Liberalization Stock Adjustment Versus Steady State

Many financial crises have been associated with changes in the regulatory regime and a process of liberalization. For decades, the economies of South East Asia were highly regulated with interest rate ceilings, limitations on lending growth by financial institutions, restrictions on foreign entry into the banking system and so on. At various times during the 1990s, these restrictions were relaxed, and the pace of financial liberalization accelerated.

Williamson and Mahar (1998) show that almost all of their sample of 34 economies (both industrialized and developing) that undertook financial liberalization over the 1980s and 1990s experienced varying degrees of financial crisis. Similarly, Kaminsky and Reinhart (1998) found that in the majority of cases in their sample of countries that had experienced banking crises, the financial sector had been liberalized during the previous five years. They conclude that financial liberalization helps predict banking crises across a range of countries. Goldstein and Folkerts-Landau (1993) observe a general pattern of deregulation inducing more competition being followed by increasing financial fragility.

Demirguc-Kunt and Detragiache (1998) find that financial liberalization increases the probability of a banking crisis. However, they also find that the probability is reduced the stronger are the institutional preconditions for liberalization and market discipline in terms of contract enforcement, lack of corruption, bureaucratic interference in lending decisions and so on. This reinforces the established wisdom that liberalization involves a significant change in the market environment and that, for the new regime to be stable and efficient, certain basic prerequisites of a well-functioning market system need to be in place. The key is that institutional structures and mechanisms need to be consistent with the prevailing market regime. Problems arise when a change to the market regime is made without there also being corresponding changes in institutional mechanisms.

While in both developed and less-developed countries banking distress has often followed periods of deregulation and liberalization, a distinction needs to be made between the transitional effect of moving from one regulatory regime to another, and the characteristics of a steady-state liberalized financial system. The instabilities that may occur in the transition period do not necessarily carry over into the new steady state.

Financial End Game

Financial End Game

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