SUMON KUMAR BHAUMIK

Liberolizotion vs Regulotion: Some Lessonsfor Finonciol Restructuringr

I . INTRODUCIION

Tfre troditionol, ondTI perhops the best

known, theory os to why bonksore importont is thot they bringsovers ond investors together(Mishkin 1992). The obviousodvontoges of this motch-moking role ore thot;

o) it lowers the seorchcosts of the two porlies, therebyencouroging both soving ondinvestmenl;

b) it helps chonnel theovoiloble investoble resourcesinto productive investment, Theimportonce of soving ondinvestment octivities, in so for osthe economic growth of ocountry is concerned, hos beenemphosized in neo-clossicolgroMh models (Domor 1946,So low 1956) ,

However, while thetroditionol role of bonks hos notbeen totolly disregorded, o

new ond more imoorfontdimension hos been odded tothe oforementioned motch-moking process, with theevolution of the literoiure onosymmetric informotion. Thereexists o serious informotionosymmetry between sovers ondinvestors os the former connotknow with ony certointy theprobobilities of success (orfoilure) of the vorious projectsundertoken by the lotter, Riskoverse sovers ore, therefore,reluctont to lend money toinvestors, without o (high) riskpremium, creoting o number ofso colled efficiency problems,A bonk, being o corporote entityond hoving, in principle, o welldiversified porffolio, is presum-obly risk neutrol, Hence, it is obleto borrow from its sovers(through deposits) ond lend it toinvestors without the need forhigh risk premiums, A Bonk'sprofits emerge from this borrow-ing-lending spreod,

However, the bonksthemselves ore not free ofosymmetric informotionproblems os they too connotknow, with certointv, theoossibil i t ies of success or foilureof the projects to which theylend money, As profit moximiz-ing entities, bonks ore con-cerned with the oossibilities ofdefoult, ond if the orobobil it iesof such ore high there con beo f l ight to quol i ty (Minsky 1972,Mishkin l99l , Kindleberger1978, D iomond l99 l ) , In suchon event, non-blue-chipborrowers would be rotionedout of the morket, thus throttlingmedium ond smoll businesses,with potentiolly disostrousconseouences, The otheroption for bonks is to chorgehigh risk premiums, However,given the stylized inverserelotionship between risk ondreturns, only investors in high riskprojects would be in o positionto occept the resulting high

1 , The monuscript wos developed during lhe oufhors lenure os o visiling lecturer of the Vorno University of Economics,Bulgorio, ond wos furlher developed during fhe oulhor's visil to the Indiro Gondhi Institule of Development Reseorch,Bomboy, Indio. The oulhor would like to lhonk lvono Jockimovo, John Veilch, Lubomir Mitov, Prodeep Agorwool, AshimoGoyol, Subir Gokhron, Joyoli Sorkor ond lhe porliciponls of o University of Economics seminor from lhe Bulgorion bonkingcommunily for their helpful comments.

Sumon Kumor Bhoumik, Notionol Inst i tute of Public Finonce ond Policy, New DelhiReseorch interests: Less developed ond emerging economiesMosl imporfont publicotions:- Bhoumik, S. K, & Srinivoson, R, (1993) Investment, Incentive ond Credit: Does the Government Motter? Poperpresented of the onnuol meeting of ihe Western Economic Associot ion Internotionol, June- Bhoumik, S. K, (1994)'The Sudden Rise of Peosont Uprisings in Bengol:The Role of Preference Folsif icot ion'. Poperpresented of the onnuol meeting of ihe Missouri Vol ley Economic Associot ion, Februory- Bhoumik, S. X, (t 994)'ATheory of tmmiseri i lng Food-Feed Competit ion , Poper presented oithe onnuol meetingof the Western Economic Associot ion lnternotionol, July- Bhoumik, S, K, , Jock imovo, 1 , , Koevo, S, , & Georg iev, L . (1995) 'An Economic Anolys is o f the Bulgor ion Bonk ingSystem: The Present ond the Future . Poper presented of the onnuol meeting of the Western Economic AssociotionInternotionol, Julv- Bhoumik, S, K. & Nugent, J, B. (. l995) Weolth Accumulotion, Fert i l i ty ond Tronsfers to Elderly Heods in Peru , Pooer

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Vol.3, No.2

l8 /2 Sotsong Vihor

LIBERALIZATION vs REGULATION...

interest roie controcts, Thisintroduces the fomilior oroblemof odverse selection (Stiglitz& Weiss l9B l ) ,

Cleorlv, the odverseselection problem is unoccept-oble. Moreover, it is l ikely thotcompetition between bonkswhich con result from economicgrowth, os the finonciol sector inon economy grows, would keeplending rotes lower thon onosset pricing model such os, forexomple, CAPM, might predict2,As o consequence, in theobsence of full disclosure byinvestors, on unlikelv ohenom-enon, oll bonks would remoinvulneroble to defoults on theloons they provide, lt is obviousthot, should the losses resultingfrom non-performing loons behigh, o bonk would be forced todeclore bonkruptcy, This is likelyto leod to o foll in the confi-dence of sovers in bonkinginstitutions ond the conse-ouence of such o foll in ccnfi-dence would be bonk ponicsond bonk runs, However, there ismore thon o groin of truth in themonetorist cloim thot bonk runsleod to finonciol crises ondeconomic slumps (Friedmon& Schwortz I963), Therefore, inorder to prevent ponics ondbonk runs, governments invorious countries insure thedeposits of sovers in bonkinginstitutions. The most widelyknown exomple of such depositinsuronce is perhops thotorovided bv the Bonk Insuronce

Fund (BlF) of the Federol DepositInsuronce Corporotion (FDIC) ofthe United Stotes,

