Bank Regulation and the Network Paradigm: Policy Implications for Developing and Transition Economies

findings Curretit issues in banking policy range from the need to Theoreticians note that banking increasingly displays construct basic institutions aTnd incentive structures in network characteristics that, on the one hand, may call transition econonmiesto the challenges posed by the for corrective action but that, on the other, make policy increasingly complex interactions involved in intervention ineffective or counterproductive.For one contcnporary banking.thing, networks are susceptible to externalities, FHonohan and Vittas outline the basic regulatory redundancy (ensuring that flows cannot be obstricted by tramework needed to reduce bank failures.Without blocking just one path), and a tendency to adapt to measures that ensure risk diversification and adequate disturbances in a complex manner.Regulation is capital reserves, for example, you get bank failures, as justified, but the complexity of the network makes recent experience shows.successful interventions hard to design.Dissatisfactioni witlh the diminishing effectiveness of Supervision has a role, and Honohan and Vittas posrmar banking regulation led to substantial outline the basic regulatory measures needed.But the deregulation.Betore adjusting to deregulation, bankers blurring of boundaries between banking and the rest of seemed vulnerable to a contagious euphoria, often the financial network has placed an upper bound on the manifested in overlending to property developers.Given effectiveness of supervision.So, a degree of modesty is the historic recurrence of carbon-copy banking failures, appropriate in designing banking policy.We have to put cLearly private ecarning will not end all bank failure.And up with bank failures (mitigated by deposit insurance to the disappointing performance of both regulated and protect small savers) but, they argue, partly because of unregulated tinancial sectors leaves a vacuum that network redundancy, the social cost of bank failure is not theorcticians have beeni trving ro fill.as high as is sometimes thought.Til's paper -a product of the tFinancial Sector Development Department -was an invited paper for the World Congress of rhe Internatiopal Economic Association, held in T unis, December 1995.Copies of this paper are available free from the W/oi Id Bmnk, I x 18 H Street NW, Washington DC 20433.Please contact Priscilla Infante, room G8-1i15, telephone 202-473-7 642, fax 2)0-522-3199, Internet address pinfante( ;worldbank.org.August 1996.