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Finance and its reform : beyond laissez-faire


  • Caprio, Gerard Jr.
  • Summers, Lawrence H.


That the financial sector should be liberalized was the orthodox view in the mid-1970s, during a pendulum swing toward reliance on the free market. In the early 1980s, the pendulum swung back to the left, based partly on evidence - especially from Latin America - that overly rapid reform had real costs, and partly on an increased appreciation of financial market failure. Blind adherence to free market principles was no longer appropriate. Now a counter-counterrevolution is in sight, with some swing back toward the view that the market makes a mess of it, but the government makes it even worse. The authors agree that market-oriented financial systems appear to do a better job than systems with extensive government involvement, but contend that the assumption that perfect competition will solve all problems in finance - especially in banking - can be dangerous. Information problems, implicit or explicit government guarantees associated with the payments system make banks unique. Governments implicitly recognize banking's uniqueness - few allow just anyone to enter banking - but public pronouncements and observers'recommendations often favor a move to more competition. Perfect competition, however, is optimal under the assumption, among others, of no government guarantee. In fact, most governments differ only in how explicit they are about their deposit insurance schemes. The financial reforms most likely to succeed are those that give banks an incentive to engage in safe and sound banking. When excessive competition is allowed, the charter value of banking diminishes to the point that it is no longer profitable for bankers to behave prudently. A consideration of finance's role, and a look at how reforming economies have fared, suggest also that gradual reform is often to be preferred in this domain. Deregulation of credit markets and interest rates can be counterproductive in unstable macroeconomic conditions and when banks are unsophisticated or have weak balance sheets. And changes in the charter value may evolve only slowly after reform. Faster progress and greater efforts should be made, however, in bank supervision and regulation and in institutional development, including accounting, auditing, legal and judicial reform, and training (of bankers and other finance professionals). In sum, many economies would benefit from less government intervention in financial markets, but the prescription should not be abrupt or total government withdrawal from the financial sector. Rather than intervening heavily in credit allocation decisions, governments should focus on doing what only they can do: providing an enabling environment for the private financial and nonfinancial sectors, and ensuring that financial operations are safe and sound.

Suggested Citation

  • Caprio, Gerard Jr. & Summers, Lawrence H., 1993. "Finance and its reform : beyond laissez-faire," Policy Research Working Paper Series 1171, The World Bank.
  • Handle: RePEc:wbk:wbrwps:1171

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    References listed on IDEAS

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    Cited by:

    1. Alba, Pedro & Hernandez, Leonardo & Klingebiel, Daniela, 1999. "Financial liberalization and the capital account : Thailand, 1988-97," Policy Research Working Paper Series 2188, The World Bank.
    2. Wyplosz, Charles, 1999. "Financial Restraints and Liberalization in Postwar Europe," CEPR Discussion Papers 2253, C.E.P.R. Discussion Papers.
    3. David T. Llewellyn, 2002. "An analysis of the causes of recent banking crises," The European Journal of Finance, Taylor & Francis Journals, vol. 8(2), pages 152-175, June.
    4. Stijn Claessens, 1998. "Banking reform in transition countries," Journal of Economic Policy Reform, Taylor & Francis Journals, vol. 2(2), pages 115-133.
    5. Ghosh, Saibal & Saggar, Mridul, 1998. "Narrow Banking: Theory, evidence and prospects in India," MPRA Paper 17352, University Library of Munich, Germany.
    6. Vittorio Corbo, 1997. "Financial Integration in Latin America," Research Department Publications 4096, Inter-American Development Bank, Research Department.
    7. Aka, Brou E., 2006. "On the duration of the financial system stability under liberalization," Emerging Markets Review, Elsevier, vol. 7(2), pages 147-161, June.
    8. Vittorio Corbo, 1997. "Integración financiera en América Latina," Research Department Publications 4097, Inter-American Development Bank, Research Department.
    9. Kenny, Charles J. & Moss, Todd J., 1998. "Stock markets in Africa: Emerging lions or white elephants?," World Development, Elsevier, vol. 26(5), pages 829-843, May.
    10. Impavido, Gregorio & Musalem, Alberto R. & Tressel, Thierry, 2001. "Contractual savings institutions and banks'stability and efficiency," Policy Research Working Paper Series 2751, The World Bank.
    11. Clarke, George R. G. & Cull, Robert & D'Amato, Laura & Molinari, Andrea, 1999. "The effect of foreign entry on Argentina's domestic banking sector," Policy Research Working Paper Series 2158, The World Bank.
    12. Mekki Hamdaoui & Abir Zouari & Samir Maktouf, 2016. "The effect of financial liberalization on banking sector stability," International Review of Applied Economics, Taylor & Francis Journals, vol. 30(5), pages 644-667, September.
    13. Yotopoulos, Pan A., 1997. "Financial Crises and the Benefits of Mildly Repressed Exchange Rates," SSE/EFI Working Paper Series in Economics and Finance 202, Stockholm School of Economics.
    14. Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, vol. 90(1), pages 147-165, March.
    15. Duran, Miguel A. & Lozano-Vivas, Ana, 2015. "Moral hazard and the financial structure of banks," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 34(C), pages 28-40.
    16. Demirguc-Kent, Asli & Detragiache, Enrica, 1998. "Financial liberalization and financial fragility," Policy Research Working Paper Series 1917, The World Bank.
    17. Vittorio Corbo, 1997. "Integración Financiera en América Latina," IDB Publications (Working Papers) 2129, Inter-American Development Bank.
    18. repec:eee:finsta:v:37:y:2018:i:c:p:60-73 is not listed on IDEAS
    19. repec:dau:papers:123456789/5962 is not listed on IDEAS
    20. Pleskovic, Boris, 1994. "Financial policies in socialist countries in transition," Policy Research Working Paper Series 1242, The World Bank.


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