However, the creotion ofinsuronce funds l ike the BIF leodsto morol hozord problems evenos it ottempts to solve theproblems ossocioted with bonkruns, On the one hond. thesovers no longer monilor thebonks, secure in the knowledgethot their deoosits ore insured,On the other hond, the bonksdo not olwovs scrutinize thepotentiol borrowers corefully,knowing thot in the event ofsolvency crises the governmentwil l boil them out. Hence, bonkinsolvency resulting from o highincidence of non-performingloons is o distinct possibil iV, Thecost of boilouts, borne in thelong run by the toxpoyers, isoften quite high3, Moreover, theDresence of insuronce reducesincentives for sovers to sovemore since thev know thot theirweolth is secure, While this resultsin some benefits for theeconomy in the short run, in theform of higher consumption, thelong run losses in productivecopitol outweigh the short runbenefits (CBO 1992),

Todoy, the debote on thefinonciol sector in on economystonds of o crossroods, On theone hond, mCIny of the formersociolist ond/or olonnedeconomies ore otfempting torestructure their f inonciol sectorsthrough liberolizotion, os policy

mokers hove begun io ogree onthe inefficiencies which resultfrom non-morket mechonismsinvolved in the disfribution of(finonciol ond other) resources,This policy opprooch which conbe cleorly identified, ot leostportiolly, with finonciolrepressionist theories (Show)973), orgues thot interest rotes,often reguloted in developingeconomies, should be ollowedto reflect the morket orice ofcopitol, lt further goes on toorgue thot so long os bonks orenotionolized, it would be optimolfor the (centrol ond stote)governments to increose fiscoldeficits (Novoes & Werlong1995), thus creoting cosh flowproblems for bonks4, The usuolpolicy prescription is theprivotizotion of bonks, lt isorgued thot privote bonks,which, like firms, seek to moxi-mize their totol volue, would notbe wil l ing to boil the govern-ment out since holding low yield(ond often i i l iquid) governmentbonds would offect theirbolonce sheets odversely ondthus reduce their shore prices,

On the other hond, thestring of bonk foilures ondfinonciol crises thot hove tokenploce in'the United Stotes overthe lost ten yeors hove given riseto the hypothesis thot ,,finonciolreform colls for more nuoncesthon simply lelting the morketworK' (Copr io el o l , 1993),Indeed, St ig l i tz (1993) orguesthot the ideo of comoetition

2. The CAPM, os the Copitol Asset Pricing Model is populorly col led, wos developed in the 1960s. l l provides omofhemolicololgori thm which con be used by investors ond lenders 1o judge lhe oppropriote r isk premiums, given therisk free rote of relurn, ond lhe expected role of return ond riskiness of the project or investmenf concerned. A detoiledexposi l ion of the model, ond some of i ls exlensions con be found in Bodie et ol. (1992).

3. Aport from lhe direcl cost of the S&L boi lout through loxes etc., the loss io the US GNB i.e., the income of thetoxpoyers, wos USD 200 bi l l ion belween

'198-| ond

. |990. l t is esf imoled lo be obout USD 500 bi l l ion by the yeor 2000

(CBO 1992). Further, note thot the method of finoncing the boilout - loxes, bonds, or monetizing lhe resultonl budgetdeficil - ore immoteriol. They would offect lhe behoviour of lhe rolionol loxpoyers similorly, ond hence hove the someeffect on the economy (Borro 197 4).

4. The logic of this orgumenl is quite obvious. lf the fiscol deficit increoses, the government hos lhree options, nomely,increose loxes which is oflen politicolly infeosible, monetize lhe debt which will give rise lo inflolion in the shorl run ondis hence olso pol i l icol ly problemotic, ond sel l governmenl bonds. Indeed, the lolter is perhops fhe mosl pol i t icol lyocceploble (medium run) solution which is enforceoble by lhe governmenl lhrough slolulory liquidily rolio (SLR) ondvoriobility rolio requirements. lt is of lillle wonder thot, ot the morgin, the SLR ond the reserve rotion occounts for obout63.5% of the deposits of Indion bonks (NCR I 99.|).

Spr ing 96 EMERGO

leoding to Poreto efficiency isconstroined by the ossumptionsthot morkets ore complete ondthot there is no osymmetry ofinformotion, However, not onlyore finonciol morkets prey toinformotion osvmmetries, butmorkets ore olso incomoleteportly becouse not oll risks oreinsured ond portly becousecredit is rotioned, He orgues,therefore, thot governmentintervention in some form mightbe optimol ond might guide themorket towords Poretooptimolily,

Generollv, the focus ofconcern omong the most vocolsupporiers of the morket hosshifteC to improved ond/or newregulotions which would intro-duce morket discioline in thebonking/finonciol sector, ondwould reduce the costs occru-ing to the government, ond inthe long run to the toxpoyers,This poper wil l troce the impor-tonce of f inonciol restructuring,os indicoted by the experiencesof severol emerging economies,It wil l highlight the inefficienciesfoced by non-morket/plonnedeconomies, os well os thevulnerobilil'y of bonks to finonciolcycles in morket economies.Finolly, if wil l explore the impor-tonce of f inonciol f ine-tuningthrough regulotions, os pulforword in the ongoing deboteon deoosit insuronce in theUnited Stotes,

I I . F INANCIAL CRISES INPLANNED ECONOMIES AND

MARKEIS

he post decode, giventhe polit icol chonges in

the former sociolist stotes in fheso-colled Soviet-bloc, hos lentcredence to whot economists inthe Western world hove beensuspecting for some time, Thelock of morket bosed incentives

hos ployed hovoc with theeconomies concerned, ondolmost oll sectors remoinoffected, The bonking/finonciolsectors hove not been onexception,

