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Fridays Academy: A Brief History of Financial Sector Reform in Developing Countries

Ignacio Hernandez's picture

Like every Friday, from Raj Nallari and Breda Griffith's lecture notes.

 

The early stage of financial sector reform in developing countries – roughly the period up to the late 1980s – concentrated on liberalizing interest rates, moving to indirect instruments of monetary control, interest rates on reserves and open market operations, dismantling directed credit and opening the capital account.  For these reforms to take hold and provide a broader liberalization of the financial sector it was necessary to remove impediments to competition. This amounted to the privatisation of banks and the establishment of entry/exit laws for banks, introducing a level playing field for taxation of banks and other financial intermediaries and establishing foreign ownership laws and allowing foreign entry. 

 

However, under a changing environment in which the world financial markets became more volatile and as inflation pressures in developing countries increased, financial sector reform came to mean something else.  Mid-stage financial sector reform sought to strengthen financial sector infrastructure and individual institutions. Macroeconomic stability and real sector reform was crucial to these requirements.  In practical terms, financial sector reform expanded to include:

  • Legal framework for the central bank through the establishment of independent central banks enshrined in legislation
  • Legal framework for banks through the establishment of prudential regulations and banking company law
  • Regulatory framework for non-banking sector through the establishment of rules governing the ratio of nonbank assets to financial sector assets and the number of listed companies on the stock exchange
  • Identification of rights and obligations of financial agents through the establishment of liquidation and bankruptcy laws, payment systems, accounting and auditing standards

Strengthening individual financial institutions required the establishment and enforcement of guidelines for supervision, restructuring and institutional reforms as summarised here:

  • Strengthening of banking supervision – establishing guidelines for: the capacity and authority to supervise; licensing criteria; and supervision systems.
  • Bank restructuring – establishing guidelines for capital replenishment, asset liquidation and privatisation.
  • Bank institutional reforms – establishing management information systems and human resource development programs.

 

The need for what may be termed ‘latter stage financial sector reform’ became apparent in the wake of the Asian financial crisis. The crisis demonstrated the links between the corporate and financial sectors and the adverse consequences that ensue when the corporate and financial sectors are at different stages of reform.  Moreover the crisis demonstrated the need for greater transparency and accountability, sequencing and ownership.  With regard to the latter, financial sector reform represents an especially difficult challenge because oftentimes owners and those with political power are closely connected.  
 
Improving transparency and accountability requires improved disclosure of macroeconomic information, improved disclosure requirements for securities markets participants, improved investor education, establishment of rating agencies and credit bureaus and transition to global accounting and auditing standards.  The sequencing or phasing of reforms will only be successful when certain conditions are in place. For example:

  • Interest rate deregulation should only be pursued when:
    • The regulatory framework is sound
    • Bank supervision is effective
    • Accounting and auditing systems are adequate
    • Financial markets are competitive
    • Banks have positive net worth and capable management and staff
  • Recapitalization of banks should be preceded by a change in the system that allows banks to lose their capital in the first place:
    • Putting a stop to lending to defaulters
    • Strong bank supervision and monitoring
    • Adequate information systems should be put in place
    • Management of insolvent banks should be changed
    • State-owned banks should be part of a privatization plan 

 

Next week:  Microfinance and the poor