This chapter reviews the experience of five developing countries in liberalizing their financial systems and summarizes the factors that contribute to successful financial liberalizations. Two broad questions are addressed: Are there specific components of financial sector reforms best implemented at specific stages of a broader stabilization-cum-reform program? Is there an appropriate sequencing of various detailed components of financial sector reforms?

This chapter reviews the experience of five developing countries in liberalizing their financial systems and summarizes the factors that contribute to successful financial liberalizations. Two broad questions are addressed: Are there specific components of financial sector reforms best implemented at specific stages of a broader stabilization-cum-reform program? Is there an appropriate sequencing of various detailed components of financial sector reforms?

The analysis considers several components of financial sector reform, namely: reforms of the interest rate regime; the development of money markets and market-based monetary control procedures; reforms of prudential regulations and supervisory systems; recapitalization and restructuring of weak financial institutions; measures to strengthen competition among banks; reform of selective credit regulations; the development of long-term capital markets; and legislative reforms.

The study examines financial sector reform in Argentina (1976-81), Chile (1974-80), Indonesia (1983-90), Korea (1980-88), and the Philippines (1980-84). Conditions prior to embarking on economic and financial reforms ranged from severe financial repression, distortion in prices, and economic imbalances (for example, in Argentina), to more progressive financial sectors and smaller economic and structural distortions (for example, in some of the Asian economies). In all the countries the activities of financial institutions were tightly controlled prior to the financial reforms, with a high degree of policy-induced segmentation between different types of financial institutions.

In presenting the individual country experiences we have sought to standardize data presentation and to develop some key indicators. Inevitably, with data drawn from many different sources, series are not fully comparable across different countries. The table in Appendix I provides a detailed description of the data. Appendix II provides the statistical tables. The indicators of financial sector development include various measures of private financial assets: currency, M2, M3, and private financial assets. M2 is defined as currency in circulation plus deposit liabilities of the banking system. M3 is defined as M2 plus deposit liabilities with nonbank financial institutions. Private financial assets, the broadest measure of liquidity presented, is defined as M3 plus identified holdings of other financial assets by the private sector, such as treasury bills, and central bank bills where they exist. The relative movements in these aggregates are indicative of portfolio shifts within the financial sector, while their growth rates and the trends in their ratios to GDP are indicative of economic monetization and the development of financial markets.

The amount of credit provided by financial institutions to the private sector—an indicator of the development of financial sector intermediation—and by the central bank to financial institutions—an indicator of the extent of official involvement in the operations of financial institutions—is also analyzed. When the central bank provides a larger part of the funding for credit to the private sector, the credit allocation decisions of the central bank—through its refinancing and rediscount policies—necessarily have a strong influence on private credit allocation decisions regardless of whether there are explicit controls.

The growth of financial institution credit to the private sector relative to the growth of private deposits with financial institutions is an indicator of the change in the use and mobilization of domestic financial resources from the private sector. A more rapid growth of credit to the private sector than of private sector deposits could signify pressures on domestic resources, which would worsen the balance of payments unless offset by a reduction in the fiscal deficit or larger capital inflows.

Other indicators include real interest rates, GDP growth rates, number and types of financial institutions, gross lending margins, international interest rate differentials, and excess bank reserves. For those countries that have faced a financial crisis, selected indicators of these crises are also shown.

Country Experiences with Financial Sector Reform

The presentations for each country describe the prereform financial structure and the broad economic circumstances that were associated with the financial reforms. The financial sector reform measures and their sequencing are then presented. This is followed by an examination of the consequences of reforms using the above-mentioned indicators. Finally, a number of broad conclusions are drawn from each country’s experience.

Comparative indicators from the five countries and the lessons from their different liberalization experiences are further examined in the final section. In particular, structural linkages among specific components of financial sector reforms are examined, as is the impact of reforms on key financial variables of macroeconomic significance. Conclusions are drawn about the appropriate sequencing of specific financial sector reforms.


Argentina’s economic problems had a long history and can be traced to inward-looking economic policies characterized by tariff protection, policy-induced transfers from the agricultural to the industrial sectors, and central control over the allocation of resources that began in the mid-1930s.

Prereform: 1974-76

The Argentinean economy of the mid-1970s was characterized by distortions in relative prices, a highly disorganized and repressed financial system, multiple exchange rates, and restricted international capital flows. GDP growth was negative in 1975 and 1976; inflation increased to as high as 443 percent in 1976; the fiscal deficit reached 12.5 percent of GDP that same year; and balance of payments pressures also increased.

Argentina’s financial sector was severely repressed and dominated by commercial banks (see Appendix II, Tables 3.9 and 3.10). The numerous nonbanks were mostly very small. Government ownership—federal, state, and municipal—of banks and other financial institutions was substantial (as measured by the number of branches of government-owned financial institutions) and the financial structure was constrained by strict central bank approval requirements for new banks and for the opening and closing of branches.

The Deposit Nationalization Law of 1973 forced banks to deposit all financial savings with the central bank, in effect creating a 100 percent reserve requirement. Banks could only lend from their capital and reserves, and from access to central bank funds, mainly in the form of selective and subsidized credit to priority sectors. Interest rates on bank deposits and loans were set by the monetary authorities, as were their fees and commissions.