The oroblems ossociotedwith bonks hove been ouite inline with economic rotionole, Inthe pre-1989 per iod, bonksoffered loons nol in occordoncewith ony risk-return rule; rother,these loons were dictoted byoolit icol motives. At the sometime, borrowing (governmentownedJ corporotions were notexpected to eorn profits, ondhence their bolonce sheetswere in the red, thus renderingthem incopoble of meeting theirrepoyment obligotions, Hence,of ter the chonges in 1989,bonks were left with non-performing loons representingon overwhelming shcre of theirporl-folios. The dvnomics of thef inonciol choos con be summo-r ized in f igure 1s,

The centrolly plonnedeconomies of Centrol ondEostern Europe (CEE) weremorked by huge governmentowned enterorises whichdominoted the orgonizedindustriol seclor, privote enter-prise being l imited to informolociivi i ies, Since the essentioloblective defined in these plonswos to meel output gools, firmsremoined lorgely unprofitoble,At the some time, monev ondcredit ployed o possive role inthe economy os bonks providedcredit to firms whenever theywere directed to do so, irrespec-tive of o firms'viobil itv, As oaonqo.'r rFn.A tho nartfnl iac nfr v l / v r l r v i l v g v l

these bonks were plogued by ohigh volume ond proporfion ofbod loons, rendering them non-vioble, unless propped up bygovernment subsidies, Theconsequence of this neor

SUMON KUMAR BHAUMIK

l ' ^ r r rn lz r r rn in r r n f aEE bOnks WOSv v r i l \ r u v r v y v r v

threefold. First, the volume ofbod credit wos so hrgn ihotmerely occordrng provrsions tothem wos unlikely to solve thenrohlem rrnless the vOlU.ne Ofcr r r -h n rnr r i c innc r ,- ,vos ntgna n a r r a h t a n r o a t gv r r v u v r I r v v r u v l

mocroeconom c oro budget-onr nrnhler . rc, SeCO^C rn The

woke of the morket zot on ofCent ro l Europe Tre e l sTngbonk monogers sougnt topreserve the,r pos'ors Oycover ing up the ev€; of bodcredit with the he p cf creotiveoccounlrng, occc. in l r rgprocesses j r CEE o- ' rg I 989-90being lorgely ncorsls ient wi thinternot ionol stonooros Third,CEE bonks, on the ysrge ofbonkruptcy ond 1u'rgv 'er cosh,become more p'or3 toproviding credil to borrov,rerswho were wil l ing to poy highinterest rotes ond, hence, wereinvolved in high-risk prolects, Thisis the fomi l ior odve'se setect ionproblem discusseo ov Stiglrtzond Weiss ( l 98 I ) ln other words,in the obsence of drostrcmeosrrres the hod loors Ondinlerest poymenis due werelikely to be posseo over by thenlr l rnrrnnaornalt fe UCtOnt tOv r v r t r v r r v v v r r r v l

relinquish its position, thuscompounding t ls orobrem ofvirtuol bonkruptcy focing thebonks (see f igure l )

A cose con cleor ly bemode in fovour of o form ofl iberolizotion thot ushers inmorket oriented incentives, Forsuch incentlves, it is generollynnrecd lcor-l to the effiCient

ollocotion of resources, Indeed,the lost decode hos seen theliberolizotion of the bonking/finonciol sector in o lorgenumber of emerging econo-mies, including Indonesio,Moloysio, Indio, Koreo, Turkey,ond New Zeolond, While there iso greot deol of dispority

5. A descripl ion of the choos in the bonking-f inonciol sector in Eoslern ond Cenlrol Europe con be found in Morresse(.|994) ond World Bonk (1 991). The deplh of the crisis hove olso been discussed in deloi l in severol issues of the CentrolEuropeon Economic Review, ond The Economist.

4 _ vor.3, No2__

LIBERALIZATION vS RFCULATION...

between the mocroeconomicconditions ond ihe socio-politicol institutions of theseeconomies, certoin commontrends ore identif ioble: theprivotizotion of notionolizedbonks ond/or the liffing ofborriers preventing the entry ofprivote (ond foreign) orgonizo-tions into the finonciol sector;the deregulotion of interest rotesond the eliminotion of cooitolcontrols; ond the reduction oreliminotion of subsidies ond/orpriority lending progroms(Coprio et o l ,

. l993)6, Empir icol

evidence tends to show thot inolmost oll these economiesthere wos on increose in thesovings rote, thereby eliminotingfeors thot f inonciol reformsmight disrupt the existingsystems so os to reducesovingsT, At the some time, thencrementol copitol-output rotioscf most of these economies'egistered increoses, indicoting'hot the ollocotion of resources,vos perhops more efficients,

Con it be orgued,'rerefore, thot the creotion of.rorket incentives throughcerolizotion or deregulotion

.lnombiguously reduces thercentive problems ossocioted.'tith the bonking sector? lf the"ends of the lost ten yeors in the-rrted Stotes ore onv indicotion,

there is little reoson to becomfortoble in such o belief. lthos been orgued, in the woke ofthe Sovings ond Loons crisis,ond other reloted ond unrelotedbonk foilures, thot the morolhozord problems creoted bydeoosit insuronce hove beensignificontly high. As o conse-quence, mony of the (relotivelydereguloted) bonks were leftwith porffolios mode up of olorge proporlion of vorious non-performing ossets, os well os lowcopitol-liobility rotios (GAOl99l ), The consequence wos olorge number of bonk foilures,the cost being borne by thetoxpoyer, The morol hozordoroblem os well os the vulner-obil ity of bonks to finonciolcycles hove forced policymokers to rethink the impor-tonce of regulotion driven fine-tunings thot ore now believed tobe on integrol port of onyfinonciol restructurino or reforme,

i l r . FTNANOO'RESTRUCTURING: WHICH WAY

TO GO?

