i n s i g h t s
D E V E L O P M E N T
R E S E A R C H
Finance matters
Financial liberalisation: too much too soon?
A
n efficient and stable financial system is important for economic
growth and poverty reduction. The financial crises that have afflicted
many countries in recent times have been a costly and painful reminder of
the disastrous consequences for development of weak financial markets.
The recurrence of financial crises, at both the
international and national levels, and the
adverse effect they have had on economic
growth and poverty levels, have highlighted
the need for a policy framework which
addresses the inherent vulnerability of
financial markets to systemic instability and
failure.
Governments have always intervened in
the financial sector and there are sound
theoretical and practical reasons for doing
so. Financial markets are characterised by
problems of limited and unequal
information, making them inherently
imperfect and prone to failure. Financial
regulation and supervision are therefore
essential for efficient and stable financial
market development. How should
governments intervene? Have financial
liberalisation and financial sector reform
made financial systems more, or less
vulnerable to instability and systemic crises?
How can the process be better managed?
What is the best policy framework for
supporting financial sector development in
low-income countries?
Repression to liberalisation
For many years, governments followed a
policy of financial ‘repression’, which relied
on fixing interest rates below market
levels and controlling the allocation
of credit. The economic distortions
induced by these policies were
considerable. Financial systems
remained under-developed,
lending patterns were inefficient
and failed to achieve their
distributional goals. Negative
real interest rates led to low
savings and encouraged capital
flight. Macro-economic
performance also deteriorated –
countries with large negative
real interest rates experienced
lower allocative efficiency and
growth rates. In the stateowned banking sector, poor
lending decisions (often politically
influenced) and low repayment rates led
to bank insolvency and large budgetary
bailouts of depositors and creditors.
March 2002
A growing awareness of the economic
costs of financial ‘repression’, led to financial
‘liberalisation’ as the dominant policy
paradigm over the past two decades. Initially,
the relaxation of controls on interest rates
was the focus for financial reform which was
often triggered by a financial crisis. The
relaxation of controls on the financial sector
was often part of a more general policy shift
towards liberalisation of the domestic
economy and opening up to the international
economy. Liberalisation soon broadened
therefore beyond interest rate liberalisation,
to include a wide range of measures
constituting a programme of financial sector
reform. For many countries, financial sector
reform was adopted under World Bank
sectoral or structural adjustment lending
conditionalities, the key elements of which
included: privatisation of banks, entry of new
domestic and foreign entrants into the
banking sector, bank restructuring and
recapitalisation, opening up of the capital
account, strengthening bank regulation and
supervision institutions.
Has financial liberalisation worked?
The period of financial liberalisation coincided
with, or was soon followed by, heightened
financial instability, culminating in the
www.id21.org
inside
Better banking in Africa?
A foreign affair
Prudence pays?
Crisis in Jamaica
Bumpy road to Basel
Regulating microfinance?
Curbing capital flight
dramatic financial crisis in East Asia in the
second half of the 1990s. Clearly, financial
liberalisation has not led to a smooth transition
to a stable and efficient financial system. It
would be wrong, however, to jump to the
easy, but shallow, conclusion that financial
liberalisation has ‘failed’. Firstly, the fact that
the period of financial liberalisation coincides
with a period of increased systemic instability
does not prove causality. Secondly, no process
of change comes cheap: a reasoned
assessment of the costs and benefits of the
policy change is needed. And thirdly, what
would have been the outcome without the
policy change? Finally, the impact of financial
liberalisation will differ between countries,
depending on each country’s economic and
institutional characteristics. The more relevant
research issue, therefore, relates to the design
and timing of context-specific policy measures
which will contribute to the development of
an efficient and stable financial system.
Could financial liberalisation have been
managed better? If so, what policies are now
needed? The articles in this issue discuss
these questions by summarising
the findings of recent research
studies on the impact of
financial liberalisation in
developing countries. The
commercial banks are the
dominant component of the
financial sector in low-income
countries and are critical to the
efficiency and stability of the
financial system as a whole.
Financial liberalisation was
associated with a shift in
prudential regulation from
direct regulation of banks, by,
for example, regular site visits,
to an indirect approach based
on the monitoring of bank
capital to ensure that it remained
adequate in relation to the risk being
taken. Additional regulatory measures are insights 40
insights 40
also necessary to restrain the activities of the
various policy interventions designed to
privatised and other newly-established private
strengthen commercial bank lending,
banks. The regulatory and supervisory
particularly to small-scale borrowers and startframework may also need to be extended, to
up enterprises.
cover microfinance institutions which have
Financial liberalisation has resulted in
developed significant depositincreased foreign participation in
The experience with
taking capacity.
the domestic banking sector.
financial liberalisation reveals Murinde and Tefula examine
Llewellyn highlights the
a strong correlation between the implications for subpotential problems of relying
liberalisation and financial
on a capital adequacy
Saharan Africa and identify
crisis.
