Emerging Market Spreads: Then Versus Now. IMF Working Paper. BIS Review 86/2001  3  The next financial bubble occurred during World War I. During the first half of the war, in particular, there was strong growth in the Norwegian economy. This provided the foundation for a boom that is unparalleled in history. Banks’ lending rose sharply. The build-up of risk in the financial system was far more pronounced than in previous episodes. A strong inflow of gold led to uncontrolled growth in the money supply and inflation at the beginning of the war. In addition, the constraints implicit in the gold standard gradually broke down, and the money supply expanded sharply. The banking crisis came in the wake of a cyclical downturn in the early 1920s and can largely be attributed to the build-up of risk 5 during the boom period. The bulk of bank losses occurred before the introduction of parity policy. The authorities’ response In response to the extensive banking crises in the interwar period, a financial safety net for banks was introduced in most developed countries. In Norway, guarantee funds were introduced for savings banks in 1921 and for commercial banks in 1938. There was also a need for separate rules on public administration of banks. These arrangements helped to dampen the effects of the crises and prevent new ones. Commercial banks were subject to separate legislation and supervised by the newly established Banking and Savings Bank Inspectorate.

This also entails increased international cooperation. Many financial crises in the 1980s and up to today have occurred in countries where rules and supervision are relatively ineffective. As a result, the financial sector has become fragile. The capital strength of financial institutions has been inadequate. Deregulation has occurred before the country’s financial infrastructure is in place. This has fuelled the build-up of financial bubbles. Large fluctuations in capital movements have often intensified the problems. Elements of this were also present during the banking crisis in the Nordic countries. The financial safety net should help prevent financial instability and curb the effects if instability should arise. This may also prevent the development of imbalances. Deposit guarantees, crisis liquidity schemes and the assumption that large banks will be rescued by the government may weaken market discipline. The result may be increased risk-taking. International organisations have developed international codes and standards for the financial infrastructure and for the regulation and supervision of the financial sector, which are in line with good 10 practices. These codes and standards should contribute to improving policy and creating more robust financial systems. They should make it easier for investors and others to keep abreast of developments, which in turn will increase their ability to assess risks in a country. This will reduce the risk of herd behaviour and the build-up of substantial imbalances. The International Monetary Fund plays an important role in international surveillance and crisis management. They have substantially strengthened their oversight of the financial systems in member countries.