Measures Taken by International Organizations in Establishing a Sound Banking System Samir El Daher World Bank July 2, 2005

2 On the Importance of the Banking Sector l Financial institution as a critical Intermediary. The relevance of both sides of the balance sheet l Outlet for national savings »Critical role of confidence (transparency, skills) l Main source for credit l Essential role in every day’s life transactions: payments, transfers, custody

3 Basic Tenets of a Resilient Banking System l Reliable legal and judicial environment l Effective regulatory and supervisory framework l Good corporate governance l Information and disclosure standards l Risk management: Identifying, assessing and pricing risk

4 Building a Reliable Legal and Judicial Environment l Improvement of framework for secured transactions l Enforcement of creditors’ rights l Effective laws on firm entry and exit (bankruptcy) l Development and updating of collateral and property registries

5 Effective Regulatory and Supervisory Framework l Credibility of a strong and independent regulator is the anchor of a sound banking system »Regulations: rules of the game »Supervision: the way rules are enforced l Licensing subject to “fit and proper” standards for shareholders and managers l Prudential oversight and norms applied with no regulatory forbearance, especially regarding capital, assets quality and provisioning, and risk controls l Emerging new private banks  need for effective regulation and supervision

6 Good Corporate Governance l Transparent business transactions l Qualified and experienced board members exercising effective oversight l Good and responsive public administration l Reliable internal controls

7 Information and Disclosure Standards l Accounting (international standards (IAS)) l Audit l Reliable quality of financial information from corporate sector needed for risk management and market development l Good credit information systems

8 Issue of Financial Repression l Need for interest rate liberalization »Implication inter-alia on mobilization of savings l Issue of subsidized credit »Implication inter-alia on bank intermediation margins l Forced or directed credit allocation »Economic distortion »Supporting unsustainable activities

9 Promoting Financial Depth l Level of financial intermediation (ratio of deposits & bank credit to GDP) l Value of banking assets per capita l Diversity of financial instruments (bank credit, debt securities, equities) promote depth, competition, and innovation »Stock market turnover, bond capitalization

10 Widening Access to Finance and Improving the Payment System l Improving access to, and quality and cost of banking services l Moving from collateral to cash flow-based lending l Meeting financial needs of SMEs, and developing micro-finance instruments l Developing markets and instruments for housing, rural, infrastructure and municipal finance l Building modern and secure payment mechanisms for small, and large, systemically important settlements

11 Dealing with Weak and Problem Banks (1) l No preferential treatment or protection for state and other large or specialized banks l Undue protection of weak banks can: »Add sizably to macroeconomic costs (inter-alia through repeated recapitalizations) »Represent a tax on growth »Distort competition and market signals »Undermine deposits safety and weaken financial sector stability

12 Dealing with Weak and Problem Banks (2) l Taking control of a problem bank l Imposing a moratorium l Restructuring bank liabilities l Transferring deposits and assets l Practice of recapitalization without reforms  recurrent crises l Where there are no apparent public bank failures, there could be hidden, and large fiscal costs

13 Role of Government in Financial Sector (1) l Regulator and supervisor l Lender of last resort l Guarantor of financial market integrity l Deposit Insurance l Crisis manager

14 Role of Government in Financial Sector (2) l Should government play same role in global, open markets l Trans-border financial markets l Provision of full financial services l Credit allocation l Equity investor

15 Public Ownership of Financial Institutions l Public ownership of financial institutions has been declining in both industrialized & emerging markets l Declining trend evident since 1970 l Yet public ownership still widespread

16 Arguments for Public Bank Ownership l Better allocation of capital by the State l Private ownership may concentrate credit in a few hands l Private banks reportedly more prone to crises

17 Arguments against Public Ownership l Political influence not congruent with efficient credit allocation (high NPLs level) l Directed and subsidized credit l Conflict of interest in government being: »Owner/operator and »Regulator/supervisor/lender of last resort l Poor record of state as bank owner

18 Change in Bank Ownership l Limiting state ownership may be easier to do than implementing the range of institutional and political reforms needed to avoid inefficiencies of state banking l Shifting from state to private ownership in a weak regulatory environment can raise difficult issues

19 Transition Countries Experience with the Pace of Reforms l Where state remained involved in banking sector  Fiscal bailouts, higher interest rates l Restriction on lending to real sector was often the response to poor creditworthiness of enterprises l Countries went through at least one banking crisis in the 90’s l Difficulty in re-building public confidence after crisis

20 Transition Countries Experience with the Pace of Reforms l Early drive to sector liberalization led to »Important private (including foreign) participation in banking sector » Higher level of bank credit/GDP l Central banks were more successful in reducing inflation and stabilizing currency l Good legal, regulatory and prudential framework for banking, capital market and insurance largely compatible with EU directives

21 Link between Banking and Real Sectors (1) l Efforts to ensure financial discipline and proper bank management need to be matched in real sector l Banking has a centralized regulatory authority with capital adequacy & liquidity and reporting requirements l No comparable discipline, transparent accounts exist in real sector companies unless exchange-listed or seeking credit

22 Link between Banking and Real Sectors (2) l Banks would remain fragile unless: »Market-based discipline is present in real enterprises (no culture of default) »Bank management, independent and focused on asset quality –Shy away from illiquid, non-earning assets –Active in loan recovery (poor asset quality results in high intermediation spreads) »Legal framework provides protection for secured transactions

23 Deposit Insurance l Relation of deposit insurance to financial sector development: an on-going debate l Moral hazard l Could absence of explicit coverage mean unlimited, implicit coverage l Insurance involving limited liability may facilitate risk-taking

24 World Bank-IMF Financial Sector Assessment Program l Main features of the FSAP program »Systemic risk »Financial sector development l Joint participation of World Bank, IMF and national regulatory authorities l Large number of industrialized and emerging countries already participated

25 Some Conclusions (1) l Changes in ownership, institutional, legal & regulatory framework require due care l Incomplete measures may not be conducive to development and growth »For example, liberalization of capital markets/flows non congruent with maintaining fixed interest rates

26 Some Conclusions (2) l Changes ought to be grounded in solid “governance” – legal, institutional as regulatory – structure l In some countries, ill-planned changes may have led to asset stripping rather than wealth creation l Option for strategic over mass privatization of financial institutions

27 Some Conclusions (3) l Sector liberalization and reforms have been shown to provide more likely basis for: l Development of open and competitive banking sector and services, with reduction in spreads and extension in maturities l Decline in government share in total credit demand with a rise in private enterprise and household share l More resilient real sector and improved prospects for long-term growth

28 Some Conclusions (4) l Economic development and growth are highly dependent upon effective national financial systems l Financial policy making is a key development issue and a main challenge l Financial system works quietly in the background l Growth and stability of national economies are best served by ensuring access to most efficient and reputable financial service providers