With their central role in making payments and mobilizing and distributing savings, banks are a key part of a country’s economy and the international financial system. Weaknesses in a country’s banking system can threaten financial stability both within that country and internationally. These problems are not limited to emerging markets. Persistent problems in Japan’s banking system, for instance, have limited that country’s economic growth and prospects for growth elsewhere. The financial crises in Indonesia, Korea, and Thailand began in the second half of 1997. Banking systems in many Asian emerging markets were at the core of the region’s financial crisis. The crises resulted in sharp declines in the currencies, stock markets, and other asset prices. By December 1997, the Korean won (Korea’s currency) had depreciated by 55 percent in relation to the U.S. dollar. By January 1998, the Indonesian rupiah (Indonesia’s currency) had fallen by 81 percent and the Thai baht (Thailand’s currency) by 56 percent. During the second half of 1997, dollar returns on Asian equity markets yielded a loss of 56 percent. The crises threatened the countries’ financial systems and disrupted their real economies. Private capital flows via short-term international bank credit and investment flows to Asia declined by about $100 billion during 1997 from 1996 levels. Most of the decline in capital flows to the Asian region reflected declines in flows to the three study countries plus Malaysia and the Philippines where net inflows of $73 billion in 1996 were replaced by net outflows of $11 billion in 1997. Most of the turnaround in these countries arose from a $73 billion turnaround in net bank lending flows— with the largest share of outflows recorded from Thailand and Korea at some $18 billion each. Financial crises in emerging markets have either been precipitated by or exacerbated by problems in banking systems. Countries with weak and ineffectively regulated banking systems are less able to manage the negative consequences of volatile capital flows and exchange-rate pressures. Establishing a strong framework of regulatory policies and institutions to underpin the financial sector is key to maintaining financial stability. The task of bank supervision is to ensure that banks operate in a safe and sound manner and that they hold sufficient capital and reserves to support the risks that arise in their business. The costs associated with financial sector problems, particularly in emerging markets, have been very large in terms of foregone growth, inefficient financial intermediation, and impaired public confidence in financial markets. The resolution costs have been largely borne by the public sector. The United States had its own financial sector problems in the 1980s and early 1990s with savings and loan institutions. We estimated a direct cost to the economy for resolving these problems of about $153 billion or two to three percent of gross domestic product (GDP). The estimated fiscal cost of systematic bank restructuring in Mexico since 1995 is on the order of 12 to 15 percent of GDP. Resolving banking crises may cost between 45 to 80 percent of GDP in Indonesia, 15 to 40 percent of GDP in Korea, and 35 to 45 percent in Thailand, according to central bank or market estimates. In early 1997, one financial expert suggested that since 1980, the resolution costs of banking crises in all developing and transition economies had approached $250 billion dollars. Most of the resolution costs in Asian crisis countries have yet to be incurred, and taxpayers in Indonesia, Korea, and Thailand will largely foot the bill. Financial crises in emerging economies can be costly for developed countries, particularly as the importance of emerging countries in the world economy and in international financial markets has grown. Developing countries now purchase one-fourth of developed countries’ exports. Thirteen percent of global stock market capitalization comes from emerging market countries. The share of emerging market securities in portfolios in developed countries is relatively small but has been increasing. To the extent that financial crises depress developing countries’ growth and foreign trade, strain their abilities to service and to repay private capital inflows, and eventually add to the liabilities of developing countries’ governments, developed countries are likely to feel repercussions. The financial systems of Indonesia, Korea, and Thailand are different from systems in many industrialized countries in several ways. Contrasting their financial systems with the U.S. financial system is particularly illustrative. The U.S. financial system emphasizes arms-length relationships between businesses and institutions that provide financing, whether through debt or equity markets, or other forms of financing. Indonesia, Korea, and Thailand place greater emphasis on debt financing through bank loans than on equity financing, have closer relationships between banks and the companies that borrow from them, and have greater government direction in credit allocation decisions. While these nations experienced years of strong economic growth, their financial systems have not been resilient when facing large capital outflows and currency depreciations. Reasons for this lack of resilience vary, but certain weaknesses in their financial systems appear as common themes. These weaknesses included (1) weak credit analysis, problems that banks faced in enforcing loan agreements in the case of defaults; (2) weak accounting practices that precluded effective credit analysis by banks or investors; (3) lack of hedging against