<!-- Start of picture text --> Policy Ro"areh<br>Financial Polley and Systems<br>WPS 1107<br><!-- End of picture text -->

- This paper a product of the (former) Financial Policy and Systems Division, Country Economics Department-presents lessons on financial reform derived from two World Bank research projects on both the real and financial sector effects of finandial reforms in selected countries. This paper is adapted from chapt2r 7 of the draft manuscript, _Financial Reform: Theory and Experience._ Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Wilai Pitayatonakarn, room N9-003, extension 37664 (February 1993, 35 pages).

The argument in favor of gradual - but sustained - financial reforn is based on two factors. First, the development of borrower net worth will determine the health of the real and, ultimately, the financial sector. Thus, speeding up reforms when borrower net worth is subject to - positive shocks or slowing them when it is - subject to negative shocks appears sensible and appears to have worked better in practice. Second, the initial conditions of the banking sector - not just its net worth but its stock of human capital, the initial portfolio mix, and the intemal incentive systems - will also determine the success of any reforms. Thus the speed of financial reform must be related .o these conditions: rapid reform with unskillec' bankers, unbalanced portfolios, and perve.se "bank cultures" is a sure recipe for flrr.icial crisis. Of course, political factors can present unique opportunities to point an economy rapidly and permanently toward a more market-based system. And these opportunities should be seized. But where possible, financial reforms should consider links to the real sector and institutional development.

The case for gradual reforms is not one for inaction, as the conclusions of this study suggest that financial reform is wort. the effort and that, with due attention to the institutional environment, the lessons can be applied elsewhere.

Authorities can do much to increase the market orientation of their financial system. with all its benefits, even without a "big bang." They can eliminate the grossest interest subsidies, move toward market financing of government debt, and raise deposit rates at least to only slightly negative or modestly positive levels, paying attention to budget realities. In severl countries, authorities ended modest financial repression early in their reform efforts, while stiU retaining some controls. Of those that moved fastest on interest rate deregulation, Indonesia and New Zealand met most of the foregoing conditions, with some uncertainty about the health of their banks at the point of deregulation. But in both cases banks had a window of a few years before new entry was permitted, allowing them time to adjust before competition intensified. Caution regarding entry helped to limit the reduction in the franchise value of bank licenses, especially given the limitations on supervisory skills. And in both cases, deregulation coincided with falling world interest rates.

Although an eclectic approach to financial reform is more difficult to manage than one of immediate, complete deregulation, it appears bome out by the country cases and the theoretical approached reviewed here.

The Policy Research Working Paper Series disseminates the findings of work under way in the Bank. An objective of the series is to get these fndings out quickly, even if presentations are less than fully polished. The fndings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

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