Beyond Capital Ideals: Restoring Banking Stability

Abstract

Hard on the heels of Mexico's crisis in 1994, a wave of financial crises swept across emerging economies - from East Asia and Russia to Brazil - bringing the fragility of banking and finance into unprecedented focus. What has gone wrong? - Caprio and Honohan examine why emerging markets, in particular, are susceptible to and affected by financial difficulties. They show that these difficulties have a richer, more complex structure than they are sometimes believed to have - with marked information asymmetries and substantial volatility. The sources of heightened regulatory failure in emerging markets in recent years include the volatility of real and nominal shocks, the difficulty of operating in uncharted territory after financial liberalization and other changes in regime, and the political pressures that can inhibit the enforcement of prudential regulation. Caprio and Honohan discuss what stronger regulation can and cannot accomplish, as well as options to improve the incentive structure for bankers, regulators, and other market participants. They probe the shortcomings of a regulatory paradigm that relies mainly on supervised capital adequacy and discuss the possible intermittent application of supplementary blunt instruments as an interim solution while longer-term reforms are being put in place. Certain well-worn messages remain valid, but are respected more in theory than in practice. There would be fewer problems, the authors say, if there were: · More diversification. · More balanced financial structures (for example, as between debt and equity). · More foreign banks in emerging markets' financial systems. · Better enforcement of both contracts and regulations. Participants in the financial sector will constantly try to get around rules that limit their profitability, so regulation must be seen as an evolutionary struggle.

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