Financial systems and development

and lowered their tariffs and other trade barriers. are not satisfied, governments may choose to con-
Firms in developing countries therefore had to face trol interest rates, but unless that control is flexible
abrupt changes in relative prices, often alongside enough to take account of inflation and market
recession at home. Many became unprofitable and pressures, it will impede financial development.
thus were unable to service their loans.
Proper alignment of interest rates is particularly
Instead of foreclosing on bad debts, many bank- important for economies that have open capital
ers chose to accrue unpaid interest and roll over markets.
unpaid loans. In some cases this was because the In the past, governments have allocated credit
borrowers were linked to the banks through own- extensively. In a world of rapidly changing relative
ership, in others because taking provisions for loan prices, complex economic structures, and increaslosses
would have made the banks insolvent. Col- ingly sophisticated financial markets, the risk of
lateral was often inadequate, and foreclosure pro- mismanaging such controls has increased. Many
cedures were slow and biased in favor of debtors. countries could allocate resources better by reduc-
So in many countries it was not thought feasible to ing the number of directed credit programs, the
start bankruptcy proceedings. The practice of roll- proportion of total credit affected, and the degree
ing over unpaid loans and making new loans to of interest rate subsidization. Governments that
cover unpaid interest has undermined the adjust- continue to direct credit should specify priorities
ment process: instead of financing new ventures narrowly. An emphasis on credit availability is
made profitable by changed relative prices, much preferable to interest rate subsidies, which undernew
lending has gone to prop up firms that are no mine the financial process.
longer viable.
Liberating financial institutions from interest rate
Financial institutions in many developing coun- or credit controls cannot, by itself, ensure that fitries
have suffered large losses: many are insol- nancial systems will develop as intended. The levent,
and some have actually failed. Bank insol- gal and accounting systems of most developing
vency is nothing new, but the scale of the countries cannot adequately support modern fiproblem-the
number of insolvent institutions, the nancial processes. Legal systems are often outsize
of their losses, and the number of countries dated, and laws concerning collateral and forecloaffected-is
without precedent. Although more sure are poorly enforced. Because collecting debts
than twenty-five developing countries took action can be difficult, and because borrowers are hard to
during the 1980s to restructure financial institu- monitor and control, lenders have been unwilling
tions, many of them dealt with only the largest or to enter into certain types of financial contract. If
most seriously affected ones; others remain se- governments overcome such reluctance by directverely
impaired. Restructuring banks is politically ing banks to make loans that the banks consider
difficult, particularly when the banks are public or too risky, losses can result. Governments can inthe
principal defaulters are public enterprises, but crease the supply of long-term loans and other
experience shows that delay is costly and that types of financing by reducing the risks to
losses mount with time. lenders-for instance, by requiring fuller disclo-
Reform needs to go beyond recapitalizing insol- sure of financial information and defining and envent
banks. It must address the underlying causes forcing the lenders' rights. To ensure the stability
of bank insolvency as well. Governments can of the financial system and discourage lenders
strive to provide macroeconomic stability, which from fraud, it is equally important for governgenerally
means reducing their spending. They ments to supervise financial markets and institucan
also undertake the structural adjustments that tions. In the past, supervisors have spent too
will lead to a more productive use of resources. much time checking banks' compliance with direc-
Restructuring or closing insolvent firms must be tives on credit allocation and too little time inspectpart
of this process; otherwise the recapitalized in- ing the quality of their loans and the adequacy of
termediaries that continue to lend to them will their capital.
once again become insolvent.
Institutions and markets
Prerequisites for financial development
Commercial banks are likely to remain the domi-
Countries with stable economies and fairly well- nant institutions for some time. Banks can be made
developed and competitive financial markets more efficient by improving their management
would benefit from giving market forces more in- systems and increasing the competition they face.
fluence over interest rates. Where these conditions Better management requires new lending policies,
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