From chaos to stability: The power of financial reforms in fragile states

Imagine living in a country where basic services are a luxury, the government is on the brink of collapse, and economic stability feels like a distant dream. This is the reality for almost one billion people in so called fragile and conflict-affected states—nations struggling to provide even the most fundamental necessities to their citizens, often ravaged by war and civil conflict. State fragility creates a vicious cycle of political and economic crises.

As growth and job creation have driven down poverty around the world, the World Bank is increasingly focused on the difficult task of supporting development in fragile and conflict-affected states. Our experience has shown that ensuring the functioning of basic financial services—with the help of advancements in digital technology—can help people improve their lives, as well as make resources available for public goods, strengthening state legitimacy and increasing state capacity.

A newly released paper - Financial Sector Policy in Fragile States - takes stock of World Bank experience in supporting financial sector reforms in fragile states and draws some lessons to guide policymakers. Here are the main findings:

The Anatomy of State Fragility

State fragility is like a house of cards—one gust of wind and everything falls apart. Fragile states are trapped in a cycle of instability, unable to support private sector development due to weak institutions and regulatory frameworks. The lack of infrastructure and skilled workforce compounds these challenges, leaving the financial system shallow and ineffective, and often a conduit for criminal activities. With security concerns and government instability at every turn, implementing reforms becomes a herculean task.

One Size Doesn’t Fit All

To navigate this complex landscape, financial reforms must be as unique as the states themselves. Policymakers need to conduct thorough assessments to understand the specific drivers of fragility in each country. This tailored approach must be flexible, ready to adapt as situations evolve. Patience and sustained efforts are key—building institutional capacity and achieving financial stability is a marathon, not a sprint. International collaboration is crucial. By partnering with international organizations, fragile states can leverage shared expertise and resources, maximizing the impact of their reforms. Together, they can address the root causes of fragility more effectively and avoid duplicating efforts.

Laying the Financial Bedrock

The first step towards stability and resilience is establishing a solid foundation for market-based banking and finance. This involves creating a modern legal framework for commercial activities and streamlining judicial procedures. These foundational reforms are critical—without them, other interventions are likely to fail. Early priorities should include halting bank losses, re-establishing monetary control, and reviving the flow of credit to the economy. Strengthening financial sector supervision, although slow to show results, is also essential. Long-term success hinges on hands-on technical assistance and capacity building. While financial deepening is an important goal, it's crucial to first restore the health and core functions of the financial sector before pursuing more advanced objectives.

Strengthening Financial Integrity

Fragile states often grapple with rampant financial crime, from money laundering to corruption. These issues can criminalize the economy and hinder progress toward stability. Strengthening the capacities of agencies involved in anti-money laundering and countering the financing of terrorism is vital. By enhancing financial integrity, states can create a more trustworthy and stable economic environment.

Building (or Restoring) Robust Payment Systems

Effective payment systems are the lifeblood of any economy, enabling the smooth flow of transactions, humanitarian aid, development assistance, and remittances. In fragile contexts, building or restoring these systems presents unique challenges. Policymakers need to conduct tailored diagnostics, set clear objectives, and avoid simply copying models from more stable markets. Agile project management and quick-to-deploy technologies, like cloud computing, can help overcome governance and institutional shortcomings.

Empowering Small Businesses: The Backbone of Stability

Micro, small, and medium enterprises (MSMEs) are the backbone of any economy, and fragile economies are no exception. They drive social stability and resilience but often face significant barriers to accessing finance. Policymakers should focus on developing basic financial and digital infrastructure, addressing capacity constraints, and unlocking bank financing. Leveraging nonbank financial intermediaries and carefully considering the need for concessional financing are also crucial strategies. Technical assistance programs can further enhance governance, risk management, and product development for both lenders and MSMEs.

A Path Forward

Reforming the financial sector in fragile states is more than just an economic necessity—it's a lifeline. These reforms can help break the cycle of instability, paving the way for a more secure and prosperous future. By implementing tailored, flexible, and sustained financial sector policy strategies, fragile states can build a foundation for stability and growth. International collaboration, strong financial integrity, and support for MSMEs are all critical components of this transformative journey. The road to stability may be long and challenging, but with strategic financial reforms, fragile states can rise from the ashes and create a brighter future for their citizens.