framework, as proposed in the
the main benefits (such as
Bank of International Settlements’ new
improvements in quality, pricing and
Basel Accord, as the main instrument for
supply of financial services, increased
regulating bank activities. Systemic stability
competition) and the costs (increased
and the safety and soundness of banks need
exposure to capital flight for example) of
to be considered in a wider ‘regulatory
foreign banks.
regime’ framework which should include
Capital account liberalisation has been a
official supervision, market discipline, incentive
prominent component in financial
structures for banks, and corporate
liberalisation programmes. FitzGerald argues
governance arrangements for banks.
that premature capital account liberalisation
Murshed identifies four main obstacles to
can be highly destabilising. Theory and
efficient banking regulation: a) information,
experience indicate the desirability of
contracting and monitoring problems, b) lack
scheduling capital account liberalisation after
of supervisory personnel, c) high operational
appropriate domestic financial liberalisation.
costs and d) poor credibility and regulation of
To prevent massive capital inflows that
regulatory bodies. The appropriateness of
threaten effective domestic policy and raise
various policy measures for dealing with these
the probability of sudden reversal if capital
constraints are discussed and ranked in terms
flows, emerging market governments need to
of their suitability for low-income countries.
use market-based intervention instruments on
What are the implications of allowing
short-term capital flows.
microfinance institutions to offer a range of
Using the case of Jamaica’s policy response
financing services beyond small-scale lending
to the financial crisis of the mid-1990s,
asks Maimbo? Drawing on research in the
Tennant and Kirkpatrick compare the
microfinance sector in Zambia, Maimbo
approach adopted to a hypothetical ‘IMF
considers options open to the regulatory
model’ policy prescription arguing that
authorities. Top of the list is a flexible,
financial crisis management programmes are
graduated regulatory structure, which
more likely to succeed if they draw on natural
encourages microfinance institutions to
stakeholders’ expertise and knowledge.
voluntarily increase their capital base in order
Too much, too soon?
to engage in a set of permitted activities.
The experience with financial liberalisation
The growth of commercial bank lending to
reveals a strong correlation between
the private sector following financial
liberalisation and financial crisis. This can be
liberalisation has been disappointing. Drawing
explained partly by the exposure of existing
on the experience in a number of sub-Saharan
inefficiencies and distortions in the financial
African countries, Brownbridge identifies
Banking
reforms in
Africa
What has been learnt?
O
ne of the major objectives of
liberalisation is to boost bank lending
to the private sector, which is regarded as
the engine of economic growth. However,
the growth of commercial bank lending to
the private sector following financial
liberalisation was disappointing in many
countries, especially bank lending to small
scale borrowers and start-up enterprises.
Many countries in sub-Saharan Africa
liberalised their financial sectors in the late
1980s or 1990s to encourage greater financial
efficiency. Policy reforms included: removing
interest rate controls, removing requirements
on banks to lend to specific sectors, privatising
state-owned banks, and allowing easier entry
by private sector banks and non-bank financial
institutions (NBFIs), including foreign banks. At
structure, and partly by a failure to develop a
strong regulatory and supervisory framework,
prior to liberalisation.
Weaknesses in the initial conditions affect the
ability of the privatised banks and new market
entrants, to operate on broadly commercial
principles. Borrowers are often unable to
service their loans, due to poor quality lending
and high interest rates. Liberalisation of the
capital account increases the inflow of foreign
capital, but at the same time threatens the
stability of the financial institutions, by
increasing the exchange rate and domestic
lending risks.
The existing regulatory and supervisory
system may be unsuited to a market-based
environment. Consequently, across-the-board,
‘big-bang’ financial liberalisation and financial
sector reform increase the likelihood of
systemic crisis, where the institutional and
human resource environment is weak.
Much of the blame for post-liberalisation
financial crisis lies, therefore, with the scale and
sequencing of financial reform. What is needed
is a more gradual and considered approach to
financial liberalisation, which recognises that
institutional strengthening, especially in the
regulation and supervision capacity, is a prerequisite for creating a more efficient and
stable financial sector which can contribute
fully to achieving economic growth and poverty
reduction in developing countries Colin Kirkpatrick
Institute for Development Policy Management, University
of Manchester, Oxford Road, Manchester M13 9GH, UK
T +44 (0)161 275 2800
colin.kirkpatrick@man.ac.uk
See also
‘Financial liberalization: how far, how fast?’ Cambridge
University Press by G. Caprio, P. Honohan, J. Stiglitz, 2001
‘Finance for Growth. Policy Choices in a Volatile World’,
World Bank and Oxford University Press: Washington DC,
2001
‘Financial regulation in developing countries’, Journal of
Development Studies 37/1 by M. Brownbridge and C.