fi t ffris juncture, of-\simolificotion is

perhops possible, The previoussection described the choos inthe finonciol sectors of theformer sociolist economies, ltcon be orgued thot f inonciol

restructuring, i,e., the introduc-tion of mojor policy chonges, isperhops more oppropriote forthose economies which lock omorket structure, Regulotion, onthe other hond, is o fine-tuningprocess perlinent to morketeconomies such os the UnitedStotes where policy chongeswould be more subtle onddirected of oorticulor incentivemechonisms rother thon of theinfrostructure os o whole. In thissection, we sholl oddress theformer oroblem,

The problems focing theformer sociolist/olonnedcountries cleorlv hove their rootsin the foct thot there hos beenno incentive for resourceollocotion bosed on onv risk-return evoluotion, The monifesto-tion of these problems is the defocto insolvency of o lorgenumber of bonks left in oosses-sion of non-performing ossets,The usuol policy prescription is toprivotize the bonks os well os thecorporotions so os to introducemorket bosed (profit/revenuemoximizing) incentives, How-ever, it is unlikely thot privoteentrepreneurs would be wil l ingto toke over componies ondbonks which ore deep in thered, The only feosible solutionperhops is to stort ofresh witho cleon slote, implying thot the

6. At lhe some time, most of these economies hove inilioted fiscol, monetory, ond lrode policy reforms. Ihese include'he reduction of loriffs, the privotizolion of induslries, ond the devoluotion ond/or introducfion of flooling exchonge rotes.

7. However, os poinled oul by Akyuz (l 993), lhe usuol finonciol repressionisl orgument (Show I 973) lhol liberolizolioneods to finonciol deepening ond higher sovings is nol very credible. For one, these orguments focus more on lhercreose in the sovings rote given on increose in the posl-liberolizofion rise in lhe interest rote (lhe subsfitufion effecl)ond;nderestimote the potentiol effecl of lhe rising inleresl rote on the mocroeconomy, ond hence on the volume of sovingsi'he income effecl). Further, these orgumenfs overeslimote lhe effect of fhe rising inleresl role on sovings by suggesting'rot in such on event sovings in fhe emerging economy concerned will shift quolitolively from commodilies fo liquid' ronciol resources. However, empiricol evidence suggests thot in most LDCs sovings ore held more in lhe form of gold or^o,d currencies fhon in the form of commodities. Finolly, finonciol lronsoclions moy increose in number, thereby suggesting' ^onciol deepening, withoul on ocfuol increose in fhe volume of sovings.

8 l t hos been orgued by Schionlorel l i et ol. (1992) fhot ICORs ore good meosures of eff iciency only under fhe:cndition thol lhe producfion functions ore of the fixed-proporlion or Leonfief type. This, however, is o reosonoble lheorelicols ̂ rol i f icol ion.

9. Finonciolcycles describe lhe behoviour of bonks during economic booms ond busts. When on economy improves,cc"rks lend more money ond, owing to lhe prevoiling optimism, continue lo lend money posl the point of ony downturn^ ''re economy. As o consequence, o lorge number of lhese loons, especiolly in the lotter port of the cycle, ore of o high's< noture. By the time the problem is discovered, however, it is usuolly loo lole, leoving bonks wilh risky porffolios. ll is.rcodont lo nofe thot finonciol cycles do nol necessorily coincide wifh business cycles, A defoiled discussion of lhiso lenomenon con be found in Rondol l (1993) .

sprinspQl EM ERGO

bod debts of the bonks, os wellos the losses of governmentowned enterprises, would hoveto be written off (Singh 1994).Further, os emphosized byThorne (l 993), ocknowledgingthe existence of non-performingloons, ond ottempting toeliminote them bvrecopitolizotion ond/or debtunderwrit ing, leods to onoggrovotion of the morol hozordoroblem if the bonks continue tobe stote owned, Hence, theorivotizotion of bonks should bethe finol steo towords o solutionof the problem of inefficiency ofwhich bod loons ore but omonifestotion, This hos lorgelybeen the cose in the CentrolEuropeon countries (CzechRepublic, Slovokio, Hungory ondPolond) where the totol cost ofdebt-loss underwriting hosexceeded USD 5 bil l ion [Morrese1994, Thorne l993 l ro ,

Given the high cost ofunderwrit ing bod loons, it hosbeen orgued by some policymokers thot the develooment ofthe securities morket is perhopso better ootion insteod(McKinnon l99l ), However, theproblem with this opprooch isthot, in the presence of osym-metric informotion, onlv bluechip firms with proven trockrecords would be oble to roisemoney through equity ondbonds (Singh 1994), The conse-quence, therefore, would be ocrowding out of investible fundsfor medium ond smoll f irms withundesiroble effects on theemerging privote sector,Indeed, in the former sociolisteconomies where olmost ollenterprises were government

owned ond debt ridden, theremight be o crowding out offunds for ol l componies, o ld ondnew, ond o flight of copitolobrood, As the recent Mexiconcrisis hos shown, this problemcon be further oggrovoted if thecurrency concerned depreci-otes shorply ogoinst hordcurrencies, In this l ight, therefore,it mighi be prudent to restruc-ture the bonking sector,

