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Strengthening Financial Systems in Developing Countries

Profile image of Stijn ClaessensStijn Claessens

2012

https://doi.org/10.1596/27109
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59 pages

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Abstract

Whenever commerce is introduced into any country, probity and punctuality always accompany it. .. . A dealer is afraid of losing his character, and is scrupulous in observing every engagement. Adam Smith n international cooperative effort has been focused on the need to reduce financial fragility and systemic risks in global financial markets. Work is proceeding in three different areas: enhancing financial market transparency, improving the international financial architecture, and strengthening financial systems. Strengthening financial systems (the focus of this paper) means cooperating to promote principles and sound practices for financial stability through development of well-functioning financial systems and market discipline. Financial sector reform and development is much more than setting rules, articulating standards, approving legislation, and creating new institutions. All are important but ultimately behavior must be changed if there is to be meaningful and lasting financial reform. For that reason, this paper emphasizes the role of incentives to induce appropriate behavior. Given all that needs to be done, financial sector development will take a long time. The fact that the process will take years, probably decades, to complete should not reduce the sense of urgency. It means, rather, that we should not have unrealistic expectations and that we must be patient. Empirical research suggests that the effect of financial sector development on economic growth is significant. Banks are one but not the only important part of a healthy financial system. Markets for bonds and equities, too, have an independent effect on growth. But banking and capital markets seem to complement each other throughout most stages of development.

Key takeaways
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  1. Incentive-based financial sector reforms enhance stability in developing economies by aligning private interests with public goals.
  2. The World Bank emphasizes long-term strategies for financial systems reform, acknowledging the need for patience and realistic expectations.
  3. Effective financial systems require strong regulatory frameworks and improved transparency to mitigate systemic risks.
  4. Banks and capital markets must work in tandem, as both play critical roles in economic growth and development.
  5. Informal financial sectors can complement formal systems by enhancing access to credit and promoting responsible behavior among borrowers.

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FAQs

sparkles

AI

What explains the significance of incentive-based financial sector reforms in developing economies?add

The research finds that incentive-based reforms can significantly induce self-policing among market participants, enhancing financial stability and efficiency in resource allocation. For example, these mechanisms are critical due to resource scarcity and the need for improved conduct in markets with poor information.

How did Chile improve its banking regulation post-crisis in the 1980s?add

Chile's reforms included mandatory private auditing of banks, aggressive market-value accounting, and introducing partial deposit insurance to promote prudent behavior. Such measures successfully aligned private incentives with regulatory requirements, leading to a more resilient banking sector.

What role does market information play in enhancing financial stability?add

The findings indicate that better information flow significantly stabilizes financial systems by allowing market participants to assess risks accurately and impose discipline on institutions. Instances from Argentina show depositors did monitor banks' performance based on available credit risk information.

Why is cooperation between government and private sectors essential for financial reform?add

The study reveals that effective financial reform is intricately linked to the collaboration between governments and private entities to ensure regulations are conducive to market functioning. Initiatives like the New Zealand and Argentina models exemplify how cooperative frameworks enhance market performance.

In what ways can self-regulating organizations strengthen financial markets?add

Self-regulating organizations can enhance market discipline by enabling members to monitor each other's behavior, thereby fostering a culture of compliance and reputational integrity. Historical practices in trade reveal this mechanism's effectiveness, demonstrating improved compliance and reduced transaction costs.

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