As a result of the controls, real interest rates became increasingly negative between 1974 and 1976 (see Appendix II, Table 3.11), and financial savings through banks and financial institutions declined in real terms, and as a percentage of total financial sector liabilities. An informal money market, based mostly on enterprise promissory notes, expanded rapidly; the size of this market in 1976 was estimated at 40 percent of the interest-bearing deposits of the banking system (Fernandez, 1985). The ratio of currency to deposits was very high and the ratios of M2 and M3 to GDP fell sharply. Only about half of the private savings was monetized by commercial banks (see Appendix II, Table 3.10), and credit extended by financial institutions to the private sector fell in real terms (on average by 17 percent a year during 1974-76), reflecting the decline in central bank credit to financial institutions, and declines in the real value of financial institutions’ capital.1 Central bank resources were increasingly directed to finance public deficits, and between 1974-76 an average of 68 percent of the fiscal deficit was financed by the central bank.

Financial sector reform: 1977-80

In the context of an economic adjustment program aimed at curbing inflation, limiting the economic role of the government, and promoting the international integration of the economy (through the reduction of tariffs and exchange controls), the Argentinean authorities introduced a range of measures to reform the financial system. Table 3.1 summarizes the main measures and the sequencing of the financial reforms.

Table 3.1

Argentina: Sequence of Financial Reform

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The liberalization of interest rates commenced in 1976 when interest rates on certificates of deposit (CDs) were freed. This was followed in 1977 by a major financial sector liberalization and reform of monetary control instruments. In 1977, all bank deposit and loan rates were liberalized, the controls on bank credit were removed, the 100 percent reserve requirement was reduced (initially to 45 percent and then lowered progressively to 10 percent by 1980), and interest was paid on required reserves held against time deposits through a newly established Interest Equalization Fund. Selective credit practices were abandoned (except for export-oriented loans), and selective rediscounts were replaced with a single discount window with the discount rate set at a penalty level compared with market rates.2 Treasury bills, which had been available on tap at predetermined interest rates, were auctioned with the aim of managing financial sector liquidity. Because of the effects on liquidity distribution of the change in the reserve requirement and rediscount policy, transitional arrangements included special temporary rediscount lines for some banks and special deposit requirements with the central bank for some other banks.

Concurrent with the financial liberalization, new prudential regulations were instituted. These included changes in the definition of minimum capital requirements; maximum ratios of assets and liabilities to total capital and reserves; and limits on loans to any single borrower in terms of both the borrower’s and the lender’s capital and reserves. The minimum requirements for opening new bank branches were eased and the need for prior central bank approval was eliminated. Also, new regulations facilitated the establishment of new financial institutions and the restructuring of old ones. Later, in 1979, the deposit insurance scheme was reformed. Full insurance coverage was removed from all but the smallest deposits, the maximum amount of insured deposits was indexed, insurance premiums were set (previously the central bank sustained the total cost), and foreign exchange deposit insurance was completely eliminated. (The maximum amount was adjusted retroactively following the onset of the financial crisis; see below.) In 1981, financial institution supervision was reorganized through the introduction of new accounting, auditing, and reporting standards, and the responsible department of the central bank was reorganized.

Effects of financial sector reforms: 1977-80

First, the reforms did not have a major effect on financial sector efficiency. Although the reforms were associated with some restructuring in terms of liquidations, mergers, and reorganizations, they resulted in increasing concentration in the financial sector and did not result in significant improvement in financial sector competition or efficiency.3 Banks’ administrative costs remained high, averaging about 8 percent of total loans, and the differential between deposit and lending rates widened following the liberalization. Although the differential narrowed subsequently—partly in response to the progressive reduction in required reserve ratios—it generally remained above its prereform level (see Appendix II, Table 3.11). Also, the capital markets were not developed as part of the reforms, and the number of companies traded, along with their capitalization, on the Buenos Aires stock exchange fell after the reforms (see Appendix II, Table 3.9). In addition to these factors, the government continued to rely on the banking system for financing purposes (see Appendix II, Table 3.12) so that the real stock of government securities outstanding did not increase.

Second, there was a shift in monetary and credit aggregates. The liberalization of bank deposit rates encouraged a shift out of currency into bank deposits, and the currency to deposit ratio fell sharply, as the ratio of broad money to GDP increased (Appendix II, Table 3.10). The growth of bank credit to the private sector increased and was considerably higher than the growth of private sector bank deposits, and the ratio of private savings to GDP fell as a result. The rapid credit expansion and slower increase in deposits in part reflected the negative real interest rates during the initial period of the reforms (the dynamics of deposit and credit growth following liberalization are discussed later in the chapter).