However, debt-lossunderwrit ing is but the beginningof the process of f inonciolrestructuring, in o morketeconomy with osymmetricinformotion, the bonks ore likelyto focus on the net worth ofborrowers os on indicoior of theirobility to repoy debts, The netwofrh of the borrowers, on theother hond, is positively relotedto the slote of the reol sector ofthe economv, Hence there is oclose relotionshio between thefinonciol ond reol sectors, suchthot f inonciol reforms con onlythrive if the reol sector of theeconomy is performing well(Gertler & Rose i992), Theimplicotion cleorlv is thotfinonciol reforms need to belimed such thot the thrust ofsuch reforms ore undertokenduring o boom. Otherwise,finonciol restructuring moy hovethe peverse effect of rotioningo lorge number of investors outof the morket, thus reducingtotol investment, lt olso emoho-sizes the role of occomponyingfiscol ond other reforms whichore essentiol for ushering ineconomic growth, the lotterbeing cruciol to the success offinonciol restructuring, The roleployed by the lotter reforms ore,

SUMON KUMAR BHAUMIK

however, outside the scope ofthis poper,

As wos mentioned in iheorevious section, interest rotederegulotion (including theeliminotion of subsidies whichleods to negotive reol lendingrotes) is o common policyinsirument in the course offinonciol restructuring. Theresultont morket incentives oreobvious, An increoses in lendingrotes, however, especiolly ofterrisk premiums ore token intoconsiderotion, is l ikelv to reducethe net worth of firms, thusreintroducing the problem ofinvestment,,crowding ouf'described in the oreviousporogroph, The success of thereforms is, therefore, olsodependent on the obility of ihebonks to identifu new clients,who were eorlier poying exorbi-tont interest rotes in the informolmorkets, ond whose net worlhmight increose if thedereguloted lending rote islower thon the high rotes in theinformol credit morket lCoprioe t o l . 1 9 9 3 ) ' ' ,

The deregulotion ofmovements of cooitol ond theeljminofion of porffolio restric-tions might olso leod to undesir-oble consequences, Often,such liberolizotion efforts leod toincreosed bonk loons for reolestote development os industri-olizotion ond economic groMhincreose the demond forhousing, This is l ikely to hoppennot only in emerging economies(e.g,, Moloysio) but olso, osproven by the recent crisis in theUnited Stotes, in developedmorket economies (Rondoll

I O, The "nderwriting

of debts ond losses wos qccomponied by eflorts lo improve the copitol-osset rotios of the bonkslhrough recopitolizotion. The oppropriote policies included dividend cops ond roising copitol through lhe issue ofgovernment bonds ond vouchers (Morresse 1994). This policy wos olso odvocoted by the World Bonk for olher counlriessuch os Bulgorio (World Bonk 199'l). These efforls, in generol, hove met with mixed success ond mony bonks hove still nolbeen oble lo meet lhe expecled copitol requiremenis.

I I . The initiol efforts of Turkey to reform its finonciol sector included the deregulotion of interest rotes during o periodof disinflolion, ond wos occomponied by the inlroduclion of free enlry into lhe finonciol sector. The resulting combinotionof lower profits ond, lhereby, dislre.ss borrowing by enterprises on the one hond, ond increosed competition in thefinonciol sector on the olher, led lo o fol l in investmenf os well os on increose in the number of non-performing loons(Aliyos & Ersel 1992l..

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LIBERALIZATION vs REGULATION...

1993), Cleorly, there is the needfor the introduction of regulo-tions concerning the portfolioconcentrotion of bonks.

Finonciol l iberolizotion iscleorly o necessory condition forfostering economic growfh, ls it,however, o sufficient condition?Would the finonciol sectoroutomoticolly become com-petitive if the bonking industrywere lorgely stote owned, butwith few or no borriers impedingentq4 Novoes ond Werlong(1995) orgue thot i f bonks orestote owned then it is strotegi-colly optimol for the govern-ment to incur higher budgetdeficits ond finonce them usingthe bonks'funds, This ohenom-enon, the best exomple ofwhich is perhops Indio (Sorkor& Bhoumik 1995), leods tosevere liquidity constroints onbonks, thus preventing themfrom diversifying their porlfoliosond/or investing in profitobleprojects, The problem is usuollyoggrovoted by the foct thot inthe mojority of less developedono emergrng economreswelfore considerotions forcestote owned bonks to invest inpriority sectors, much of thiscredit beoring low interest rotesond being non-recoverobleINCR l99 l ) r2 , Hence, f inonc io liberolizotion ond the l ift ing ofentry borriers should perhops besupplemented by the privotizo-'ron of bonks (Sorkor & Bhoumik-ees) .

While the need for' tonciol restructuring is indisput-:ble, there is reoson to believe'-rot the process of reform.^culd be groduol, o view thot- :s goined importonce given--: debote which continues to;3e between the groduolists;^C the shock therooists in thell i context, lt is imoortonl to

note thot groduolism does notimply inoction (Coprio et ol,1993). Rother, it stresses theimportonce of toiloring thereforms so thoi they move instep with the institutions ondenvironments which need to bein ploce in order for thosereforms to succeed, As the crisisin the United Stotes, discussed inthe nexf section, hos high-lighted, restructuring is not o onestep process but rother odvnomic one which needs tomove in hormony with the times,

IV. HOW TO REGULATE IN THEPOST.REFORM ERA?: LESSONSFROM SOME INDUSTRIALIZED

COUNTRIES

fi s indicoted eorlier, the/-Wiobilifu of borrowers is

o vitol l ink in the tronsformotionof the finonciol sector In theobsence of orofitoble enter-prises ond vioble projects,morket oriented bonks mightrotion most ootentiol borrowersout of the morket, thus l imitingtheir own obility both to providemore credit ond to diversify theirporffolios (Jockimovo et ol,. l995,

