From Finding Facts to Creating Policies

Once the data gathering and analysis have been conducted (as outlined in sections 4.2 through 4.6), policies and reforms must be identified and prioritized. The task of policy formulation consists of distilling those findings into an overview of the principal strategic issues and development gaps—specifically in terms of the functions that finance is sup­posed to perform—and of opportunities. The reforms needed to enhance development of the financial system typically fall under the headings of (a) infrastructural strengthening,

(b) policy corrections to reduce unintended side effects of regulatory or tax policies, or

(c) governance reform. Those reforms must be prioritized and synthesized.

A medium-term vision for where the financial sector should be going helps to focus the recommendations and to avoid being distracted by the immediate political impera­tives and obstacles that often make progress seem impossible. Because the quantity, term, and price of credit and other financial services are crucial and will generally depend on the efficiency and competitiveness of the sector and on the cost structure facing market participants (including the cost of taxation and regulation), these elements should be among the major dimensions considered in such a vision. Thus, the vision could include an indication of likely ownership patterns: what share to be owned by government and by foreign concerns, how much competition in banking and insurance, what change in the scope of activities allowed to banks, and what degree of subsectoral specialization. The vision could also address the likely growth in the assets of insurance, pension, and contractual savings and how they are likely to be allocated among domestic and foreign equities, bonds, and bank deposits. The institutional prospects for the securities markets, including the potential for collaboration or integration with securities markets abroad, will also be relevant.

image009Institution building to enhance the soft infrastructure tends to be the least contentious area, though the reforms are not always easy to accomplish in practice. In particular, the infrastructure for payments transactions can usually be strengthened with noncontrover­sial legislation and with the introduction of cost-effective technology. Credit information and accounting improvements may take longer and may demand the formation of more sustained human capital. Some legal reforms to enhance creditor rights (such as those needed to underpin a leasing industry) are also straightforward, but effective reforms in such areas as bankruptcy and enforcement of collateral tend to be more controversial and difficult to bring into effect.

Shortcomings in regulatory and tax policy design often represent a judgment call relat­ing to some tradeoff (perhaps involving stability against efficiency) and, as such, require careful analysis to arrive at an acceptable compromise. Even then, special interests may have congregated around the regulations (for example, entry restrictions) that hamper reform. Nevertheless, the removal of regulatory and tax barriers to competitive provision of needed financial services is a crucial component of most financial sector development strategies. In some countries, the special interests of incumbent financial service provid­ers (including the employees of government-owned financial agencies) have become entrenched through disproportionate representation in regulatory bodies or even in the legislature. If so, implementation of reforms is likely to be blocked indefinitely. Wider constitutional reforms, such as establishing or strengthening independence of the regula­tors from such special interests, may be a prerequisite for achieving deep reform of finance and—through that achievement—enhanced growth and poverty reduction. Yet such recommendations are, of course, the most difficult to sell.

Having identified the infrastructural weaknesses and policy flaws, assessors should formulate a clear prioritization and justification of recommendations addressed to senior policy makers and top politicians. The reform program is likely to entail short-term politi­cal costs, as well as fiscal outlays, and the program needs to be justifiable in terms of a simple and compelling rationale. In contrast to the stability assessment, where the con­sensus behind the core principles may be sufficient justification for some policy reforms, the more debatable nature of the development assessment, as well as the often more
far-reaching nature of the reforms, calls for reliance on careful justification of policy pro­posals. For example, if what is needed is greater independence of the regulatory authority or greater liberalization of interest rate spreads, elimination of compulsory reinsurance cessions, commercialization and privatization of the major banks, or liberalization of entry by foreign financial service providers, then this need must be embedded in terms of the vision of the future financial system and of the desired potential benefits.

image010Reforms will take time, and policy makers need to know what the priorities are—both what is more important and whether specific sequencing is required. Sequencing and coordination of different measures are important to ensure a robust transition path. For example, early liberalization of deposit rates may not be appropriate in a system still dominated by poorly managed state-owned banks whose insiders’ apparent goal is market share rather than sustained profit. Similarly in a system with large nonperforming loans and significant corporate financial fragility, some initial bank and corporate restructur­ing and some strengthening of prudential supervision may be needed before substantive liberalization of interest rates and entry. Thus, the scope and priorities of policy measures would depend both on the state of development of the financial sector and on the initial level of financial stability.

