Financial systems and development

Chapter 2 stressed the roles of risk, information, ing financial institutions. Toward this end, they
and transaction costs in determining the supply of nationalized the largest, and in some cases all,
finance. In developing countries, investment was commercial banks; in Costa Rica, India, Indonesia,
relatively risky. Production was in new sectors and Mexico, and Pakistan, for example, the majority of
used technologies unfamiliar to the work force, en- banking system assets are government-owned. In
trepreneurs and managers were inexperienced, addition, they created and supported developand
marketing channels had not been developed. ment finance institutions (DFIs), which were spe-
Natural calamities and fluctuating commodity cifically mandated to provide long-term finance to
prices could drastically affect the incomes of particular sectors. Governments applied interest
farmers. Government policy was a constraint and rate and credit allocation controls to public and
a source of uncertainty: trade and pricing policies private institutions alike and ordered banks to
discriminated against exports and agriculture; de- open branches in rural areas. Bilateral and multilatvaluations
and tariff changes could radically alter a eral aid agencies participated in targeted credit
firm's competitive position and the cost of servic- programs by providing financial support and instiing
its foreign debt; trade and foreign exchange tutional assistance.
restrictions could reduce access to needed imports. Governments in high-income countries also in-
Volatile inflation caused abrupt swings in relative tervened in their financial systems. Although they
prices, periodic recessions reduced product de- exerted some influence over the flow of credit, inmand,
and government borrowing crowded firms terest rate and credit controls were less extensive
out of the financial markets.
than in developing countries. The principal em-
Furthermore, the instruments and markets phasis was instead on measures designed to safethrough
which risks could be pooled or transferred guard the stability of the financial system. In dewere
undeveloped. Financiers lacked the tools to veloping countries, however, governments paid
evaluate, price, and monitor risks. The weakness inadequate attention to regulatory and prudential
of accounting, auditing, and disclosure regulations matters, to the detriment of their financial
limited the information available to lenders about systems.
borrowers. Legal procedures for collateral and
foreclosure were poorly specified. These factors, Government intervention
together with uncertainty about borrowers' pros- in credit allocation
pects and the future inflation rate, deterred creditors
from providing long-term funds; lack of infor- Developing country governments have played a
mation and collateral discouraged banks from large role in credit allocation. For example, in Pakilending
to farmers and small businesses.
stan in 1986, 70 percent of new lending by the na-
Governments could have tried to increase the tional banks, which dominate the banking system,
willingness of creditors to provide long-term fi- was targeted by government, although this pronance
and equity capital by modernizing legal sys- portion was reduced substantially by 1988. In India
tems and making contracts more easily enforce- about one-half of bank assets had to be placed in
able; by clarifying property rights and improving reserve requirements or government bonds, and
title transfer and loan security; by improving bank 40 percent of the remainder had to be lent to priorregulation
and supervision; by training accoun- ity sectors at controlled interest rates. In Yugotants
and auditors; and by ensuring adequate dis- slavia in 1986, 58 percent of short-term loans were
closure of information. Chapter 6 discusses such directed credits. In Brazil in 1987, government
changes in more detail. But institution building credit programs accounted for more than 70 pertakes
time. Understandably, many governments cent of the credit outstanding to the public and
wanted faster results. Moreover, many wanted to private sectors. In Turkey in the early 1980s,
use the financial system for such purposes as allo- roughly three-quarters of all financial system adcating
resources to projects with high social re- vances were made at government directive or at
turns, redistributing income, reducing costs in preferential interest rates, or both, although the
state-owned enterprises (SOEs), and offsetting the proportion has since fallen (see Box 4.1). In Malayeffects
of an overvalued exchange rate and restric- sia directed credit has accounted for an estimated
tive trade policies.
30 percent of bank portfolios.
Rather than lay the foundations of a sound fi- Many such regimes were immensely complinancial
system, most governments concentrated cated. At one point Korea had 221 formal directed
on intervention designed to channel resources to credit programs. In 1986 the Philippines had fortyactivities
that they felt were poorly served by exist- nine schemes for agriculture and twelve for indus-
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