Kirkpatrick, 2000
borrowers from the credit markets.
the same time, to promote sounder banking
Financial liberalisation has changed the nature
and help protect bank deposits, reforms were
of the risks facing the banking system.
introduced to strengthen the prudential
Reforms have reduced the risk of
regulation (rules and regulations
Liberalised financial
bank distress caused by
designed to restrict banks from
markets require strong,
governments directing banks
taking excessive risks with
impartial supervision,
(government-owned banks
depositors’ funds) and
independent of political
in particular) to lend to
supervision of banks by
interference, to protect
unviable and uncreditworthy
improving banking laws and
depositors’ funds.
borrowers. New sources of risk
expanding supervisory capacities.
have emerged, however: greater
It has proved difficult for
competition is squeezing the profits of weaker
commercial banks to build up sound
banks; the entry of new banks that lack the
commercially viable loan portfolios, for several
expertise to manage risks in liberalised markets;
reasons:
greater opportunities for fraud and abuse of
● Domestic private sectors are weak: few
depositors’ funds by banks and NBFIs; and risks
creditworthy borrowers exist.
arising from foreign exchange denominated
● Banks face acute problems of information
transactions such as lending by banks in foreign
(concerning the viability and
exchange and the contracting of foreign
creditworthiness of borrowers) and contract
exchange liabilities by banks.
enforcement problems which increase the
Kenya, Nigeria, Uganda and Zambia and
risk of loan default.
others have suffered from the failure of
● High inflation and exchange rate volatility
privately owned banks and NBFIs – often due to
has exacerbated the risks of lending in
fraud and abuse by managers and owners,
some countries.
especially insider lending. These bank failures
Large government deficits in some countries,
have proved costly for taxpayers, who have
which have to be funded through sales of
often had to fund the reimbursement of
treasury bills to domestic financial markets to
deposits. Many of the failures exposed serious
avoid inflationary growth of the money
weaknesses in prudential systems: prudential
supply, have crowded out private sector
www.id21.org
A foreign
affair
How far does Africa need
foreign banks?
F
●
Swaziland. A small domestic market means
that locally-owned banks cannot recover
high set-up costs as foreign banks can
from profitable operations elsewhere.
Financial liberalisation increases the degree
of access by foreign banks. Foreign banks
in Tanzania had only 5 percent access pre1980 when policies were restrictive. This
figure has now risen to 76 percent. So too
the trend in Ethiopia (at 2 percent because
of its barriers to entry under a Marxist
regime) is now expected to change.
Although bank loan growth patterns are
similar for both domestic and foreign
banks, increased foreign participation
reduces the variability of loan supply.
Contrary to expectation, foreign and
domestic banks both shoulder a
considerable amount of non-performing
loans, possibly due to differences in
accounting practices.
Foreign banks are more profitable but not
necessarily better capitalised than their
local counterparts.
ree foreign bank entry is essential to
financial liberalisation in Africa. It is
also integral to the World Trade
●
Organisation (WTO) protocols on the
General Agreement on Trade in Services
(GATS) embraced by most African
governments. What are the pros and
●
cons of free foreign bank entry? What
are the implications for local domestic
banks?
Foreign banks are central to the evolution
of African banking. In colonial times, formal
●
banks were foreign. Post-independence in
the 1960s saw the creation of a two-tier
banking system, with a central bank
responsible for monetary policy, and several
Mixed blessings? The pros and cons of
commercial banks handling deposits and
foreign bank entry
loans. The lending objectives of foreign
Foreign banks directly improve the quality,
banks, however, severely marginalised
pricing and availability of financial
indigenous entrepreneurs.
Foreign banks
services. They engender
Some governments
engender competition with
competition with domestic
intervened by
domestic banks and improve
banks and improve financial
nationalising foreign
financial system architecture, for
system architecture, for
banks – most are
example, accounting, auditing,
example, accounting,
now insolvent and
transparency, and risk
auditing, transparency, and
either privatised or sold
management.
risk management. Foreign banks
to foreign owners.
also increase competitiveness and
Recent research by the
efficiency leading to better quality customer
Birmingham Business School and the
services.
Institute for Development Policy and
However, foreign banks can destabilise
Management examined how open 26
domestic bank credit by providing additional
African economies are to foreign
channels for capital flight. Foreign-owned
participation in their domestic banking
banks also tend to withdraw quickly from the
markets. Key findings include:
domestic market in the face of financial crisis,
● Foreign banks can be totally involved in
as was the case in South East Asia. In
smaller economies such as Lesotho and
regulations were not properly enforced and
distressed banks were allowed to continue
operating, often with financial support from
central banks and governments, for too long
after they had become insolvent, merely
increasing the eventual cost of collapse.
What should governments do? To
encourage the growth of bank lending to the
private sector, governments should:
● Maintain macroeconomic stability and
avoid financing large fiscal deficits from the
domestic banking system.
● Accumulate savings in the domestic
banking system to create more room for
private sector borrowing: in Uganda in the
1990s, fiscal reforms enabled the
government to accumulate bank savings,
which in turn facilitated a strong recovery
in private sector bank credit.