Against this background, rather than (or in addition to) presenting a comprehensive list of reforms, it is suggested that four or five themes may be identified in order of their importance, and the major thrusts of reform under each theme may be explained and pri­oritized. The particular conditions in each country would determine what those themes should be. No template is offered here nor should one be. Some of the themes might cut across sectors. For example, it could be a needed strengthening of political independence of regulatory authorities in several subsectors, or it could be a lack of competition and contestability reflecting inappropriate regulation in several sectors, or it could be the need for a root-and-branch reform of the tax code. Identifying the fact that such problems crop up in several sectors will help decision makers who are concerned with each sector realize the common position that they are in and may help point to the potential for organi­zational or legislative approaches that may not seem feasible to those in charge of any one sector. Other themes may be sector specific, such as either inadequate enforcement of stock exchange rules on transparency or a chaotically dysfunctional credit registry. Even if a similar problem exists to a lesser extent in other sectors, pointing the finger at a particularly damaging weakness can help ensure that top policy makers will allocate the financial and political resources necessary to fix it. The design and prioritization of broad themes and specific measures under each theme should help support financial and mac­roeconomic stability and should facilitate effective implementation. The principles and considerations in sequencing of reforms are more fully explained in chapter 12.

Notes [3]

damage the interests of local financial firms. Because of their specialist knowledge, incumbent providers are often in a strong position to resist policy changes that, though good for growth and overall financial development in the economy generally, may damage their sectoral interest. For a detailed and instructive account of how bank­ruptcy professionals, judges, and lawyers systematically blocked bankruptcy reform in the United States throughout the twentieth century, see Skeel (2003).

2. image009For the importance of the functional approach as opposed to the institutional approach, see Beck and Levine (2002) and Levine (1997).

3. Beck, Demirgug-Kunt, and Levine (2000) provide a set of benchmark indicators for different parts of the financial system. Research is ongoing to enrich the cross-country data, notably on access.

4. For example, Demirgug-Kunt, Laeven, and Levine (2003) find a significant role for bank-level variables (such as bank size, equity and liquidity ratios, and fee income), together with national-level variables (such as bank concentration, inflation, GDP per capita, quality of governmental institutions that are based on governance indicators compiled by World Bank), property rights, and restrictiveness of bank conduct and entry regulations).

5. Regulation and supervision are also part of the infrastructure review, here covered in the information-gathering phase on a sector-by-sector basis.

6. Chapter 9 contains a discussion of the scope of the insolvency and creditor rights standards.

7. Chapter 10 contains a discussion of the scope of corporate governance standards.

8. Jappelli and Pagano (2002) present an early study on the positive relationship between the availability of debtor information through credit registries and financial develop­ment. Miller (2003) is a collection of papers on different aspects of the issue. Levine, Loayza, and Beck (2000) discuss the importance of accounting standards for financial intermediary development. The Center for International Financial Analysis and Research Inc. provides data for 44 countries on accounting standards.

9. Honohan (2004b) describes of a wide range of data sources, including recent efforts to increase systematic coverage of financial issues in surveys. For example, the World Bank-led Enterprise Surveys have already covered approximately 50 countries since 2002 and are being rolled out at the rate of about 20 countries per year. The World Bank has also surveyed bank regulators in approximately 70 countries about overall access indicators—such as number of branches and ATMs, average loan and deposit size—and provider banks in approximately 60 countries about product and process technology.

10. The Basel Core Principles (BCPs) for Effective Banking Supervision state that “bank­ing supervision is only part of wider arrangements that are needed to promote stability in financial markets” (see chapter 5). Those prerequisites are spelled out in the BCP source document, and they include much of what is needed for efficiency and reach, as well as stability. If a BCP assessment is being conducted in parallel, the assessors will also be gathering information relevant to the sectoral development assessment on banking. For an overview of relation between standards assessments and sectoral reviews, see box 4.5.

11. For recent cross-country studies on interest rate margins, see Demirgug-Kunt and Huizinga (1999) and Demirgug-Kunt, Laeven, and Levine (2004).

12. The interest spread studies by the Brazilian Central Bank (http://www. bcb. gov. br/) are a good example.

13. image010The Microfinance Consensus Guidelines by the Consultative Group to Assist the Poorest (CGAP) (Christen, Lyman, and Rosenberg 2003) provides a useful framework defining good practice for the MFI subsector.

