Financial sector adjustment lending : a mid-course analysis

Nearly 100 countries have experienced bank insolvencies in the past 20 years. Weakness in the financial sectors of many countries is reflected in the size of the insolvencies -in many cases, the cost of bailout exceeded 15 percent of GDP- and the fact that these crises often recur. Because a strong financial sector is important for economic growth, the World Bank has increasingly granted loans with conditions attached to achieve specific financial sector reforms. The Bank often employs financial sector adjustment loans (FSALs) or, in poorer countries, credits (FSACs). FSALs are generally more comprehensive than other types of interventions and tend to concentrate on the reform areas most closely linked to the operations of deposit banks. Since 1990, their main focus has shifted from improving prudential regulations and correcting interest rate distortions to privatizing and recapitalizing banks. The author examines whether 1) initial conditions in a recipient country explain a substantial amount of the variation in intervention outcomes (as measured by post-intervention financial deepening) and 2) whether the changing nature of interventions has had implications for their success. He finds that: 1) the decline in post-intervention performance since 1990 cannot be attributed solely toinitial macroeconomic and financial sector conditions in the recipient country. 2) When initial macroeconomic and financial sector conditions were controlled for, certain types of reform, especially those dealing with prudential regulations, were associated with relatively large increases in the ration of money supply (M2) to GDP. Those dealing with recapitalization have also been relatively successful, especially when they also tackled prudential regulation or banking supervision. Those that focused on supervision did not, on average, substantially outperform those that did not, on average, focus on supervision. And reform focused on bank privatization was associated with much less financial deepening three years after the intervention. 3) In addition to reform aimed at institutional strengthening, the reform environment itself had a substantial impact on intervention outcomes. Financial deepening was positively associated with macroeconomic stability (low inflation) and an initially underdeveloped financial sector. 4) As the Bank's operational directives suggest, some macroeconomic stability is important for the success of financial sector interventions, especialy those that incorporate interest rate liberalization. While it may be best to move more aggressively on financial reform when macroeconomic circumstances are favorable,"visible"reform (such as privatization or interest rate deregulation) should be slowed down rather than abandoned in less fortunate circumstances. By contrast, less visible institution-building efforts should be continued regardless of macroeconomic conditions.