● Improve the institutional environment for
bank lending by strengthening the
commercial legal system, so that banks can
enforce contracts and foreclose on
defaulters without long delays.
● NBFIs – leasing companies, merchant
banks, mortgage institutions, microfinance
institutions for example - good at filling
specific niches in the financial markets,
need support and encouragement. Most
commercial banks are not suited to lending
to the small scale enterprises likely to prove
crucial to future growth.
Liberalised financial markets require strong,
impartial supervision, independent of political
interference, to protect depositors’ funds.
While many countries have brought their
banking laws into line with what is regarded
as best practice, better enforcement of
prudential regulations is essential. Regulators
must force insolvent banks to be re-capitalised
by their owners or by new owners, or close
them down promptly. Since supervisory
resources are scarce, regulatory agencies must
focus their limited resources on those banks
and NBFIs which pose the greatest prudential
risk Martin Brownbridge
Institute for Development Policy and Management
(IDPM), University of Manchester, Crawford House
Oxford Road, Manchester M13 9GH, UK
MartinBrownbridge@hotmail.com
See also
‘Financial regulation in developing countries’ Journal of
Development Studies 37/1 by Martin Brownbridge and
Colin Kirkpatrick, 2000
‘Banking in Africa: The impact of financial sector reform
since independence’, James Curry: London by Martin
Brownbridge and Charles Harvey, 1998
addition, foreign banks use their financial
power to cherry pick the most lucrative
transactions, thus relegating domestic banks
to more risky markets.
How should African governments
respond?
● Where there is too much foreign bank
involvement, local private banks should be
encouraged to merge and expand to
become more viable.
● Policy makers should not be complacent
regarding the liquidity and capitalisation of
foreign banks, even if the banks fall under
the jurisdiction of the parent country. Both
domestic and foreign banks should be
subjected to the same regulatory regime,
and the level of monitoring should be
equally strict.
● By designing policies that enhance foreign
bank participation for example setting up
new banks or privatising state-owned
banks.
● Sequencing is crucial. It is important to
strengthen and enhance the international
competitiveness of the domestic banking
system before opening up fully to foreign
entry Victor Murinde
Birmingham Business School, University of Birmingham,
Edgbaston, Birmingham B15 2TT, UK
T +44 (0)121 414 6704
V.Murinde@bham.ac.uk
Moses Tefula
Institute for Development Policy and Management,
University of Manchester, Oxford Road, Manchester
M13 9GH, UK
T +44 (0)161 275 2827
Moses.Tefula@man.ac.uk
See also
‘Foreign bank participation in the domestic banking
market of African economies’, Finance and
Development Research Programme Working Paper #37:
IDPM, University of Manchester, 2002
Crisis in Jamaica
Has the cost been excessive?
I
n recent decades, financial crises have
threatened the financial and monetary
systems of many developing countries.
But have the crisis management measures
alleviated or intensified the
accompanying economic, social and
political upheaval?
Research from the University of
Manchester’s Institute for Development Policy
and Management looks at Jamaica’s recovery
from financial crisis in the mid-1990s. The
paper argues that financial crises can be
resolved without excessively impairing the real
economy, but only if the problem is properly
diagnosed and if the treatment is appropriate,
as determined by local conditions. It rejects
the IMF’s standard shock treatment as a
panacea for local financial crises. Instead it
uses Jamaica’s experience in responding to its
crisis without the IMF’s involvement to show
that crisis management programmes are more
likely to succeed if they draw on the national
stakeholders’ expertise and knowledge.
The Jamaican financial crisis was severe. A
downturn in the real estate and stock markets
precipitated illiquidity problems in the
March 2002
Bumpy road to Basel
countries. Banks will be required to hold more
capital against loans to developing countries
than is justified, reducing the supply of loans
Banking regulation: precision v accuracy
and increasing their costs. Increased
sophistication and precision does not
anks play an important role in the economy and need to be regulated. Safe, sound
necessarily imply increased accuracy: the
banks and a stable financial system are essential. Without regulation, the banking
distortion of bank lending with respect to loans
system would be unable to perform its basic functions well, such as financing
to developing countries is an important
economic development and poverty reduction. Nor would people have the confidence
example. Would the same objectives be
to use banks.
achieved with a less complex and costly
system?
