Alternative Frameworks for Providing Financial Services

Abstract

The behavior of actors in financial systems depends crucially on the incentives that motivate them. The right regulation, supervision, and incentives - including the scope of permissible activities, degree of contestability, and extent of the safety net - for financial services can make the sector more resilient in the face of adverse shocks. Drawing on country experience, Claessens and Klingebiel analyze alternative frameworks for providing financial services.

Scope of permissible activities. The integrated banking model (commercial banking fully integrated with other financial services, including investment banking) benefits both financial institutions and consumers. Potential costs, such as extending the safety net to nondeposit financial services, can be mitigated with safeguards and firewalls, which require regulatory enforcement and monitoring. Internationally, countries are moving toward the integrated model. The wider scope of services appears to improve financial stability and mitigate the risk of a banking crisis.

Degree of competitiveness and contestability (openness to competition). Competitiveness need not require many financial institutions; a concentrated system can be competitive if contestable. Allowing the liberal entry of foreign banks lowers the franchise value of (domestic) institutions, but the evidence suggests that on balance foreign entry provides important benefits. Systems should not be overcompetitive, however. They should allow enough franchise value that future profits give institutions an incentive to behave prudently.

Design of safety net. The design of the safety net is important in the tradeoff between ensuring the safety and soundness of financial institutions and allocating resources efficiently. A well-functioning safety net minimizes regulatory forbearance and gives banks incentives to act prudently. Owners of financial institutions behave more prudently if they have much at risk, in the form of capital, future expected profits, or their own jobs.

The wrong safety net, especially the wrong deposit insurance, entails great moral hazard. Large deposit holders are more likely to provide market discipline if they are not covered by deposit insurance (explicit or implicit), if disclosure is extensive, and if the accounting framework is adequate.

Supervision. Best international practice suggests that supervision of the financial conglomerate should probably be consolidated in one agency. Supervisors should have incentives both to monitor and to take appropriate action. Supervisory salaries should be sufficient, relative to those in the private sector, to attract and retain competent and motivated staff.

This paper - a product of the Financial Sector Strategy and Policy Group - is part of a larger effort in the group to study the importance of the financial sector framework for the stability, efficiency, and accessibility of financial services. The authors may be contacted at [e-mail] or [e-mail].