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

This paper emphasizes the need to establish basic mechanisms and incentive structures in changing and developing economies, so as to prevent extreme financial sector failures as witnessed in the countries of central Asia and African-franc zone. It presents an institutional framework comprising:

• Autonomous central banks;
• Profit-oriented commercial banks having clear ownership and control structures;
• Enforceability of financial contracts.

The paper traces the following root-causes for successive waves of bank failure in both developing and industrial countries, especially since deregulation:

• Environmental causes beyond the control of policy makers such as prolonged international economic recession and the collapse of a major country or region;
• Policy failures at the macro and the micro levels;
• Improper banking operations such as imprudent lending, abusive self lending and fraudulent behavior.

The financial sector reflects a complex set of interacting networks which have implications in designing policy for soundness, effectiveness and fairness of banking systems. It has the following network characteristics:

• Externalities which call for corrective actions;
• Redundancies which makes it robust to partial failures;
• Disturbances which makes it difficult to gauge the effect of interventions.