The regulation of banks for capital
■ Do the regulatory requirements correspond to the amount of
Regulation is a response to
adequacy purposes (ensuring that banks hold
capital a bank really needs, given the risks involved?
market failure. Regulation,
sufficient capital to cover their risks) has
■ Do they create incentives for effective and efficient risk
however, may undermine other
important implications for the safety and
analysis, management and control mechanisms?
mechanisms in the regulatory
soundness of banks, stability, efficiency and
■ Does the regime create incentives for an efficient allocation
regime: excessive reliance on
consumer protection. Regulation may be
of capital within the bank across different business areas and detailed and prescriptive rules
precise, through detailed and prescriptive
asset classes?
may weaken incentive structures
rules, but is it always accurate? While capital
■ Does it create perverse incentives for regulatory arbitrage –
and market discipline. It may also
adequacy rules may specify how much capital
business structures that lower capital requirements without
weaken corporate governance
each bank should hold, such rules may not
any corresponding reduction in the bank’s risk profile?
within banks and blunt the
truly reflect the risks involved and
■ Are the capital requirements competitively neutral as
incentives of the market, other
unintentionally force banks to hold either too
between countries and competing banks?
banks, depositors and so on, to
much or not enough capital. Too little capital
■ Is the amount of capital appropriate for overall portfolio
monitor and control the
increases the danger of bank failure whilst
risks?
behaviour of banks. The value of
too much capital imposes unnecessary costs
■ Do the requirements impair competition in banking markets?
Basel 2 depends upon its accuracy:
on banks and their customers and may reduce
■ Do they have detrimental effects on the macro-economy?
● Is better accuracy possible at
the efficiency of the banking system.
■ Is the regime unnecessarily complicated and prescriptive?
an acceptable cost to banks and
A major new initiative from the Basel
■ Does it create or reinforce incentives for stakeholders?
regulatory and supervisory
Committee on Banking Supervision is the
agencies?
Basel 2 Accord – the proposed new capital
● Are the benefits of a complex set of capital
suggested in the box above.
adequacy framework. Set to replace the Basel
adequacy arrangements enough to offset the
What is impact of the Basel Accord on
Accord of 1988, accepted by nearly all
higher compliance and monitoring costs that
developing countries likely to be? Will it
countries as the basis for the regulation of
they will inevitably entail discourage banks from lending to
their banks, the Basel 2 Accord stipulates how
developing countries if excessive risk weight
much capital banks should hold in relation to
David T. Llewellyn
is applied to loans to the south, as critics
their risks. But shouldn’t systemic stability and
Economics Department, Loughborough University,
maintain?
the safety and soundness of banks be
Leicestershire, UK
Basel 2 is more detailed and complex
considered in a wider framework than just
T +44 (0)1509 222 700
D.T.Llewellyn@lboro.ac.uk
than its predecessor, for example applying
capital adequacy rules? A ‘regulatory regime’
risk weight to different classes of assets and
should also include official supervision, market
See also
‘Some regulatory lessons from recent bank crises’, De
loans. If risk weights don’t reflect true risk,
discipline, incentive structures and corporate
Nederlandsche Bank Staff Report: Amsterdam, by D. T.
banks’ balance sheets and lending policies
governance arrangements for banks, and
Llewellyn, 2001
will become seriously distorted. If risk
intervention arrangements should they get
‘Bumps on the Road to Basel: An Anthology on Basel 2’
weights are too high, lending will decrease
into difficulty. Ten tests to gauge the
Centre for the Study of Financial Innovation: London,
2001
with serious consequences for developing
suitability of any capital adequacy regime are
B
overexposed life insurance industry. Affiliated
arrangements to protect depositors. The
commercial banks were infected, and despite
ensuing credit crunch, and contraction in
Central Bank assistance, panic spread
economic activity and social unrest, stand in
throughout the sector. The government was
stark contrast to the relative calm maintained
initially inclined to follow the standard remedy of
in the Jamaican financial sector and wider
closing distressed institutions. However, after
society.
pausing to evaluate the extent of the
The paper recognises the high cost of
problem, fast track legislation and
the Jamaican intervention, and
The Jamaican case study
other measures were introduced
the worrying resultant debtshows that the cure for severe
to resuscitate the sector.
overhang, but argues that
financial crises will always
The Jamaican response to
this is less significant
be painful, but the adjustment
the crisis was unusual, as it
when compared to what
costs can be reduced if an
disregarded contemporary
would have occurred if the
appropriate policy response
multilateral wisdom and fully
standard IMF prescription
is adopted.
protected all deposits. This was
had been adhered to. The
done to maintain the public’s confidence in
Jamaican case study shows that the cure
the sector and prevent international capital
for severe financial crises will always be
flight. Instead of closing institutions, the
painful, but the adjustment costs can be
government created the Financial Sector
reduced if an appropriate policy response is
Adjustment Company (FINSAC) to assist troubled
adopted. The adoption of universal panaceas
financial institutions with an injection of capital.
has tended to worsen rather than alleviate
In exchange, FINSAC acquired a combination of
crises. Responses must be appropriate to each
equity, board seats and other assets, which
financial sector’s structure and history and to
facilitated the much-needed restructuring and
the broader social and economic environment.
subsequent divestment of the sector.
● During periods of financial panic,
A comparison of the effect of this response
governments should adopt an approach
with that of the IMF-led response to the South
aimed at restoring public confidence. Public
East Asian crisis is instructive. The Asian
resources may have to be used for bank
meltdown resulted from financial panic,
restructuring and protection of deposits, but
triggered by the closure of institutions without
should be complemented by strong
incentives against future moral hazard.
