• Financial liberalisation

Financial liberalisation

This paper investigates the importance of the quality of prudential supervision during financial liberalisation and its implications for the level of minimum capital requirements. In particular the paper highlights the trade-off between the quality of supervision and the level of minimum capital requirements.

The paper makes the points that:

• prior to liberalisation, there is often little need for prudential supervision: interest rates and credit allocation are under direct government control
• when liberalisation occurs, bank competition and the sophistication of financial instruments both increase
• to keep up with these developments, supervisory agencies need to redirect their efforts toward more sophisticated, risk-based supervision
• capital requirements are a readily available tool to combat excessive risk-taking during liberalisation, but these are often applied without taking into account country specifics such as quality of control.

The author finds that:

• if the supervisory authorities are ineffective during financial liberalisation, competition reduces the franchise value of banks and may entail costs for governments and depositors
• if prudential supervision is weak, capital requirements should be set at higher levels than those designed for more developed supervisory capacities
• strengthening prudential supervision can help avoid financial crises during financial liberalisation.

It makes the policy recommendations that:

• the minimum capital requirements should not be applied uniformly, but need to be adjusted to compensate for extra risks associated with poor quality supervision
• when implementing minimum capital requirements along the lines of the Basel Accord, economies with poor quality supervision need to be treated as special cases
• because liberalisation reduces the franchise value of banks, risk-taking can be more attractive, and therefore supervisors need to be particularly skillful and vigilant
• a numerical analysis should be undertaken to assess whether the implied capital requirements are not be excessively high and thus inapplicable in practice for countries with particularly low quality supervision
• a link should be developed from the microeconomic analysis to the macroeconomic effects.

[adapted from author]

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