A fundamental question raised by recurrent financial crises in mature and emerging economies is how to ensure that the financial markets serve development rather than being a constant source of instability and disruption in pursuit of self-interest.

This is not only a question of how best to regulate the existing institutions and markets, but also how to restructure and organise them.

Now, a rebalancing is necessary between state intervention and free markets in the sphere of finance in search for greater stability and sustained industrialisation and growth. In this context at least five key issues need to be reexamined, drawing upon the recent experience of both mature and emerging economies: the pros and cons of bank-based and market-based financial systems; the role of the state-owned banks; public intervention in private banking; the role and impact of foreign banks; and capital account liberalisation.

Banks vs financial markets: The first issue is whether developing, emerging economies (DEEs) should focus on developing and modernising their banks along the lines of the German-Japanese bank-based system or promoting direct financing through securities markets following the Anglo-American market-based system of finance. The bank-based finance involves long-term lending to enterprises and, hence, necessitates substantial own capital to safeguard solvency. By contrast, in the market-based finance, banks focus on short-term lending and hence need only adequate reserves and access to lender-of-last resort financing in order to avert liquidity crises, while corporate investment depends mainly on share issues. It is often argued that the bank-based system allows better monitoring of enterprises by banks and of banks by the state, gives access to finance to larger segments of the society and generates more evenly spread wealth. On the other hand, stock markets are said to provide wider options in the allocation of risks and monitoring by shareholders, but foster short-termism.

State-owned banks: Privatisation has always been advocated on grounds that state-owned banks are prone to inefficiency, waste and political capture. However, after recurrent crises involving private banks, it is now widely recognised that what is privately profitable is not necessarily socially efficient, and waste and political capture are not peculiar to state-owned banks. Indeed, private and public banks now appear to have reached a modus vivendi, and state-owned banks in some developing economies are now considered as more secure than private banks, with the public shifting deposits from the latter to the former during the recent crisis.

Public banks appear to have three main advantages compared to private banks. First, they can accelerate industrialisation and development by directing credits at appropriate terms and conditions to sectors that have greater capacity to contribute to overall development. Second, they can embrace all segments of society in providing financial services, including poor and self-employed in rural and urban areas and SMEs. Efficient operation in these areas calls for reciprocity between support and performance and clear identification of the subsidy elements in lending and provision in the budget. Third, public banks have proved to be more effective in providing counter-cyclical financing during the recent economic downturn brought about by the sub-prime crisis.

A main challenge thus is how to ensure that the public banks effectively render the function of developmental, inclusive and counter-cyclical lending while avoiding political cycles and rent-seeking.

State intervention in private banking: State ownership is not always necessary for many of the above functions to be rendered effectively. In Japan, without ownership the government exerted considerable control over the banking system through moral suasion and other means in the course of its industrial development. Again, late-industrialisers in East Asia implemented policies of directed credit for industrialisation through private banks, using administrative control, cross subsidies and incentives. However, in many cases intervention in the credit market was designed to provide cheap finance to the public sector by means of control over interest rates and compulsory holding of non-interest bearing government paper.

Such controls existed until the 1980s not only in DEEs but also in advanced economies. Re-strictions on interest rate are estimated to have made a major contribution to the reduction of government war debt in the US and UK between 1945 and 1980.

Recent interventions in several mature economies are also seen in this light. Increased purchases of government debt by central banks, negative real interest rates, higher liquidity requirements to be held in government securities and legislation forcing pension funds to hold government debt are all seen as signs of return of financial repression in mature economies.

Still, it remains true that these measures have been introduced not out of ideological conviction but to address the problem of increased public debt resulting from bailout operations and countercyclical policies necessitated by the financial crises triggered by speculative lending and investment by private banks.

The US experience with community banking also holds lessons for DEEs on how arrangements in a system dominated by private banks can help promote inclusive finance. Until 1980, the US legislation placed constraints on geographical diversification of activities of private banks. This forced them to focus on the neighbourhood in which they were operating, allocating much of their credits to communities in which they collected deposits. These restrictions were dismantled after the 1980s leading to a rapid concentration in the banking sector, a factor widely seen as having made a major contribution to the sub-prime crisis.

Another factor that favoured community banking in the US was the Community Reinvestment Act of 1977 designed to promote lending by commercial banks and savings associations to all segments of the society, notably in low- and medium-income areas. Nevertheless, the policy of providing shelter to all segments of the society allowed the banks to engage in reckless lending without coming under close scrutiny. This experience thus holds lessons on how to prevent attempts to take financial services to all segments of the society becoming a source of instability.

Foreign banks: Entry of foreign banks to DEEs is often encouraged for two major reasons. First, by bringing know how, technology and competition foreign banks could increase efficiency in the banking system, improving financial services and reducing intermediation margins. Second, greater presence of foreign banks is seen to increase the access of DEEs to international financial markets and enhance their resilience to external financial shocks.

However, it is also recognised that the presence of foreign banks in DEEs enhance the scope for regulatory arbitrage. Such banks can easily shift large deposits and lending abroad in order to benefit from more favourable regulations. They tend to focus on more profitable operations such as trade credits, credit card lending to consumers and lending to large corporations, leaving less profitable activities and weaker borrowers, including SMEs, to domestic banks.

By contrast, significant presence of foreign banks in DEEs could increase their susceptibility to external financial shocks. When the subprime crisis broke out and banks in advanced economies came under liquidity squeeze, their subsidiaries acted as a conduit of capital outflows in support of their parent banks.

The pros and cons of opening markets to foreign banks in terms of efficiency, its effect on vulnerability to external shocks and regulatory arbitrage need to be assessed.

Capital account liberalisation: Just as in case with domestic financial liberalisation , there is a strong link between capital account openness and economic growth. But there is mounting evidence that capital account openness tends to lead to increased susceptibility to financial instability due to the swings in capital flows and international contagion.

In view of heightened instability of capital inflows due to self-seeking policies and increased financial difficulties in advanced economies, it is important to consider the policy response to surges in capital flows to DEEs. A key question is this respect is whether DEEs should establish a permanent regime of controls, to be used in appropriate doses as and when required, rather than introducing ad hoc market-friendly measures on a temporary basis, as advanced by the mainstream, including the IMF.

—Edited extracts from ‘Policy Brief’ by South Centre, Geneva, an inter-governmental body of developing countries.