● Post-crisis financial restructuring is vital and
best carried out by strong, independent
public agencies with political and legal
clout to implement difficult decisions.
● Strengthened prudential regulation and
supervision of the financial sector is crucial,
but in periods of crisis, banks should be
given appropriate leniency to meet these
regulatory standards.
● Post-crisis policies should focus on the
reduction of social hardships resulting from
the linkages between the financial sector
and the real economy David Tennant
Department of Economics, University of the West
Indies, Jamaica
Davidf_Tennant@hotmail.com
Colin Kirkpatrick
Institute for Development Policy and Management,
University of Manchester, Oxford Road, Manchester
M13 9GH, UK
T +44 (0) 161 275 2800
colin.kirkpatrick@man.ac.uk
See also
‘Responding to Financial Crisis: Better off without
the IMF? The case of Jamaica’ Finance and
Development Research Programme WP #38: IDPM
University of Manchester, by C. Kirkpatrick and D.
Tennant, 2002
insights 40
Prudence pays?
Regulating the financial sector
A
that two banks with the same capital adequacy
ratio and using similar risk management
procedures, may have completely different risk
profiles if bank owners and managers’ interests
diverge.
Direct control and impact on output: such as
ceilings on risky assets and on total asset growth
and lending rates. While direct controls may
prevent countries from experiencing crises, they
are usually at the expense of financial sector
performance – important for stimulating general
economic activity. Restraints on output can also
lose effectiveness as a result of financial
innovation and if the incentives driving bankers’
actions are ignored.
Controls on process or supervision:
Prudential restraint such as overseeing and
influencing banks’ risks policy framework,
internal reporting standards, or market and
credit risk management procedures would result
in the least crisis-prone financial sector, but are
complex and expensive to implement in
countries where rent seeking activities such as
corruption, bribery, and lobbying are
commonplace.
Increasing bankers’ liability limits: a powerful
incentive to bank owners to stay
prudent if liability is extended to
typical LDC circumstances
personal wealth, although penalties for
c. Small
d. Poor
risk-taking may become too high.
banking
credibility of
While raising capital ratios and liability
sector
government
limits might be suggested to countries
agencies for
with insufficient supervisory skills both
regulatory
policy tools could induce either banking
enforcement
disintermediation. To guarantee
profitability, limiting entry could be a
✶✶✶
✶✶✶✶
solution, although rent-seeking
activities may emerge.
LDCs need a regulatory framework
✶✶✶✶✶
✶
that rewards prudent risk-taking and
punishes misconduct: possible policy
options are summarised in the table strong banking system is the backbone of
a robust financial sector. Research by the
United Nations University’s World Institute for
Development Economics Research identified
four main obstacles to efficient banking
regulation in LDCs:
a serious information (data on many aspects of
the economy is unavailable), contracting and
monitoring problems
b a paucity of well-paid,
qualified officials and
Incentive-compatible policy instruments under
infrastructure for
a. Information, b. Paucity of
adequate supervision
monitoring,
well-paid,
c high operation costs and
contracting,
qualified
a limited choice of
problems
officials and
financial assets for
infrastructure
diversification purposes
for adequate
curtails profitability
supervision
d poor credibility of
Capital adequacy
✶✶✶
✶✶✶✶✶
government agencies.
What policies would work
Contingent
best to strengthen the
liability limit
✶✶✶✶✶
✶✶✶✶✶
banking sector and restrain
Entry
barriers
irresponsible bank
with openness
behaviour?
✶✶
✶✶✶✶✶
✶✶✶✶
✶✶✶
Restraints on input: capital to foreign banks
adequacy (having enough
Fit and proper
capital is a minimum
testing of bankers
✶
✶
✶✶✶
✶
banking regulation), liability
composition (types of assets Self-policing
arrangements
✶
✶✶✶
✶✶✶✶
✶✶✶
banks are allowed to hold)
and tests for bank managers Restrictions on
are generally considered the bankable activities
✶✶✶
✶✶✶
✶
✶
least effective measures but
The suitability of policy instruments are ranked from least suitable (*) to most suitable (*****)
with the lowest verification
under the four impediments (a–d) to building strong financial sector in small countries.
costs. Critics say, however,
Capital flows?
Balance of payments management
T
he free movement of capital across
national boundaries can ensure a more
efficient allocation of savings, channelling
resources to countries where they can be
used to increase growth and welfare.
Further arguments in favour of the free
movement of capital relate to allocational
efficiency and macroeconomic policy discipline,
according to research by the University of
Oxford, but may have to be set against the
public good of financial stability:
● Access to foreign capital markets may enable
investors to achieve a higher degree of
portfolio diversification, allowing them to
obtain higher risk-adjusted returns.
● Full convertibility for capital account
transactions may complement the multilateral
trading system, broadening the channels
through which emerging market countries can
obtain trade and investment finance.
