is critical to developing sound personal finance, which contributes to efficient allocation of financial resources and financial stability. Greater financial literacy can also be an important component in efforts to increase saving rates and lending to the poorest and most vulnerable consumers. But while financial literacy is portrayed in global policy circles as a panacea for many recent crisis-related ills, with countries developing financial literacy programs for the general population, we know relatively little about whether such programs actually work, how they affect the use of financial services and financial vulnerability and behavior of individuals and firms during crises.
- The third area has to do with bankruptcy prediction and resolution. The crisis has certainly revealed significant weaknesses in the way financial risks are measured and managed. Rapid growth of innovative products in structured finance has made corporate bankruptcies interdependent, thus making default correlation an important component of portfolio credit risk and bankruptcy prediction. We need to study drivers of corporate stress more carefully since this will have important implications not only for how we define risk but also have practical use in calculating economic capital and in determining capital adequacy regulations. With mounting bankruptcies during and following crises, another important concern for policymakers is the effectiveness of their bankruptcy regimes. We need to learn from examining the impact of bankruptcy reforms and explore the role of different instruments and mechanisms to resolve financial distress.
For further reading, please see Demirguc-Kunt and Luis Serven, “Are all the sacred cows dead? Implications of the financial crisis for macro- and financial policies.” World Bank Research Observer (Forthcoming). In the meantime, here is the Policy Research Working Paper  version.