Third, real deposit and lending rates subsequently rose sharply from the highly negative prereform levels (see Appendix II, Table 3.11). Beginning in 1978, the authorities had tried to reduce inflation by posting a devaluation schedule (tablita) for the exchange rate that lagged behind the general price increases. The success of such a policy required credibility and monetary and fiscal discipline, but ambiguities surrounded the tablita, weakening its credibility.4 Fiscal deficits were large and growing, and averaged 12.8 percent of GDP between 1978-82, and monetary financing of the deficits was inconsistent with the preannounced rates of devaluation. The ensuing inflation, which averaged 153 percent in 1977-80, appreciated the real exchange rate by 64 percent between 1977 and 1980, fueled expectations of a breakdown of the tablita, and contributed to the sharp rise in real interest rates in 1981. The tablita was abandoned in 1982. The real sector’s health was damaged by the appreciation in the exchange rate and the sharp increase in real interest rates.

Domestic deposit and loan rates also rose substantially above U.S. dollar interest rates, after adjusting for the actual devaluation of the exchange rate. Although capital movements into and out of Argentina were gradually liberalized, remaining restrictions constrained the scope for international interest rate arbitrage and allowed the domestic-international interest differentials to persist.5 The remaining exchange controls also protected the inefficient domestic financial system.

Fourth, the initial rapid expansion in bank loan portfolios exposed banks to increasing risks and, combined with the rise in nominal interest rates, resulted in a sharp increase in problem loans (see Appendix II, Table 3.13). Business enterprises’ debt to equity ratios also rose with the freer access to bank credit, increasing their vulnerability to a rise in real interest rates. When real interest rates rose in 1981, the result was a sharp increase in distress borrowing.

Financial sector crisis

In March 1980 a major bank failed. The ensuing reshuffling of bank deposits to banks perceived as safer and the drying up of the interbank market placed serious strains on the financial system. By May 1980, the government was forced to intervene in three additional institutions, and by March 1981, it had liquidated a total of 62 financial institutions, holding approximately 20 percent of the country’s total deposits.

The financial sector crisis reflected a number of factors. While the prudential regulations instituted in 1977 were fairly comprehensive, their implementation and subsequent bank supervision were inadequate (for a more detailed discussion, see Baliño, 1987). Only in 1981, four years after the financial reforms were initiated, was the supervisory system strengthened. In the interim, bank supervision had weakened. For example, the central bank inspections of financial institutions had fallen to only 10 percent from 23 percent before the financial reforms—and the share of problem loans in bank portfolios had increased fivefold. Comprehensive official deposit guarantees and the associated moral hazard problems further exacerbated the deficiencies in bank supervision. In 1979 the comprehensive deposit guarantees were replaced with partial guarantees.6 The moral hazard problem became more acute in the early 1980s, since the financial institutions, which eventually failed, had begun offering the highest deposit rates to mobilize resources so as to meet their customers’ distressed borrowing requirements and interest payments on deposits.

In the aftermath of the financial crisis, the authorities completely reversed the liberalization measures in 1982, with the aim of redistributing wealth from depositors to borrowers through sharply negative interest rates. Interest rates on most deposits were re-regulated, the 100 percent reserve requirement was reintroduced on most deposits, and the central bank became the major source of funds to the financial sector through its rediscount policy.7 As a result, there was a complete reversal of the financial deepening trends established during financial liberalization, real interest rates became highly negative, and gross margins between deposit and lending rates widened.8


The financial reforms in Argentina for the years 1977-80 illustrate the risks of financial sector liberalization when other structural and macroeconomic policies are inadequate to support the liberalization. Unfortunately, the reforms did not sufficiently promote competition within the financial system, and largely resulted in a reshuffling of existing institutions and ownerships rather than a fundamental reorganization. New instruments and markets in securities were not part of the reform. Consequently, the financial system remained uncompetitive and underdeveloped, and borrowers continued to rely mainly on bank borrowing rather than on equity financing. Also, prudential controls were not developed, while at the same time, deposits were guaranteed by the state. As a result, there were problems of moral hazard and credit allocation was ineffective, resulting in an increasingly poor quality of loan portfolios among banks.

Macroeconomic policy also contributed to the failure of the liberalization, where relaxed direct credit controls and initially low real interest rates allowed for a rapid expansion of bank credit. Concurrently, the government deficit was increasing, and gross domestic savings declined as a percent of GDP. In addition, the overvaluation of the exchange rate created by the tablita aggravated the external position and weakened the financial position of business enterprises. When monetary policy was eventually tightened in 1981, due to the loss of confidence in the exchange rate, it precipitated a financial crisis because of the weak position of banks and business enterprises.


Chile’s experiences with financial sector reforms between 1974 and 1981 provide another example of the risks of reforms when there is inadequate attention to the weaknesses in financial institutions and regulatory arrangements.

Prereform: 1970-73

The Chilean economy of the early 1970s was characterized by weak GDP growth, domestic and external imbalances, and extensive controls on trade, capital flows, and enterprises. In 1973, GDP fell by 5.6 percent, the fiscal deficit reached 21 percent of GDP, and the inflation rate was approximately 500 percent.

The prereform financial sector consisted of 20 government-owned domestic commercial banks, one foreign-owned commercial bank, and a limited number of nonbank financial intermediaries. The financial sector was highly regulated through interest rate ceilings, quantitative controls on banks, substantial directed credit, and restrictions on operations of financial institutions. Real interest rates were negative.