● By subjecting governments to greater market
discipline and penalising unsound monetary
and fiscal policies, liberalisation may improve
macroeconomic performance.
Both theory and experience indicate the
desirability of scheduling capital account
liberalisation after appropriate domestic financial
liberalisation. Significant foreign investment in
domestic financial markets and foreign
borrowing by domestic banks and corporations
call for minimum levels of market efficiency and
institutional and regulatory capacity to safeguard
stability. The liquidity and volume effects of large
foreign capital inflows on the domestic equity,
bond and foreign exchange markets, can be
highly destabilising.
Following convention wisdom, major
industrial countries and OECD members
adopted the gradual and sequenced approach
toward capital account liberalisation in the
1960s and early 1970s. Yet in recent decades,
some emerging market economies adopted
wrongly sequenced liberalisation programmes
and undertook ‘big bang’ approaches instead,
often under pressure from G7 governments.
A shift in external market sentiment can
cause a sudden (possibly excessive) reversal in
the availability of external finance, destabilising
the economy. Experience indicates that before
liberalising capital account, fiscal balance and
discipline, measures to attain a private sector
savings-investment balance, and prudential
regulation of bank and non-bank financial
intermediaries should be in place. However,
such measures have not proved sufficient to
prevent the overheating of domestic financial
markets, following capital inflows, and their
subsequent market collapse.
Until recently, international financial
institutions were pressing for the immediate
liberalisation of the capital account. But recent
experience suggests that premature opening
without macroeconomic pre-conditions, capital
market depth, and sound financial regulation
and supervision may be destabilising. This
problem arises not only from distortions or
imbalances in the host economy but also from
the lack of breadth and depth in emerging
capital markets.
Unrestricted capital inflows lead to excessive
appreciation of the domestic currency, current
account deterioration, and increased instability
S Mansoob Murshed
Institute of Social Studies (ISS), PO Box
29776, 2502 LT The Hague, Netherlands
Murshed@iss.nl
See also
Prudential regulation of banks in less
developed countries, Finance and
Development Research Programme Working
Paper #19: IDPM, University of Manchester by
S.M. Murshed and D. Subagjo, 2000
of the economy in general. What are the policy
options?
● Active intervention in money markets to
sterilise capital inflows is one possible
response. Large-scale sterilisation policies
could lead, however, to higher domestic
short-term interest rates, which in turn would
further stimulate short-term capital inflows.
● A free-floated exchange rate system would
maintain free capital mobility. However, large
exchange rate fluctuations in emerging
economies may have significant economic
impacts.
● If emerging market economies decide to stay
with managed exchange rate regimes that
target a competitive real exchange rate, they
could establish mechanisms of managing
short-term capital movements.
● The IMF still advocates the overall
liberalisation of capital account transactions
but also recognises the necessity of measures
to influence the volume and composition of
capital flows. Market-based instruments, such
as taxes on short-term foreign borrowing, can
thus be used to lengthen the maturity
structure of external liabilities Valpy FitzGerald
Finance and Trade Policy Research Centre, University of
Oxford, 21 St. Giles, Oxford, UK
edmund.fitzgerald@queen-elizabethhouse.oxford.ac.uk
See also
‘Going with the flows? Capital account liberalisation
and poverty’, Oxford: OXFAM and FTPRC by A.
Cobham, 2001
‘Rebuilding the international financial architecture’;
Seoul Report Emerging Markets, Eminent Persons
Group (2001)
March 2002
Blurring the boundaries?
Microfinance vs formal banking
ID21
Institute of Development
Studies,
University of Sussex,
Brighton BN1 9RE, UK
T: +44 (0)1273 678787
F: +44 (0)1273 877335
Insights@ids.ac.uk
www.id21.org
Senior Editor: Louise Daniel
Academic Advisor: Richard Batley
Design: Robert Wheeler
Electronic version: Alistair Scott
and Caroline Lowes
Printed in UK by Colorscope Ltd.
ISSN 1460-4205
Insights is supported by DFID,
as part of the ID21
programme. Views expressed
in these pages do not
necessarily reflect the official
position of DFID, IDS or any
other contributing institution.
Copyright remains with the
original authors. Unless rights
are reserved in specific cases,
however, any article may be
copied or quoted without
restriction, provided both
source (Insights) and
authorship are properly
acknowledged.
