Main Messages of This Report
The report’s overall message is cautionary. The global financial crisis has given greater credence to the idea that active state involvement in the financial sector can help maintain economic stability, drive growth, and create jobs. There is evidence that some interventions may have had an impact, at least in the short run. But there is also evidence on potential longerterm negative effects. The evidence also suggests that, as the crisis subsides, there may be a need to adjust the role of the state from direct interventions to less direct involvement. This does not mean that the state should withdraw from overseeing finance. To the contrary, the state has a very important role, especially in providing supervision, ensuring healthy competition, and strengthening financial infrastructure.
Incentives are crucial in the financial sector. The main challenge of financial sector policies is to better align private incentives with public interest without taxing or subsidizing private risk-taking. Design of public policy needs to strike the right balance—promoting development, yet in a sustainable way. This approach leads to challenges and trade-offs.
In regulation and supervision, one of the crisis lessons is the importance of getting the “basics” right first. That means solid and transparent institutional frameworks to promote financial stability. Specifically, it means strong, timely, and anticipatory supervisory action, complemented with market discipline. In many developing economies, that combination of basic ingredients implies a priority on building up supervisory capacity. Here, less can mean more: less complex regulations, for instance, can mean more effective enforcement by supervisors and better monitoring by stakeholders.
The evidence also suggests that the state needs to encourage contestability through healthy entry of well-capitalized institutions and timely exit of insolvent ones. The crisis fueled criticisms of “too much competition” in the financial sector, leading to instability. However, research presented in this report suggests that, for the most part, factors such as poor regulatory environment and distorted risk-taking incentives promote instability, rather than competition itself. With good regulation and supervision, bank competition can help improve efficiency and enhance access to financial services, without necessarily undermining systemic stability. Rather than restricting competition, it is necessary to address distorted competition, improve the flow of information, and strengthen the contractual environment.
Lending by state-owned banks can play a positive role in stabilizing aggregate credit in a downturn, but it also can lead to resource misallocation and deterioration of the quality of intermediation. The report presents some evidence that lending by state-owned banks tends to be less procyclical and that some state-owned banks even played a countercyclical role during the global financial crisis. However, the track record of state banks in credit allocation remains generally unimpressive, undermining the benefits of using state banks as a countercyclical tool. Policy makers can limit the inefficiencies associated with state bank credit by paying special attention to the governance of these institutions and schemes and ensuring that adequate risk management processes are in place. However, this oversight is challenging, particularly in weak institutional environments.
Experience points to a useful role for the state in promoting transparency of information and reducing counterparty risk. For example, the state can facilitate the inclusion of a broader set of lenders in credit reporting systems and promote the provision of highquality credit information, particularly when there are significant monopoly rents that discourage information sharing. Also, to reduce the risk of freeze-ups in interbank markets, the state can create the conditions for the evolution of markets in collateralized liabilities.