Reform and stabilization: 1974-81

The Chilean authorities followed programs of stabilization between 1974 and 1981. An initial effort at stabilization through reducing the fiscal deficit and restricting money supply growth coincided with major international shocks, particularly the decline in copper prices, and resulted in GDP contracting by 12.9 percent in 1975. Subsequently, the foreign exchange rate became the main anti-inflationary instrument, the fiscal deficit was gradually reduced until it showed a surplus in 1979, and monetary operations were used mainly for smoothing liquidity.9 Inflation declined from 212 percent in 1976 to 20 percent in 1981, and real GDP growth recovered; however, the real exchange rate appreciated, which brought into question the sustainability of the policy.10

Concurrent with the stabilization program, sweeping liberalization measures were enacted covering the spectrum of economic activities, including an opening of the current account and a gradual liberalization of the capital account between 1976 and 1982.11 These reforms had as objectives the international integration of the Chilean economy and the improvement of the price mechanism.

The main elements of the financial sector reform and their sequencing are summarized in Table 3.2. First, the measures included financial sector restructuring. In 1974, all but one of the 20 domestically owned commercial banks were privatized. The following year new regulations were introduced allowing the creation of new financial institutions; in 1976, the distinction between banks and nonbanks was removed and liberal rules allowed foreign banks to open numerous branches and purchase Chilean banks. In 1981 the distinction between commercial and development banks was abolished. Finally, during the period 1977-80, banks generally became freer to borrow abroad.12

Table 3.2

Chile: Sequence of Financial Reforms

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Measure rescinded.

Second, several measures were introduced relatively early to strengthen banking supervision and regulation as part of the financial reform. In 1974, minimum capital requirements were raised and penalties imposed for noncompliance, restrictions were placed on the concentration of bank ownership and bank disclosure, and reporting requirements were strengthened. Between 1974 and 1976 the jurisdiction of the supervisory authorities was widened to include all financial institutions, but important weaknesses in the supervisory and regulatory framework remained. The restrictions on concentration of bank ownership were difficult to enforce and were removed in 1978. Only in 1980-81, after the financial crisis had developed, were limits imposed on bank lending to interrelated and individual entities (including purchases of shares), and loan classification and provisioning rules established. Further measures to tighten bank supervision were subsequently approved in 1982 and in 1986.

Third, major reforms to monetary and interest rate policy were enacted. Initially, in 1974, interest rates on short-term capital market transactions outside the commercial banking sector were liberalized, followed a year later by the liberalization of commercial bank interest rates. In 1975, quantitative controls on bank credit were abolished and selective credits to priority sectors were greatly reduced. An indirect system of monetary control was implemented, based on auctions of central bank credits and treasury bills, and a reform of the central bank’s discount window. In 1976, interest was paid on required reserves. Subsequently, with the lowering of reserve requirements, and their unification across different financial institutions, the payment of interest on reserve requirements was phased out between 1977-80.13

Results of the reforms: 1975-81

The financial reforms resulted in an increase in the number of financial institutions (see Appendix II, Table 3.14). The number of commercial banks rose from 21 in 1974 to 41 in 1981; 17 of the new banks were foreign owned. The number of bank branches also increased substantially. The liberalization of short-term capital market interest rates in 1974 also resulted in an initial increase in a new kind of financial entity—financieras.

The financial restructuring, however, raised a number of problems. First, the privatization of the domestic banks was controversial. The regulations on the concentration of ownership were not enforced and were abandoned in 1978. As a result, banks were purchased by large conglomerates. The high concentration of ownership, together with the lack of regulation on bank loans to interrelated entities, and the absence of loan classification and provisioning requirements were major factors in the subsequent insolvency of financial institutions. Second, the financieras were less stringently supervised and regulated than commercial banks, and, in 1976, financieras faced increasing difficulties and eight failed. Only thereafter did the supervisory authorities institute a formal approval procedure for financial institutions or individuals receiving deposits from the public. Accounting procedures for financieras were tightened and capital requirements increased to 75 percent of that for commercial banks.

Following the liberalization of bank interest rates in 1975, real interest rates increased sharply (Appendix II, Table 3.15). The gross differential between bank deposit and lending rates fell substantially but remained wide. A subsequent fall in the differential reflected the reduction in reserve requirements and an increase in financial sector competition associated with the entry of foreign banks and the opening of the capital account.14

The private sector’s holdings of financial assets initially contracted in real terms following the reforms (see Appendix II, Table 3.16). The slow response to the liberalization measures may have reflected the adverse effects on confidence of the severe economic recession in 1975 and the continuing high inflation rate and negative real deposit rates in the immediate postreform period. Once interest rates became positive after 1977, holdings of financial assets increased rapidly in real terms, and money and financial asset to GDP ratios rose. Subsequent to the financial liberalization, the currency to deposit ratio fell steadily.