Boldensperger & Dermine1987),lt would, however, beinteresting to control this foctorby toking into oc.count industriol-ized countries where there ore olorge number of vioble ondprofitoble firms, ond henceisolote policy issues in the post-tronsition slote of the economv,

The Sovings ond Loons(S&L) crisis in the United Stotes,together with the foilure of olorge number of bonks, hosroised the question os to howprivotely owned ond monogedbonks con be reguloted so os tominimize the possibil i ty of bonkfoilures, ond hence the cost tothe tox poyers. Rondol l (1993)ond CBO (1992) provide o

summorv of the events thotprecipitoted the crisis,

Ihe eorly 1980s sow thederegulotion of interest rotes inthe United Stotes, The emer-gence of money morket mutuolfunds dur ing the 1970s hodmode the morket for depositsmore competitive, As o conse-quence, the borrowing rote forbonks increosed, The rise ininf lot ion dur ing the 1970sougmented this increose ininterest rotes. However, mony ofthe bonk ossets were locked inlong term lower interest loons orbonds, The net vields for thebonks were, iherefore, low ond,in some coses, even negotive,At the some time, the oil boomin the Southwest ond the boomin Southern Colifornio during thel97Os led to o rosh of reolestote loons ond mony S&Lsheld obout 80% of their ossets inreol estote loons, With the croshof reol estote orices in thel9B0s, the bonks were leflholding o lorge number of non-performing loons, Hence,between the higher interest rotesond the non-performing loons,the bonks were focing severecosh flow oroblems,

It is ot this ooint thot themorol hozord problem becomeocute, Ihe bonks, desperote toeorn higher yields, investedmore ond more in risky ventures,The emergence of junk oondsdur ing the l9B0s, os mony f i rmschose to substitute equity fordebt, ond/or enter intoleveroged buy-outs, contributedto the increosed riskiness of theirporffolios. To moke mottersworse, the bonks volued theirossets of book prices rother thonmorket prices, thus hiding theproblem till the very lost mo-ment by which time it hodolreodv become ocute, The

.l2. In

.|99.|, Indion bonks hod to moinloin o vorioble reserve rolio ond stotulory legol reserves, the lotter to be held

c'mori ly in governmenl bonds, which, ol lhe morgin, omounfed lo 63,5% of the lolol reserves. Af lhe some t ime, Indionoonks hod to direcf oboul 4oo/o of their credit fo priority sectors. However, it is interesting to note lhot privote bonks, which,.' ere subject fo fhe some regulolions, were much more profiloble thon the molority of the nolionolized bonks.

Spring 96' EMERGO

consequence wos thot the USexperienced the insolvency,ond eventuolly the foilure, ofover 200 bonks, The post-crisisregulotory meosures olsoperhops left o lot to be desired,In the cose of the S&Ls, forexomple, the US Congressollowed thrifl orgonizotions toomortize their mortgoge lossesrother thon recognize the lossesimmediotely, thus ollowing theproblem to be postponed, ondperhops oggrovoted, rotherthon be el iminoted (ERP l99l ) ,

Con the oroblems ofmorol hozord ond odverseselection be eliminoted? As theJoponese bonking crisis indi-cotes, while o closely monitoredsystem might eliminote odverseselection to o lorge extent, theoroblem of morol hozord ispevosive so long os there is onimplicit or explicit guorontee bythe government thot bonks willnot be ollowed to go bonkrupt(Zysmon 1983, Dole 1992),

One of the most cruciolissues of stoke in the deoositinsuronce debote is whethersome bonks should be deemedtoo-big-to-foil, During theprevious crisis, the FDIC under-wrote not onlv the insureddeposits, those under USD100,000 in volue, but olso 68%of uninsured loons (GAO l99l) .The economic logic behind thisis perhops thot the potentiollosses orising from economicchoos ond loss of consumerconfidence, when lorgedeposits ore not repoyoble,exceed the short term benefitsresulting from the decreosedburden on the government ondthe tox poyers. However, this lineof orgument ensures thot defocto oll lorge bonks, thebonkruptcy of which might leodto finonciol ond economicinstobil ity, should be boiled outin the event of o finonciol crisis,This gives bonks the perverseincentive to expond ondbecome too-big-to-foil if they

funds to ,,ploy the morkef' ondspeculote on bonk borrowingrotes, But the resulting lorgedeposits ond withdrowols ployhovoc with the bolonce sheetsof the bonks, The oroblem isfurther oggrovoted il os in thecose of Jooon, bonks ond firmsore involved in the cross-ownershio of stocks, In such

reloted meosures would hove tobe underfoken under thedirection of some regulotorybody, However, if the finonciolsituotion of the bonk continuedto deteriorote ond copitol fellbelow 3"/" of its ossets/liobilities,the bonk would be forced tomerge or l iquidote, A cruciolissue thot needs to be od-