14. International Association of Insurance Supervisors (IAIS)’s Core Principles also address aspects of development issues in Insurance. See box 4.4.

15. Even a listing of broad lines of business would include categories such as auto; employ­er’s liability, product liability, and medical malpractice; marine (including other transport); commercial fire and theft; machinery; flood and other weather-related occurrences such as earthquake, etc.; mortgage protection, export credit, and other credit-related items; homeowners; health and disability; and life and annuity.

16. For example, overly generous tax incentives for life insurance can result in what are little more than tax-avoidance schemes dressed up as insurance policies. Or, onerous regulation of the investment of insurance or pension funds can result in too much being placed in short-term bank deposits, effectively resulting in reverse maturity transformation for the system as a whole. Again, unduly favorable differential tax and regulatory treatment of managed funds can result in a large fraction of investable funds being diverted into inadequately regulated fund management concerns that are sometimes associated with self-dealing.

17. For a discussion of these restrictions and how development and prudential consider­ations may be balanced, see Vittas (1998). A draft code for the regulation of private occupational pension schemes has been prepared for the Organisation for Economic Co-operation and Development (OECD) (OECD 2003).

18. Indeed, weaknesses in the government’s institutional and strategic arrangements for debt management may be the focus of a special side study, for example, using the guidelines recently developed by the IMF and World Bank (2001).

19. Except to the extent that the financial condition of the corporate, household, govern­ment, and external sectors has been examined with a view to forming an opinion on the quality of the banks’ loan portfolio. See chapters 2 and 3 on the use and analysis of balance sheet-financial soundness indicators of those sectors.


Barth, James, Gerard Caprio, and Ross Levine. 2004. “Bank Supervision and Regulation: What Works Best?” Journal of Financial Intermediation 13(2): 205-48.

Beck, Thorsten, Asli Demirgug-Kunt, and Ross Levine. 2000. “A New Database on the Structure and Development of the Financial Sector.” World Bank Economic Review 14: 597-605.

— . 2003. “Law, Endowments, and Finance.” Journal of Financial Economics 70(2):


Beck, Thorsten, and Michael Fuchs. 2004. “Structural Issues in the Kenyan Financial System: Improving Competition and Access.” World Bank Policy Research Working Paper 3363, World Bank, Washington, DC.

Beck, Thorsten, and Ross Levine. 2002. “Industry Growth and Capital Allocation: Does Having a Market – or Bank-Based System Matter?” Journal of Financial Economics 64: 147-80.

image009Beck, Thorsten, Ross Levine, and Norman Loayza. 2000. “Finance and the Sources of Growth.” Journal of Financial Economics 58: 261-300.

Bossone, Biagio, Patrick Honohan, and Millard Long. 2002. “Policy for Small Financial Systems.” In Financial Sector Policy for Developing Countries—A Reader, eds. G. Caprio, P. Honohan, and D. Vittas, 95-128. New York: Oxford University Press. See also “Policy for Small Financial Systems,” Financial Sector Discussion Paper No. 6. Washington, DC: World Bank, 1991. Available at http://wbln0018.worldbank. org/ html/FinancialSectorWeb. nsf/(attachmentweb)/Fs06/$FILE/Fs06.pdf.

Christen, Robert Peck, Timothy R. Lyman, and Richard Rosenberg. 2003. Microfinance Consensus Guidelines. Consultative Group to Assist the Poorest: Washington, DC.

Claessens, Stijn, and Luc Laeven. 2003. “What Drives Bank Competition? Some International Evidence.” World Bank Policy Research Working Papers No. 3113.

Demirgug-Kunt, Asli, and Harry Huizinga. 1999. “Determinants of Commercial Bank Interest Margins and Profitability: Some International Evidence.” World Bank Economic Review 13: 379-408.

Demirgug-Kunt, Asli, Luc Laeven, and Ross Levine. 2004. “The Impact of Bank Regulations, Concentration, and Institutions on Bank Margins.” Journal of Money, Banking, and Credit 36, (3 Part 2): 593-622.

Doing Business Database. World Bank. Available at http://rru. worldbank. org/ DoingBusiness/.

