Financial systems and development

ingly as universal banks, engaging in commercial in big product markets, such as wholesale banking
as well as investment banking activities. Argu- (loans to larger borrowers) and deposit taking in
ments in favor of universal banking include sav- cities. This can be done, even when the creation of
ings in overhead costs, better information about another big commercial bank would not be justiclients,
and greater diversification of risks. The ar- fied, by encouraging the development of specialguments
against are mostly prudential: universal ized intermediaries. A postal savings bank, for inbanking
could lead to undue exposure to risk and a stance, would extend financial services to new
concentration of economic power. As discussed in clients and foster competition for deposits; finance
Chapter 6, however, prudential regulation can deal and leasing companies would spur competition in
with these drawbacks.
the market for loans.
To improve competition and efficiency, some
The banking sector
small countries have opened their markets to foreign
banks or have encouraged joint ventures be-
The banking sector in developing countries must tween foreign and domestic institutions. Many
confront several difficult issues. The most pressing small and medium-size countries could buy the
is that many banks are insolvent and must be re- specialized financial services they need (such as
structured. This problem was discussed in Chapter reinsurance, swaps, and forward contracts) from
5. Another is that wide-ranging intervention in the abroad. Small, specialized institutions and foreign
financial sector must gradually give way to sys- competition can force even big oligopolistic banks
tems that provide services in response to market to behave competitively-although not necessarily
signals. This, in turn, calls for more competition across the full range of financial services.
and better management.
As the demand for financial services grows,
countries will need to encourage the development
INCREASING COMPETITION. Commercial (or de- of nonbank financial intermediaries and securities
posit) banks hold between 50 and 90 percent of the markets in order to broaden the range of services
assets of all financial intermediaries in most devel- and to stimulate competition and efficiency. Some
oping countries and will continue to be at the heart countries have already made considerable progof
their financial markets for the foreseeable fu- ress toward more diversified financial systems. In
ture. In many countries these markets are domi- Malaysia, for example, a wide variety of institunated
by a few large banks. The lack of effective tions and markets are operating in an environment
competition is not so much due to monopolies of macroeconomic stability. Brazil and other Latin
based on economies of scale as to restrictions on American countries have had some success in ininterest
rates, on product innovation, on branch- stitution building, although high and volatile inflaing,
and on the entry of new institutions. Greater tion continues to undermine financial developfreedom
for banks to respond to market signals, to ment. In recent years several developing countries
choose their own customers, to set interest rates, have broadened their money and capital markets
and to determine the location of branches would and created new intermediaries, such as leasing
stimulate greater competition. The creation of new companies and contractual savings institutions.
banks and other institutions should be constrained Most countries, however, are still at an early stage
only by the prudential regulations discussed in of financial development.
Chapter 6. Competition also means allowing failed
institutions to go out of business. Allowing foreign IMPROVING MANAGEMENT. Poor management
institutions to open branches, start joint ventures has contributed to banks' difficulties in many
with a local institution, or provide specialized ser- countries. A 1988 study of bank failure in the
vices from abroad can be another source of United States concluded that management weakcompetition.
nesses, especially among smaller banks, were an
Although economies of scale are not great in fi- important factor in 90 percent of the cases ananance,
it may not be possible in small economies to lyzed. Improvements must be made in the skills of
ensure a competitive market for every financial management and in the banks' internal systems,
product. A few commercial banks supplemented particularly if the banks are to survive in the more
by a postal savings bank may be all a small econ- competitive markets of the future (see Box 7.5).
omy can support. Even in larger economies, finan- Many management tasks are similar to those of
cial markets are often uncompetitive. In these it bank regulators and supervisors, as discussed in
should at least be possible to promote competition Chapter 6. Indeed, banks with large branch net-
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