trust and prudence increase the return to all participants. Thus, producing and maintaining financial infrastructures require cooperation both among market participants at the industry level, and between the private and public sectors. In particular, externalities in production of trust and prudence call for private-sector self-policing arrangements as generating incentives to higher efficiency _and_ stability.

Third: information. The incentives for acquiring, exploiting, and disseminating information are central to the effective functioning of a financial circuit process. On the one hand, the emergence of a market for financial information is necessary to the integrity and stability of the circuit, especially as both decentralization of decisions and agent interdependence increase. In particular, CTF shows that efficient information provision is essential to reconcile choices from firms producing capital goods and investing companies, and choices from savers and fund-users. Reconciliation of such choices is vital both for intra-circuit and inter-circuit stability. Also, as CTF suggests, the stability of the circuit benefits from reducing segmentations that hamper efficient information flows and distort incentives to optimal intertemporal decisions. Banks must be able to assess the debt-repayment capacity of individual firms in deciding whether to refinance indebted firms at the end of the circuit round and under what conditions. They therefore stand to benefit significantly from factoring the long-term market potential of borrowing firms in their risk analysis. The higher their reputational capital, the stronger their incentive to lengthen the time horizon of their approach to risk management. Similarly, investment financial institutions would benefit from gaining knowledge associated with undertaking commercial banking relationships with fund-users, as these can provide relevant and timely information on changes in business conditions and market moods. Finally, personal and social linkages characteristic of the information structure in informal financial markets can be exploited to maximize complementarity between formal and informal finance, especially in countries at early stages of development with large shares of population beyond the reach of the formal financial circuit.

A financial sector reform strategy based on incentives is especially fitting where the need to economize on scarce resources is more pressing and the circuit is riddled with discontinuities in information and trust. In particular, four contentions justify the use of incentives for financial sector reforms in emerging economies:

- _Incentives to prudence and honesty can protect the stability of the circuit by directing private_

- _sectorforces unleashed by liberalization._ Many developing countries have undertaken the transition from financial repression to market-based finance. The vulnerabilities of marketbased finance, discussed earlier, call for major institutional measures to prevent or minimize the likelihood of circuit breakdowns. Such vulnerabilities are most acute during liberalization, when private-sector agents are suddenly allowed to operate across a broader decisional space than under financial repression, with unpredictable shifts in structural parameters and very limited knowledge. Under these circumstances, incentives and incentive-compatible regulations are essential to induce agents to factor prudence and honesty in their action plans during and after reform.

- _Emerging economies sufferfrom relatively scarce institutional resources in both the public_

- _and the private sector._ In emerging economies the resources to be devoted to monitoring and enforcing rules and regulations are typically more scarce than in industrial countries. The necessary skilled human resources have a relatively higher opportunity cost (and the technologies available for control purposes are presumably less effective) than in industrial countries. Incentives to induce self-policing within the private sector would complement public sector's efforts to enforce rules and best practice standards.

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