After the removal of controls on credit and interest rates, the growth of private credit was considerably faster than the growth of private bank deposits and financial assets. In particular, the growth of peso-denominated bank credit occurred far more rapidly than the growth of peso-denominated bank liabilities. By 1980 domestic currency credit issued by financial institutions had exceeded domestic currency deposits, whereas it accounted for only 40 percent of such deposits prior to the reforms (see Appendix II, Table 3.17).15 The initial rapid growth of bank credit was not prevented by highly positive real loan rates in the postreform period, but the growth of credit declined subsequently.

A number of explanations have been provided for the growth in private credit. Initially, the credit growth was associated with borrowing by Chilean conglomerates (grupos) that were active in takeovers and in asset price speculation. Facilitated by the ownership structure of the banking sector and inadequate bank supervision, enterprise shares were used as collateral for bank credit, and share and property prices experienced a speculative boom. Later, as the business sector started facing difficulties resulting from the overvalued currency and the high financing costs, there was distressed borrowing by enterprises, and the capitalization of interest payments became common.

Despite the rapid growth of private credit, the ratio of savings to GDP gradually increased between 1977-80, as the growth of private credit was partly offset by a reduction in the government fiscal deficit. Part of the increase in private credit was used for the purchase of publicly owned enterprises that were privatized.

Financial crisis

In the early 1980s, the Chilean authorities faced a financial crisis. By 1981, two years after fixing the exchange rate, the degree of overvaluation of the real exchange rate had become significant and ultimately unsustainable. There was massive speculation against the peso, and interest rates rose sharply because the authorities did not sterilize the capital outflows. The increase in interest rates, combined with the exchange rate overvaluation, led to widespread business bankruptcies, which were subsequently accompanied by a run on a major bank along with government intervention in several smaller financial institutions. The situation was sharply aggravated in 1982 when the stock market crashed, leaving many corporations insolvent, since they had collateralized loans with borrowed shares. This same year, the peso was devalued, further damaging the solvency of the business sector, which was already heavily indebted with foreign loans.

A number of indications of the extent of the financial crisis are provided in Appendix II, Table 3.18. In 1982, 21 percent of total bank loans were judged to be nonperforming; this proportion had increased to 62 percent by 1986. Six commercial banks and eleven financieras failed during 1981-83, and the authorities had to intervene in another seven banks and one financiera.

Three features of the postreform Chilean financial system facilitated excessive risk-taking and unsound lending practices. First, as noted, the supervisory framework was weak until 1980. Second, the ownership structure contributed to excessive lending to interrelated entities. Third, banks were not subject to discipline by depositors. Although explicit peso deposit guarantees did not exist in Chile until January 1983, there appears to have been a widespread perception that the government would rescue depositors in the event of a bank crash. It has also been argued that firms borrowed excessively because they expected a government bailout (see Arellano, 1983).

The authorities’ reaction to the crisis is summarized in Appendix II, Table 3.19.16 The crisis resulted in a temporary reversal of some of the liberalization measures and in a strengthening of regulations and supervisory arrangements. With the transfer of problem loans to the central bank, the central bank subsequently became a major provider of liquidity to the banking system.17 In December 1982 the central bank initiated a policy of guiding interest rates through posting suggested deposit rates set on the basis of expected inflation plus a premium.

The strengthening of bank supervisory arrangements the same year included a more precise definition of the limit on loans to a single enterprise that took into account the interlocking ownership of firms. Commercial banks were prohibited from investing in equity capital, agricultural land, merchandise, or livestock, and were barred from accepting stock equity as loan collateral. In addition, the Superintendency of Banks began to develop a formal system of rating financial institutions.18 In 1986, a new banking law further strengthened banking supervision, while permitting banks to establish subsidiaries to engage in new lines of financial business (mutual funds, leasing companies, and credit cards), and related nonfinancial businesses.19


The financial liberalization in Chile illustrates the risks in financial reform even with fiscal adjustments and a restrictive monetary policy. In spite of the highly positive real interest rates after the reforms were in place, private credit growth was very rapid—more so than the growth of private sector deposits. This partly reflected the weak prudential regulations that permitted a rapid credit expansion to nonviable projects and subsequent distress borrowing on account of the persistence of high real lending rates. In the meantime, the reduction in the fiscal deficit minimized the impact of the faster growth of credit than deposits on the investment-savings balance. However, the rapid credit growth associated with a high concentration of bank ownership, loans to interrelated entities, and inadequate supervision resulted in a weak allocation of private credit and a serious banking crisis.

Although the authorities in Chile revised the prudential regulations at the beginning of their reforms, the controls were poorly designed, and inadequately implemented, particularly with respect to the concentration of ownership, restrictions on bank loans to interrelated entities, and loan classification and provisioning requirements. There was also little market discipline on the banks, because of implicit deposit guarantees. The weak prudential controls and rapid growth of credit allowed banks and borrowers to become overexposed. A financial crisis resulted when financial conditions tightened in 1981 because of pressure on the overvalued exchange rate.


Indonesian reforms during 1982-90 initially followed a gradual approach; as the reforms accelerated they exposed financial sector weaknesses.