SUMON KUMAR BHAUMIK

ore in crises, Further, the de of its ossets/l iobil i t ies, furtherfocto insuronce of de jure exponsion of the bonk's octivit iesuninsured deposits ollows lorge would be holted, onddepositors such os pension recopitolizotion ond other

o situotion non-follible bonks dressed in this context is whetherbecome credit instruments of (ond how) the copitol require-industry, credit being on ments would (ond con) beinstrument to fos'rer industriol ond odiusted to be in hormonv witheconomic groMh, the risks orising out of off-

bolonce sheet octivit ies, OverIt is presently being the lost decode, off-bolonce

orgued by experts both within sheet octivities, os o key port ofond outside the bonking system o bonk's operotion, hovethot coinsuronce by lorge substontiolly increosed indepositors is perhops the best frequency ond volume, How-woy out of this problem (Rondoll ever, os Berger et ol, (1995)1993, ERP l99l ) , l f lorge hove pointed out, of f -boloncedepositors, together with the sheet octivities would, inbonks, hod to poy for insuronce equil ibrium, increose the copitolpremiums thot voried positively requirements of o bonk sincenot only with the omount of the they ossure ,,senior cloims" todeposits but olso with the the benefoctors of guoronteesriskiness of the bonks' porffolios, emonoting from such off-these lorge depositors would be bolonce sheet octivities,much more wil l ing to monitorthe bonks concerned, Such Simultoneouslv, efforts oremonitoring, together with being mode to omend regulo-legislotion which would force tions which currently restrict thebonks to disclose more informo- inter-stote ocouisition of bonkstion to their depositors, would by holding componies, ondperhops porliolly eliminote the efforts ore being mode to usherproblem of morol hozord, of in o system of universol bonking,leost in the cose of the lorge Indeed, the Gloss-Steogoll Act,depositors, which prohibited universol

bonking in the oftermoth of theRegulotoryorgonizoi ions GreotDepression, is increosingly

such os the Federol Reserve being questioned by econo-System ore olso deboting the mists os relevont to present-doypossibil iV of direct supervision, conditions (Kroszner & RojonUnder the proposed new 1994, Bentson 1994), The usuolregulotions, bonks would be orgument ogoinst universolforced to mointoin strict copitol- bonking is thot it would creoteosset rotios such thot the osseis i lorge bonks thot ore too-big{o-would be evoluoted of the foil ond would thus foster morolmorket price, ond the copitol I hozord problems, This orgumentrequirement would vory posi- is occomponied by the notiontivelv with the riskiness of the thot volotile ond underdevel-bonks' oorffolios. lf o bonk's I ooed finonciol morkets with

B vots, No.2

cooitol were to foll below l0% inodequote tools for supervision,

IN

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LIBERALIZATION vS REGULATION...

which is the cose in mostemerging countries os well os inGermony ond Jopon, mightleod to risk toking losses for bonkoorffolios thot would hovesignificont ond odverse budget-orv ono mocroeconomrceffects, This lotter hypothesis isbolstered by the recent fioscosexperienced by Borings ondDoiwo Bonk, Furfher, proponentsof the Act hove worned ogoinstthe donger of lorge universolbonks crowding out empiricollymore efficient stock morkets, oswell os other smoller f inonciolorgonizotions,

Indeed, both the US ondJopon, the two lorgest econo-mies in the world, hove thus forshown remorkoble similority intheir belief in the seoorotion oftroditionol bonking octivit ies, oswell os those divisions pertoiningto securities morkets, Suchpolicy thinking is perhops moresurprising in ihe Joponesecontext since the Securit ies ondExchonge Low ond the BonkingLow of Jopon ollow bonks tocross-own stocks, hove unlimitedoccess to the finonciol futuresmorkets, ond underloke trode infinonciol securit ies on beholf ofclients, In the US, on the otherhond, while cross-ownership ofstocks is prohibited, bonks oreollowed to deol in o wider rongeof securit ies thon their Jooonesecounterports, This is lorgely oconseouence of the foct thotsecurit ies houses in Jooon oreonly ollowed to deol directly withtrust bonks, Furfher. Jooonesebonks ore not ollowed tounderwrite corporote bonds ondSTOCKS,

Current opinion in bothcountries, however, is groduollyleoning towords some form ofuniversol bonking, This hos beenbrought obout lorgely byorguments fovouring economiesof scole ond scope, ond olso bythe historicol exoeriences of theUS ond Germony which suggestthot there is l i tt le or no emoiricol

support for the hypothesis thotuniversol bonking is inherentlymore risky, Indeed, olihoughJoponese bonks, which hodinvested heovilv in stock indexfutures, suffered huge porffoliolosses following the foll in theNikkei index, the bonking crisesthot occurred in both the US ondJopon ore primorily o conse-quence of bod credit ond o follin reol estote orices,

While Germony perhopsprovides the best exomple ofo success storv for universolbonking, it is importont to notethot the Germon cose is unioueond would be rother diff icult toemulote in emerging countries,It is often orgued, incorrectly,thot the Germon bonkingindustry is oligopolistic ondhence not comoetit ive, Inreolity, while Germon bonks orepowerful, they ore both hetero-geneous - being comprised ofcommerciol bonks, sovingsbonks ond their centrol giroinstitutions, os well os ogriculturolond commerciol credit cooo-erotives - ond distinctly competi-t ive (Zysmon 1983, Cox 1986,Dole 1992). Indeed, dur ing theI980s. these different kinds ofbonks begon to steodilyencrooch on eoch othersterritories, thus increosing thedegree ond intensity of compe-tition, The difference betweenGermonv ond other morketeconomies, however, l iesprimori! in the foct thot in theformer it is legolly possible foro bonk to own huge portions ofo compon/s stock, so long os,in occordonce with the Euro-peon Second Bonking Directive,individuol investments orelimited to l5%, ond overollinvestmenl Io 60%, of the bonk'scopitol, As o consequence, it isoossible for Germon bonks tomoinioin o strong presence ono firm's boord of directors, either

. in the form of their own repre-sentotives or by meons of proxyvotes, They thus hove monitoringpower which significontly

ritol

nering,\ t

reduces their morket risk, bothby providing them with informo-tion ond ollowing them toinfluence the decisions of f irms,Such o situotion is very difficult toemulote in other morketeconomies without significontchonges in the legol structuresof the lotter,

