16

# (4) Institutional and Legal Framework for Bank Supervision

The strategies discussed above will reduce system-wide risks. However, the financial system could be still fragile if banks do not select sound and profitable borrowers, and monitor and enforce loan contracts effectively. The business of banking and finance is essentially the business of public confidence. The public at large and market participants more specifically expect a degree of official surveillance over the system in which credit and credibility is a unifying force (Corrigan 1987). The financial sector should therefore be closely monitored and supervised by the government.

An important function of financial sector supervision is to develop an institutional and legal framework for enforcing debt contracts, measuring and reporting the solvency and efficiency of borrowers and lenders, and to ensure that systemic risks and sectoral imbalances are not such that the soundness and safety of the financial system is jeopardized. Where the financial sector may have to intermediate high risks, appropriate instruments and adequate capital should be put into place to support such activities. In short, national risk management is an important raison d'etre of effective bank supervision.

# _(5)_ Financial sector liberalization and risk management

Financial sector liberalization itself entails high risks as well. A major issue in the design and sequencing of economic liberali;7ation is to engender change without instability. Economic liberalization involve changes in relati {e prices, which have large wealth and income distribution effects. In the process, certain sectors may experience rapid deteriuration of their net worth. The use of sectoral and national balance sheets can identify the effects of such relative price changes and consequently the risks associated with price reforms.

A major lesson of recent financial sector reforms is that the fiscal costs (in terms of actual as well as contingent liabilities) of liberalization could be very large (Caprio, 1992). Large sectoral wealth losses (such as enterprise or bank losses) are shifted to the budget, which may not be in a position to digest such losses in one go, without losing monetary and macroeconomic stability. Indeed, when there are insufficient national resources, nor well established institutional framework for prudential regulation, to cushion the shocks, a country may have to take an approach in which distortive regulations are gradually removed, in parallel with the deepening of capital markets, institutional building and supervisory capacity. The proper sequencing is to remove those distortive regulations which can be removed without causing major instability, while others are removed as the market and institutional environments are mature enough to cushion the impact of deregulation. In general, this has been the approach of the East Asian economies.

Financial liberalization in OECD countries have been much more successful, because most OECD countries opened their financial systems during the 1980s, when their financial markets have become mature and well diversified. They had the institutional development and market depth to cushion the shocks arising from market liberalization. They also can spread the costs of external shocks through time while most developing countries do not have this option. For example, recent banking and savings and loan problems did not hamper the US access to