Prereform: 1978-82

Indonesia achieved high rates of growth during the 1970s, mainly because of oil exports. For the period 1978-82, real GDP growth averaged 7 percent, and gross domestic savings averaged 28 percent of GDP. Savings were generated largely through the oil revenues accruing to the government, and the resources were redistributed to the economy by way of government policies affecting resource allocation, production, price setting, and financial sector decisions. The efficiency of investment, however, was declining and private savings were low.20 In 1982, as a result of the decline in the prices of oil, real GDP growth slowed to 2.2 percent and the current account registered a deficit.

The structure of the Indonesian financial sector is summarized in Appendix II, Table 3.20. The five state commercial banks dominated the financial sector, accounting for an average of 76 percent of total financial sector assets, followed by private and foreign banks, accounting for 7-9 percent each; nonbanks accounted for only about 4 percent of the total. The Indonesian stock market, established in 1977, revealed only limited activity.21 Indonesia had a convertible currency, the rupiah, and a managed floating exchange rate indexed to a basket of currencies. It also had eliminated most controls on capital outflows while retaining controls on capital inflows.22

The financial sector was highly, and asymmetrically, regulated, which resulted in a high degree of policy-induced segmentation. State banks were subject to ceilings on most deposit and lending interest rates, but had a number of advantages over other financial institutions. State bank interest revenues were tax exempt. State banks also had larger and easier access to liquidity credits, their deposits were guaranteed, and they had a virtual monopoly over government and other public sector banking activities. Foreign and private domestic banks and nonbanks were free to set their rates. The central bank automatically rediscounted priority loans (liquidity credit) at highly subsidized rates, and in 1982 the liquidity credits amounted to 27 percent of total bank credit. Detailed credit ceilings applied to all individual banks based on the category of bank, category of assets, previous performance, and aggregate monetary targets. The permissible activity of each type of financial institution was restricted and regulations on licenses and branch openings differed according to the type of institution.23 Nonbanks in contrast were subject to neither interest rate nor credit ceilings, and development banks, while restricted in the scope of their operations, had generous access to liquidity credit. The interbank market was thin and segmented.

Prudential regulations and banking supervision were weak in the prereform period. Banks supervised by the central bank were categorized according to four levels of “soundness,” based on capital, liquidity, and compliance with credit regulations. Reliable information was lacking, however, and basic regulations on capital adequacy, loan concentration and provisioning, and interest accrual rules were inadequate. Nonbanks were under the jurisdiction of the Ministry of Finance.

Monetary policy was based on interest rate controls, credit ceilings, and access to central bank liquidity credits. The effectiveness of the central bank refinance policy as a monetary instrument was weakened by its development-oriented objective, and the automatic availability of credit for this purpose. Moreover, because of the liberal supply of liquidity credits and binding credit ceilings, the state banks at times accumulated excess reserves.

The implication for interest rates and financial assets of the asymmetrical financial regulation and system of direct monetary controls are summarized in Appendix II, Tables 3.21 and 3.22. The administratively fixed state bank deposit rates were negative in real terms, and considerably below the corresponding private national bank rates. As a result, the share of domestic currency deposits accounted for by state banks fell from 82 percent to 56 percent between 1978 and 1982. The rigid structure of interest rates was at times inconsistent with banks’ liquidity and with free capital mobility.24 International interest rate differentials resulted in large swings in bank liquidity and a volatile call money market rate. Foreign currency deposits, which were not subject to interest rate controls, grew rapidly, and by 1982 accounted for 17 percent of total bank deposits.

Adjustment and financial sector reform: 1982-90

After 1982, the Indonesian authorities adopted programs of adjustment that included exchange rate devaluations in 1983 and 1986, fiscal retrenchment (especially in public investments), progressive deregulation of trade and industry, and financial sector reform. These measures enabled the economy to maintain growth in GDP, private investment, and nonoil exports, while achieving a significant reduction in external and domestic imbalances.

The main financial sector reforms and their sequencing are illustrated in Table 3.3. The financial sector reforms began in June 1983 with the elimination of credit ceilings and interest rate controls on most categories of deposits and all but priority loans, and with an extensive modification of the liquidity credit facility. Indirect instruments of monetary control were introduced and discount window policy was reformed beginning in February 1984. Open market operations using regular auctions of central bank certificates (SBIs) became the main monetary instrument. In February 1985, new money market instruments (SBPUs—essentially banker’s acceptances) were introduced, and a publicly owned investment company was also established as a market maker in money market papers.25

Table 3.3.

Indonesia: Sequence of Financial Reform

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In January 1989, the role of the investment house was replaced by establishing a network of 15 dealers in SBIs and SBPUs through whom interventions were implemented.

Despite these reforms, Bank Indonesia continued as a major supplier of credit to the financial system and the share of central bank credit in total financial institution credit to the private sector increased on average following the reforms (see Appendix II, Tables 3.22 and 3.23). This factor inhibited financial sector competition and the development of the money and interbank markets. Thus, while the capital and money markets, in particular, expanded with the issue of short central bank and private papers, these markets remained small compared to credit provided through financial institutions (see Appendix II, Table 3.24).26 Moreover, the initial reforms did not ease barriers to entry, and the total number of financial institutions remained largely unchanged between 1983 and 1988.