It hos been orgued bysome policy mokers thotperhops the simplest, yet mosteffective, solution lies in thedivision of bonks into monetoryservice comoonies ond finon-ciol service componies (Rondoll1993). The monetory sevicecomponies would deol only withtronsoction occounis thot oreinsured, However, the ossets ofthese componies would hove tomeet strict credit roting regulo-tions, forcing these componiesto hold only shorl term blue chipossets. The finonciol servicescomponies would occept olltypes of deposits, providecommerciol ond non-commer-ciol loons. ond invest in ossets oftheir choice, but would beuninsured, lt hos been orguedthot this meosure (which, inprinciple, wos proposed in 1990in the second interim reoort ofthe Second Finonciol SystemsCommittee of Jopon) wouldlorgely eliminote morol hozordproblems, ond ensure the freeflow of finonciol tronsoctionswhich is essentiol for economicgrowth, Bonks would oct os onumbrello orgonizotion for thesetwo Vpes of componies, ondthe some employees wouldhondle both types of ossets ondoccounts, The key is thotmonetory service componiesshould not lend money to theother oorts of the umbrelloorgonizotion, nor be responsiblefor ony debts of the lotter,

While the oforementionedpolicies otfempt to reduce themorol hozord problems which, itis believed, ployed o mojor rolein the bonking crisis in the US,others simply ottempt to

Spring 96' EM ERGO

minimize the losses to thegovernment ond the toxpoyers,It hos been suggested, forexomple, thot the bonks' ossetsbe sold in the securities morket,perhops over the counter, ossubordinoted debts or oossthrough securities, lt is hopedthot the risk toking investorswould then more effectivelymonitor the octivities of thebonks, Similorly, orguments hovebeen mode in fovour ofollowing bonks to trode in non-performing loons in the securit iesmorket rother thon exercisingtheir implicit,,puf' option with theFDIC, In this event, it hos beenorgued, cosh rich bonksinterested in loons with long termgroMh potentiol, even if theyore of present non-performing,might purchose these non-performing loons, ond hencethe,,puf'option, from the coshhungry bonk, thus ollevioting thepressure on the FDIC (Rosengren& Simons 1992),

V. CONCLUSION

Tt . globolizotion of theI economy, through

increosed trode in goods ondservices, os well os internotionolcopitol investments, hosenhonced the importonce ofthe finonciol/bonking sector ineconomic policy, Interestingly,while the former sociolist ond/orolonned economies orefocusing on the deregulotionond liberolizotion of the finon-ciol/bonking sector, morketeconomies, os exemplif ied bythe US, ore ottempting toregulote this oreo, ls there oporodox in these seeminglypolor opposite opprooches?

We must note thot morketeconomies ore efficient. withrespect to resource ollocotion,only to the extent thot they oresubject to the proper incentives,Given the frequent conflict ofinterests between o bonk'smonogement ond its deposi-tors, os well os between com-merciol ond finonciol orgonizo-tions, it is perfectly feosible thotincentives moy toke perverseforms os the problems of morolhozord ond odverse selectionbecome opporent. Moreover,given the existence of osymmet-ric informotion ond incompletemorkets, loissez foire might wellbe o sub-optimol policyprescription, Hence the need forfine-tuning the incentives tomotch the prevoil ing conditions,ond for vigilonce on the port ofthe government, Morket bosedincentives ond regulotions oreinseporoble in thot they supple-ment eoch other in the complexdynomics of todoy's economies,The chollenge before theemerging economies is not onlyto be oble to time the policies,but olso to find the rioht mixbetween the two,

Whot svstem, however,might be construed os oreosonoble porodigm for thenewly emerging morkets ofCentrol ond Eostern Europe?These economies, especiollythose in Eostern Eurooe ond theformer Soviet Union, ore morkedby deindustriolizotion, ond highlyunderdeveloped copitolmorkets, In other words, bonkscould ond should ploy o mojorrole in these economies, of leostin the short to medium run, bvproviding credit to industry ondmobilizing finonciol resources,

l o Vol.3, No.2

SUMON KUMAR BHAUMIK

At the some time, however,investment in these economies,in the form of credit or otherwise,continues to be riskv owino notonlv to unstoblemocroeconomic conditions butolso to the severe osymmetry ofinformotion between investors/creditors ond the monogementof f irms, ono oersisting firm levelogency problems Hence, theobil i ly of bonks to monitor theoctivit ies of debtor f irms os-sumes poro-nourlt importonce,The opproor ore bonkingfromework for these economies,iherefore, s kerv 'o oe onesimi lor to the Germon systemwhich ollows l|^re ciose monitor-ing of f irms ov oo'r(s To oe sure,the HousbonK svstem is for frombeing perfect os , 'orovidesbonks with quosi-monopol ist iccontrol over firms Holever, thisis l ikely to be o short to mediumterm problen- os r tre longrun, f irms ore lrkely to hoveoccess to olternot ve forms ofinvestible funds os tney becomemore orofitoble fond hencehove ovoi loble internol funds)^ ^ / ' { ^ l ^ ^ a n n n n i 4uru urso us cuprrol morKeTSdevelop over time Arguobly,none of the exist ing bonkingsvstems ore perfect, ond orechonging ond improvingcontinuolly os weoker l inksbecome increosingly evident,Hence, given thot the US,Germon ond Joponese systemsore provrng rncreostngly moreeffeciive thon their counteroortsunder specific conditions, theissue is cleorly one of oppropri-oteness, The chollenge focingthe governments remoins theformulotion of regulotions thotwould moke the oppropriotesystem most effective ondefficient.

LIBERALIZATION vs RECULATION."

V

FIGURE

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EMERGO l lSpring 96'

SUMON KUMAR BHAUMIK

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