foreign currency exposure by corporate borrowers; and (4) weaknesses in bank supervision that limited the governments’ ability to respond to financial problems. While countries financial systems do not need to be mirror images of one another, several characteristics are widely viewed as crucial to making a financial system robust or able to weather shocks. These characteristics were set forth in April 1997 by Deputy Finance Ministers of the Group of Ten (G-10) in its strategy for fostering financial stability in countries experiencing rapid economic growth and undergoing substantial changes in their financial systems. The G-10 calls for, among other things, a legal environment where the terms and conditions of contracts are observed and where legal recourse, including taking possession of collateral, is possible without undue delay; comprehensive and well-defined accounting principles that command international acceptance and provide accurate and relevant information on financial performance; standards for disclosure of key information needed for credit and investment decisions that are high quality, timely, and relevant; effective systems of risk management and internal control with strict accountability of owners, directors, and senior management; financial institutions that have capital that is commensurate with the risks openness and competitiveness in banking and financial markets subject to safety net arrangements—deposit insurance, remedial actions, and exit policies—that provide incentives for depositors, investors, shareholders, and managers to exercise oversight and to act prudently; supervisory and regulatory authorities that are independent from political interference in their execution of supervisory tasks but are accountable in the use of their powers and resources to pursue clearly defined objectives; and authorities with the power to license institutions, to apply prudential regulation, to conduct consolidated supervision, to obtain and independently verify relevant information and to engage in remedial action. In June 1996, the G-7 heads of government called for the Basel Committee on Banking Supervision—a committee of banking supervisory authorities, which was established in 1974 by the central bank governors of the G-10 countries—to participate in efforts to improve supervisory standards in the emerging markets. In response, the Basel Committee issued core principles for banking supervision in September 1997. The Core Principles provide operational guidance for preconditions for banking supervision—bank supervisory agencies with clear responsibilities, operational independence, and adequate resources; legal protections for supervisors; legal powers to authorize banks and address compliance and safety and soundness concerns; licensing and structure—clearly defined permissible activities; licensing authority with the right to set criteria and reject applications; prudential regulations and requirements—minimum capital requirements that reflect the risks undertaken by banks, independent evaluation of bank practices relating to granting loans and making investments, adequate practices for evaluating the quality of assets and the adequacy of loan loss provisions and reserves; identification of loan concentrations to single borrowers or groups of related borrowers, lending on arms-length basis; procedures for controlling country risk, transfer risk, and market risk; methods of ongoing banking supervision—on-site and off-site supervision; regular contact between bank supervisors and bank management; independent evaluation of information supplied by banks; and ability to supervise on a consolidated basis; information requirements—satisfaction that a bank has adequate records and financial statements that fairly reflect a bank’s condition; formal powers of supervisors—adequate supervisory measures to bring about corrective actions against a bank; cross-border banking—practicing global consolidated supervision, adequately monitoring and applying prudential norms to the banking organization’s foreign operations; establishing contact and information exchange with other countries’ supervisors; requiring local operations of foreign banks to operate at the same high standards as required of domestic institutions and having powers to share information with home- country supervisors to supervise on a consolidated basis. These core principles are intended to serve as standards against which countries may evaluate the adequacy of their supervisory systems as well as guidance to countries that are changing their systems. Bank supervisors from Indonesia, Korea, and Thailand participated in developing the Core Principles. The G-10 central bank governors endorsed these principles. “banking supervisors must set minimum capital requirements for banks that reflect the risks that the banks undertake, and must define the components of capital, bearing in mind its ability to absorb losses. For internationally active banks, these requirements must not be less than those established by the Basel Capital Accord.” Many countries adopted this standard for internationally active banks. However, differences among the countries in accounting practices, such as classifying and reserving for delinquent loans, can affect a bank’s level of capital. Differences in accounting rules can make capital levels appear higher than if the country followed stricter international rules. For example, in Thailand, an unsecured loan had been considered substandard after it was 6 months past due, while best practices in international accounting classify a loan as substandard when it becomes 90 days past due.