Fazzari, Steven, Glenn Hubbard, and Bruce Petersen. 1988. “Financing Constraints and Corporate Investment.” Brookings Papers on Economic Activity 1: 141-95.

FSF (Financial Stability Forum). “Compendium of Standards.” Financial Stability Forum. Available at http://www. fsforum. org/compendium/about. html.

Honohan, Patrick, ed. 2003. “Avoiding the Pitfalls in Taxing Financial Intermediation.” In Taxation of Financial Intermediation: Theory and Practice for Emerging Economies, pp, 1-30. New York: Oxford University Press.

—- . 2004a. “Financial Development, Growth, and Poverty: How Close Are the Links?”

World Bank Policy Research Working Paper 3203, World Bank, Washington, DC. Available at http://econ. worldbank. org/files/32898_wps3203.pdf. See also Honohan, Patrick. 2004. “Financial Development, Growth, and Poverty: How Close Are the Links?” 2004. In Financial Development and Economic Growth: Explaining the Links, ed. Charles Goodhard. London: Palgrave.

—- . 2004b. “Measuring Microfinance Access: Building on Existing Cross-Country

Data.” Prepared for the United Nations Development Programme, World Bank, and International Monetary Fund Workshop, “Data on the Access of Poor and Low – Income People to Financial Services,” Washington, DC, October 26.

IMF (International Monetary Fund) and World Bank. 2001. Guidelines for Public Debt Management. Washington, DC: International Monetary Fund and World Bank. Available at http://www. imf. org/external/np/mae/pdebt/2000/eng/index. htm.

—- . 2003. “Development Issues in the FSAP.” International Monetary Fund and

World Bank. Washington, DC. Available at http://www. imf. org/external/np/fsap/2003/ 022303b. htm.

Impavido, Gregorio, Alberto Musalem, and Dimitri Vittas. 2003. “Promoting Pension Funds.” in Globalization and National Financial Systems, eds. James A. Hanson, Patrick Honohan, and Giovanni Majnoni. New York: Oxford University Press.

image010___ “Contractual Savings in Countries with a Small Financial Sector.” 2002.

World Bank Policy Research Working Paper Series, No. 2841.

La Porta, Rafael, Florencio Lopez-de-Silanes, and Andrei Shleifer. 2002. “Government Ownership of Commercial Banks.” Journal of Finance 57: 265-301.

La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny. 1997. “Legal Determinants of External Finance.” Journal of Finance 52: 1131-50.

—- . 1998. “Law and Finance.” Journal of Political Economy 106: 1113-55.

Levine, Ross. 1997. “Financial Development and Economic Growth: Views and Agenda.” Journal of Economic Literature 35: 688-726.

Levine, Ross, Norman Loayza, and Thorsten Beck. 2000. “Financial Intermediation and Growth: Causality and Causes.” Journal of Monetary Economics 46: 31-77.

Jaffee, Dwight M., and Betrand Renaud. 1996. “Strategies to Develop Mortgage Markets in Transition Economies.” World Bank Policy Research Working Paper 1697. Washington, DC.

Jappelli, Tullio, and Marco Pagano. 2002. “Information Sharing, Lending, and Defaults: Cross-Country Evidence.” Journal of Banking and Finance 26: 2017-45.

Miller, Margaret, ed. 2003. Credit Reporting Systems and the International Economy. Cambridge, MA: MIT Press.

OECD (Organisation for Economic Co-operation and Development). 2002. Insurance and Private Pensions Compendium for Emerging Economies. Paris: Organisation for Economic Co-operation and Development.

— . 2003. Occupational Pensions Core Principles and Methodology. Paris: Organisation

for Economic Co-operation and Development.

Skeel. David A. Jr. 2003. Debt’s Dominion: A History of Bankruptcy in America. Princeton, New Jersey: Princeton University Press.

Vittas, Dimitri. 1998. “Regulatory Controversies of Private Pension Funds.” World Bank Policy Research Working Paper 1893, World Bank, Washington, DC.

World Bank. 2001a. Finance for Growth: Policy Choices in a Volatile World. New York: Oxford University Press.

— . 2001b. Principles and Guidelines for Effective Insolvency and Creditor Rights Systems.

Washington, DC: World Bank.

—- . 2001c. Developing Government Bond Markets. Washington, DC: World Bank.

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