A second phase of reforms began in 1987-88. Commencing in mid-1987, following a deterioration in the external sector, monetary policy shifted to protecting the exchange rate, and as a result the interest rates became more flexible. In 1988 the Indonesian authorities relaxed restrictions on the ability of banks and nonbank financial institutions to establish new branches and on the creation of new private and joint-venture banks. The measures included the following: (1) all domestic commercial banks were permitted freely to open new branches throughout the country; (2) nonbank financial intermediaries and foreign banks were permitted to open one branch in each of seven cities; (3) joint-venture banks could be established by foreign banks already operating in Indonesia; and (4) new private banks became eligible for licenses. Rural banks could also upgrade their status to private bank—outside main cities and municipalities—conditional on a certain operational history.

Reserve requirements were also unified among various classes of banks and reduced from 15 percent to 2 percent.27 Public enterprises were permitted to deposit up to 50 percent of their deposits with nonstate banks, and prudential regulations were strengthened by limiting the concentration of bank lending, extending central bank supervision to the rural banks and nonbanks, and developing a comprehensive supervisory monitoring system.

Several measures were also enacted to strengthen the money and capital markets. Interest income from bank deposits became subject to withholding taxes, thus, equalizing the tax treatment with other debt and equity instruments. In January 1989, Bank Indonesia organized a syndicate of 15 private banks and nonbanks to act as dealers and agents for the issuance of SBIs in regular weekly auctions and as market makers in the secondary market. All money market operations of Bank Indonesia began to be implemented through this dealer network. Limits on interbank borrowing were removed, and an active campaign was mounted to encourage the use of SBIs in liquidity management.28 In addition, in January 1990, wide-ranging reforms of institutional and regulatory aspects of capital markets were initiated, including privatization of the stock exchange.

Results of the reforms

The removal of the credit ceilings, interest rate controls, and discriminatory regulations on different financial institutions benefited the more efficient private banks, and their balance sheets grew more rapidly than those of the state banks in the postreform period (see Appendix II, Table 3.24).29 The pressures of competition led to a narrowing of interest margins and led the national commercial banks to adopt modernization programs in order to compete more effectively with the private banks.30

Real lending rates did not rise initially because the increase in bank deposit rates to positive real levels was absorbed through a reduction in lending margins. Concurrently, the growth of bank deposits fell, reflecting a sharp increase in capital outflows in response to expectations of rupiah devaluation. The loss of bank liquidity was financed through a large expansion in central bank credit to the banking system and nominal interest rates were maintained broadly unchanged.31 A rapid growth of bank credit in 1984 initially followed the removal of credit ceilings, but credit growth fell in 1985 in response to a slowdown in the economy and a sharp rise in real lending rates to historically high levels. Credit growth increased sharply again following the 1988 reforms.

The ratios of private financial assets, M2, and private bank credit to GDP all increased substantially, while the ratio of currency to deposits fell steadily in the postreform period. Commercial bank holdings of excess reserves, which had averaged 7 percent of deposits in 1978-82, fell to about 2 percent in 1983-88, reflecting both the rapid growth of bank credit and the development of short-term markets that facilitated banks’ day-to-day cash reserve management.

The first phase of financial reforms in Indonesia did not involve banking system instability. In part, this seemed to reflect the gradual nature of the reforms, the continued large role of subsidized liquidity credits, and a tighter management of interest rate levels during the liberalization.32 Competition-enhancing policies were also adopted only at a later stage in the reform process. Real GDP continued to expand during and after the financial reforms, and serious problems of industrial reorganization and bankruptcy did not arise; however, the weaknesses in bank supervision and regulation and in banking solvency were highlighted by the subsequent developments. Soon after the announcement of the 1988 reforms, two private banks faced short-lived bank runs and liquidity problems that were contained through lender-of-last-resort support from Bank Indonesia. The rapid expansion of money and credit following the second phase of financial liberalization in 1988, and the 1989-90 investment boom, resulted in a deterioration in the quality of many banks’ assets. The reforms in 1988 also reduced the regulatory segmentation between different financial institutions, leading to a substantial increase in financial sector competition. To enhance the soundness and stability of the banking system, new prudential regulations for capital adequacy, liquidity, and mandatory provisioning for nonperforming assets were introduced in early 1991, and the supervisory authority of Bank Indonesia was further enhanced by a new banking law enacted in March 1992.


Indonesia’s phased and gradual approach to reforms appeared to mitigate some of the major risks of financial sector reforms. The first phase of the financial reforms in Indonesia involved removal of direct credit and interest rate controls, and a shift toward a more market-oriented system of credit allocation and monetary control. The central bank continued to refinance a very large proportion of commercial bank credit, however, and many portfolio and entry regulations limiting competition remained. Market-based instruments of monetary control and capital markets evolved relatively slowly, partly reflecting the heavy involvement of Bank Indonesia in credit allocation and the limited interest rate flexibility.

