ntil recently, macroeconomists paid comparatively little attention to banks and other financial institutions. The analysis of monetary policy has tended to rely on the study of interest rates, credit availability, and government policy. The unique role of banks as a link between monetary authorities and the economy was often overlooked. However, today, in developing countries and emerging markets, financial intermediation by banks and the existence of sound domestic financial institutions are accepted as necessary conditions for economic growth.

The greater appreciation of the role of banks is partially due to the transition economies of Eastern Europe and the former Soviet Union. After all, Soviet-era planned economies did not have modern banking sectors. Eastern bloc banks were merely payment agents for government bureaucracies. As a result, the transformation of the various state mono-banking systems into systems composed of a central bank and commercial banks was frequently one of the first steps of modernization. Indeed, in countries such as Hungary and, more recently, China, the transformation started before political liberalization.

Since banks were established before other economic reforms or structural changes were enacted, they continued to function as sources of credit to state-owned enterprises. As a result, these newly established banks did not develop lending skills, easily became overextended, and had to be recapitalized. The existence of weak banks, which were backed by central banks and sometimes aided by international financial institutions, led to resource misallocations. Specifically, banks failed to develop risk management skills because they expected the central bank and the international community to be a lender of last resort.

The failures of many of these banks led to increased focus on efforts to design and implement appropriate regulatory structures. As a result, it is now generally accepted that sound domestic market-oriented financial institutions will enhance the stability of the international financial system. Such banking systems, however, must meet three essential criteria: (1) independence from political influence with or without private ownership; (2) market competition or at least contestability; and (3) credible and effective regulation.

Independence. In more than a few countries, many banks are private in name only. Extensive government ownership is common. Even where banks are privately owned, government-bank links are frequently very strong. Moreover, foreign ownership of banks or allowing foreign participation in the financial services industry is often proscribed. Such insulation from international markets is a destabilizing influence, and the lack of independence from the state deters sound banking.

Privatization is usually viewed as the way to create market-oriented banking sectors in transition economies. Indeed, market-oriented banking requires the state to disengage from direct governance of banks (whether they are state-owned or privatized) and to develop an effective regulatory framework for the banking sector. Governments thus face the tricky maneuver of simultaneously getting out of the banking business and getting into the regulatory/supervisory business.

Managing these two seemingly contradictory tasks is often difficult. Successful regulatory policy requires the state to assume an arms-length role as banking sector regulator and supervisor without any direct involvement in the conduct of the banking business – even if it remains a passive shareholder in certain institutions.

n independent banking sector also requires entities that are independent of control by insiders. The inherited legacies of planning mechanisms (in transition economies) or economic oligarchies (in many non-democratic developing economies) encourage a continuation of directed credit allocation that is not based entirely on strict commercial conditions. For example, the Czech banks continue to support large firms with massive loans and Indonesian banks were responsible for the diversion of assets to the President’s family. Interlocking arrangements between bank insiders and clients often result in excessive accumulation of bad debt in hostage-like situations. Due to a combination of political interference and a lack of expertise, bank personnel are often incapable of and unwilling to monitor company behavior. An independent bank is able to shed its unprofitable customers without state interference or the influence of managers.

Competition. The second element of market-oriented banking is competition or contestability. Competition can be introduced by easing the entry of new entities into the local banking scene. However, an increase in the number of banks is problematic for at least three reasons. First, the creation of a bunch of inefficient and poorly capitalized banking institutions may not improve the efficiency of financial intermediation. Second, poorly capitalized banks that undertake risky activities have systemic implications. Third, since bank licensing is often subject to political influences, the managers and owners of new domestic banks are often poorly chosen.

Competition in banking does not require a large number of banks. Many countries (both small and large) have relatively few banking institutions. The situation in the U.S. – with thousands of banks – is the exception and not the rule. In other countries, competitive pressures come from the structure of the financial system generally and the extent to which other non-bank financial institutions compete with the banks.

The possibility of the entry of foreign banks and the provision of banking services by other institutions make the financial services market contestable. Contestability can lead banks in even a highly concentrated, seemingly protected market to operate as they would under pure competition. And it can create a competitive framework for banking without increasing systemic risks.

Effective regulation. The third element of an independent banking system is an effective bank regulatory structure. The regulatory structure must remain independent of any residual state involvement in the banking business; the credibility of bank supervisors and regulators must be unquestioned. This is not a simple matter of putting legislation and bureaucracies in place. Rather, it entails the development of institutions that can provide credible regulatory threats to the banks.

There is no clearly appropriate design for bank regulatory structures. The mechanism can be run by the Finance Ministry, a central bank, or by some other entity. Where it is located is less important than how it operates.

ecent large country experiences have illustrated the importance of these issues. In the United States, an inadequate regulatory structure was not, in all likelihood, responsible for the crisis in the thrift industry in the 1980s. However, the inadequacies of the regulatory response probably aggravated the crisis. A similar argument can be made regarding the ongoing crisis in Japanese banking. Although a regulatory structure is in place, it has not responded in a sufficiently timely fashion.

A regulatory structure that responds quickly is an important tool in avoiding the international exposure of both banks and firms with excessive risks. The Asian crisis of 1997 showed clearly that international financial stability is threatened when both domestic and foreign institutions rely on lender of last resort promises and inadequate supervision. These experiences suggest that conventional forms of bank supervision may not be able to stem bank failures in all situations.

