Policy uncertainty, information asymmetries, and financial intermediation

Financial reform is often accompanied by other changes, including structural adjustment. Entrepreneurs'judgements about investing in a post-reform world are important but so are banks'considerations of the sunk costs of investments in both physical capital and information development. The accepted wisdom is that financial reform should not precede"real"sector adjustment, or banks will get into trouble by lending at disequilibrium prices. But postponing all financial reform until structural adjustment is complete is equally dangerous : unless the financial sector is prepared, investors will not have enough capital to invest, even given credible programs. The best candidates for reform - in both real and financial sectors - are countries with more diversified banking systems. These are more likely in well-diversified economies, with no recent history of severe financial repression. Countries that have had open capital markets will be better off since they do not have pent-up demand for such assets. Well capitalized banking systems will tend to fare better under reform, even though ample financial capital may not lead banks to lend aggressively in the face of greater uncertainty. Clear signals from reforming governments on where policies are headed will help both entrepreneurs and their financiers. Without these signals, banks will not be sure where to concentrate their investment in gathering information, and periods of loan retrenchment are likely to be prolonged.