RE
EY
S
icrofinance practitioners want to see special regulations allowing
microfinance institutions to provide a range of financial services
without attracting formal banking sector regulations – especially
minimum capital requirements. If adopted, this approach will stretch the
limited financial resources and technical capacity of many central banks
in developing countries. It will blur the traditional boundaries of
financial sector regulation. What options would best help regulators
faced with a burgeoning microfinance sector?
while others provide demand
Research in Zambia by the University
accounts facilities and a wide range
of Manchester’s Institute for
of other banking type services. Only
Development Policy and Management,
the latter need regulating.
argues against the need for the central
● No capital requirements should be
bank to impose an excessive level of
stipulated for microfinance
prudential regulations. The
institutions at the lower end of the
microfinance industry in Zambia is still
regulation ladder for an interim
relatively new and should be nurtured
period of five years. There is
within the parameter of an
currently no justifiable basis upon
accommodating legislative and
which such capital requirements can
regulatory structure. So too, regulatory
be made.
theory is in its infancy and lacks
● Prudential limits on the scale of
sufficient guidelines for regulators
microfinance operations, if required,
faced with a growing microfinance
should be based on the institutions
sector. At this stage, a detailed
deposits-to-loans ratio. The ratio
regulatory structure may stifle rather
measures the extent to which a
than promote the growth of the sector.
microfinance institution is able to
Ideally for Zambia, a flexible
mobilise deposits from its members
graduated regulatory structure would
and, where applicable, from the
encourage microfinance institutions to
general public. A higher ratio is
increase their capital base voluntarily,
associated with a greater element of
allowing them to engage in the
risk.
permitted activities in the next
The regulatory responsibility of the
regulatory level.
central bank should be restricted to
Recommendations for designing and
those institutions with potential
developing effective regulatory
systemic financial sector risk. Greater
classifications for microfinance
emphasis should be placed on
institutions include:
strengthening the self-regulatory
● Simple registration procedures are
capacity of the Association of
needed for all microfinance
Microfinance Institutions. Selfinstitutions that take public deposits.
regulation combined with targeted
A self-regulating association should
central bank involvement is more
be responsible for non-prudential
favourable at this early stage of the
monitoring of these institutions.
industry’s development ● Classifications should be based on
an institution’s potential systemic risk
to the financial sector and not size
Samuel Munzele Maimbo
of membership or area of operation.
World Bank, 1818 High Street NW,
Regulators cannot verify membership
Washington, DC 20433, USA
and geographical size in an
T +1 (202) 472 3115 F +1 (202) 522 2433
smaimbo@worldbank.org
economically efficient manner,
especially in an industry where there
See also
is high group turnover and mobility.
‘The regulation and supervision of
● Regulators must carefully delineate
microfinance institutions in Zambia’ by Samuel
between seemingly homogenous
Munzele Maimbo in ‘Financial System
groups such as co-operatives. Some
Regulation and Supervision in Zambia’ edited
K. Mwenda, forthcoming, 2002
cooperatives do not accept deposits
A
SO
good starting point
to investigate issues
around financial liberalisation,
privatisation, banking restructuring,
capital account regulation and
microfinance is the World Bank’s Financial
Sector network at
www1.worldbank.org/finance and the search
facility at www.worldbank.org/search.htm. A
wealth of relevant reports are found via the
search engines of the regional development
banks: Inter-American Development Bank
www.iadb.org; Asian Development Bank
www.adb.org and African Development Bank
www.afdb.org. Reports on bank privatisation
processes in eastern Europe are provided by the
European Bank for Reconstruction and
Development www.ebrd.com.
The work of the Basel Committee on Banking
Supervision is on the site of its host, the Bank for
International Settlements, at
www.bis.org/bcbs/index.htm. Further news of
Basel and other regulatory policy initiatives is
provided by the Institute of International Finance
(a global association of financial institutions) are
at www.iif.com/ifr/index.quagga. Regulation is
among the themes of the collection of proliberalisation articles on the Knowledge Navigator
database of the multinational-supported World
Economic Forum www.weforum.org.
There are links to Africa’s online central banks
and economic reports from around the continent
at www.newafrica.com/economy/centralbanks.asp.
Links to Asia’s central banks are at www.businessline.com/cebanks/asia/asia.htm. The Microfinance
Gateway of the Consultative Group to Assist the
Poorest nt1.ids.ac.uk/cgap/index.htm is a huge
source of information on all aspects of managing
and supervising microfinance institutions. The
Asian Development Bank reviews the role of
central banks in microfinance regulation at
www.adb.org/Microfinance/default.asp. The DFIDfunded Finance and Development Research
Programme website is at:
www.devinit.org/findev/index.
Among sites questioning, or campaigning
against, the neo-liberal consensus are the Bretton
Woods Project www.brettonwoodsproject.
org/topic/financial, the Bangkok-based Focus on
the Global South www.focusweb.org and the
Malaysian-based Third World Network
www.twnside.org.sg. Both the Public Services
International Research Unit (PSIRU) www.psiru.org
and its partner, Public Services International
www.world-psi.org critically examine privatisation
and deregulation initiatives. Public Eye on Davos
www.publiceyeondavos.ch monitors the World
Economic Forum. The finance section of OneWorld
is at www.oneworld.net/themes/
topic/topic_122_1.shtml.
E
M
● SITES FO
R
Tim Morris
Refugee Studies Centre, University of Oxford
Fmr@qeh.ox.ac.uk
Coming in issue 41
The perfect pension?
Getting pensions right
in an ageing world