The regulatory framework should not serve as a substitute for the salutary effects of market discipline but as a complement to it. In New Zealand, regulatory authorities are introducing a system where conventional bank regulation will be augmented by market discipline. The government will not provide deposit insurance and banks will be required to publish information on their condition regularly. We are likely to see other countries experimenting with such market-based regulatory mechanisms.

International standards for regulatory oversight are important because central banks can sometimes find themselves with conflicting goals. For example, the central bank may be reluctant to take regulatory actions that might lead to increased demand for central bank loans if, at the same time, macroeconomic policy dictates that it tighten the money supply.

And if the central bank does not provide liquidity to a troubled banking institution, another regulatory structure must be in place to oversee the troubled institution’s needs. That is, there needs to be an independent regulator, such as a powerful deposit insurance agency, that can either close down or sustain failed banks.

Since it is almost impossible to envision a deposit insurance fund that is sufficiently well capitalized to provide insurance against all risks, the deposit insurance agency should have sufficient power to minimize the calls on the insurance funds. Thus, the deposit insurance agency should also have extensive regulatory powers over banks.

he rules regarding the deposit insurance scheme should be as transparent as possible and should be uniformly and consistently applied. Any deviation from specified rules will create the expectation that the government is willing to guarantee the continued existence of banks. The efficacy of bank regulation is undercut when all the players – bankers and government officials alike – believe that the government will provide support in the event of any bank failure.

Coordination of regulatory authority is particularly important when banks may be viewed as being too big to fail. In such instances, regulatory action must be timely because closing the bank with or without deposit insurance guarantees may be impossible for any of several reasons.

n some cases, bank closure may simply be politically unfeasible. Or regulators may fear systemic economic consequences. If closure is precluded, then effective regulation takes the form of examining and disciplining the bank’s activities. Regulators should have a clear understanding of the types of sanctions – a forced sale, merger, recapitalization, or limits on activities – that can be applied to a troubled bank prior to closure and they should be applied promptly.

In many countries, authorities are beginning to recognize the need to ensure independence, contestability, and credible regulation in domestic financial services. Sound banking is a necessary complement to the sound fiscal and monetary policies that have been the focus of macroeconomists in the past.

Frequently, the introduction of foreign banks or foreign owners has helped push the development of sound banking forward. Nevertheless, there is still a persistent and puzzling resistance to foreign entry.

Countries as disparate as Brazil, France, and Poland have been loath to let the national financial system become subject to foreign influence. And foreign ownership of the banks seems to convey the appearance of foreign control. But there are many fundamental reasons why foreign strategic investors are important to the banking industry. Even when foreign banks enter with little capital at risk, they are placing their international reputational capital at risk. Foreign ownership helps clarify private sector control that is independent of the government. Foreign banks are able to transfer modern banking technology easily. And such ownership reduces the potential for politicization of bank lending and increases the international integration of financial markets.

Most importantly, foreign bank ownership may reduce the likelihood of financial crises. Indeed, it would have significantly reduced the seriousness of the recent financial crises in Asia. Making foreign investors – the bank owners in emerging markets – responsible for the consequences of their lending practices creates a disincentive for damaging speculative short-term financial flows. Foreign banking interest is a genuine market test of the value and soundness of domestic banks. So it is a useful signal when local financial markets are too thin or too small to draw such attention.

If we have learned anything from the cascading crises of the past five years, it is that traditional macroeconomic analysis of external sector fundamentals is not always an adequate indicator of vulnerability to exchange rate crises. Indeed, understanding the crucial role of banks and financial institutions should lead analysis into an incisive new direction. For in addition to the traditional macro fundamentals – inflation, growth, fiscal deficit, external debt, current account, and exchange rate – we must now monitor the new fundamentals that relate to the financial sector. These new fundamentals include the strength of the banking system, quality of bank supervision, exchange rate exposure of the financial sector, and the adequacy of the legal and financial infrastructure.

nderstanding and monitoring these new fundamentals may help ward off international financial crises, for domestic banking crises are more often than not precursors to exchange rate crises. An important implication of the relationship between financial fragility and international crises is that financial liberalization and the development of sound financial institutions and regulatory structure should be carefully sequenced.

In the end, the best protection against exchange rate crises may be a sound banking system. Moreover, the integration of financial systems that comes with open financial markets, international banking, and foreign bank ownership provides a clear incentive to maintain a sound banking system. Poor banking practices and poor banking regulation invite destabilizing capital flows and unsound financial decisions. A closed banking sector that is protected by government ownership or regulatory weaknesses leads to moral hazards. An independent and open financial system on the other hand will have self-interest in avoiding destabilizing transactions.

It is no surprise that international financial institutions like the International Monetary Fund have begun to pay more attention to the financial sectors in their regular country evaluations. As we strive to head off the next international financial crisis, it may be more important to evaluate the financial sector than to monitor traditional macroeconomic indicators.

More information can be found at: www.stern.nyu.edu/~pwachtel/research.htm

Paul Wachtel is research professor of economics at Stern.

This article is based on a paper delivered to: The International Monetary System: Current Situation, Perspectives and Reform Proposals, A Conference in Memory of Rolf Mantel, Buenos Aires, Argentina, August 11-12, 1999.