The second phase of deregulation, which began in October 1988, significantly altered the financial system structure, with a substantial reduction in directed credit and a major increase in the number of financial institutions. It also included measures aimed at further developing the money and capital markets, reducing the central bank’s role in credit allocation, and streamlining the operating procedures of monetary policy and banking supervision. The second phase of reforms highlighted the weaknesses in prudential regulation and supervision.35

The sequencing also illustrated the essential complementarily of financial sector reform and macroeconomic and monetary management. On the one hand, the challenges of dealing with capital inflows and outflows complicated domestic monetary management and speeded up the need for the introduction of indirect monetary controls; the increased flexibility of interest rates allowed the authorities to manage more effectively the volatile capital flows. On the other hand, the expansionary impact of the initial surge in private sector credit following the liberalization was offset by a fiscal surplus, and the potentially destabilizing macroeconomic consequences of the rapid credit expansion were avoided. The increase in real interest rates to substantially positive levels following the reforms also appeared to be an important factor that contributed to an increase in deposit mobilization and helped to mitigate the rapid growth of bank credit. The reforms resulted in a rapid growth of financial intermediation, with sharp increases in both the money to GDP and credit to GDP ratios, and a decline in the currency to deposit ratio.


Korea followed a very gradual and managed process of financial sector reforms from 1980 to 1988.

Prereform: before 1980

Korea’s average annual growth during the 1960s and 1970s was more than 8 percent. This strong increase depended on heavy government intervention that directed the economy according to detailed five-year plans. By the second half of the 1970s, however, the economy became too large and sophisticated to be efficiently directed by central controls. In the period 1975-80, GDP growth slowed and was negative in 1980.34 Fiscal and current account balance of payments deficits averaged 1.7 percent and 4.5 percent of GDP, respectively, during this time; the ratio of gross external debt to GDP rose from 40.5 percent to 44.7 percent; and inflation increased, reaching 29 percent in 1980.

The financial system consisted of nationwide, local, and specialized banks; branches of foreign banks; various nonbanks; a capital market; and an active informal credit or curb market.35 There were high barriers to entry for new banks and the number of domestic banks hardly changed between 1975 and 1980. The number of bank branches increased by 46 percent and the number of foreign banks rose from 9 in 1975 to 33 in 1980 (see Appendix II, Table 3.25).36 Meanwhile, the government used banks to finance investment and to guarantee foreign investment in heavy industry.

The government relaxed restrictions on entry of nonbanks in the mid-1970s as part of its efforts to restrict the curb market.37 Together with the less stringent restrictions on their activities, including higher interest rate ceilings, the number and magnitude of nonbanks’ operations grew rapidly, and their share of total deposits increased from 8.5 percent to 11.8 percent between 1976 and 1980 (see Appendix II, Table 3.26). The size of Korea’s capital market declined during 1977-80 and the curb market remained active despite efforts to absorb it into the formal sector.38

The financial sector was highly regulated. Monetary policy was conducted through direct instruments, of which the most important were interest rate and individual bank credit ceilings, the central direction of credit to specific sectors, a varied reserve requirement ratio, and subsidized central bank rediscount operations. The Bank of Korea’s lending and rediscounting operations were also used as development instruments, resulting at times in inconsistencies between monetary control and development objectives, with the latter taking priority. Strict exchange controls facilitated monetary control through direct instruments. The monetary authorities were also closely involved in the personnel budgeting decisions of financial institutions, including privately owned banks but less so in the nonbanks, and the introduction of new financial instruments required a lengthy approval process. Prudential regulations on banks were reasonably strict, but less so for nonbanks.39

The main characteristics of the prereform interest rate structure are shown in Appendix II, Table 3.27. Ceilings on deposit and loan interest rates were changed in response to inflation; nevertheless, real interest rates fluctuated by large amounts and were significantly negative in 1980-81. During the high inflationary period of 1978-81, nonpreferential loan rates were raised by less than the corresponding increase in deposit rates, leading to a considerable decline in banks’ gross lending spreads. Preferential lending rates were 8 to 10 percentage points below the nonpreferential rates. The interest rate ceilings on nonbank financial intermediaries’ operations were higher than the corresponding ceilings on bank rates, and nonbank financial intermediaries were better able to circumvent the interest rate ceilings through charging fees and commissions. The spread between the curb market rate and bank deposit rate remained wide throughout the period 1975-80.

The combination of interest rate and credit ceilings, segmentation between the activities of different financial institutions, and directed credit led to an inefficient pricing and allocation of credit. The priority sectors (export, heavy chemical, and large manufacturing industries) had preferential access to bank credit and faced lower borrowing costs than nonpriority sectors. However, the average rate of return on the capital invested in these sectors was 1-3 percent below that in the nonpriority sectors in the prereform period (see Cho and Cole, 1986). The debt/equity ratio of the manufacturing sector increased considerably during the 1970s, in part reflecting the subsidized cost of bank borrowing.

Financial deepening as measured by increases in financial assets relative to GDP was not significant during 1975-80 (see Appendix II, Table 3.28). The increase in the financial sector’s activity was mostly accounted for by the less regulated nonbanks. The ratio of M2 to GDP was broadly flat in this period, while the ratio of M3 to GDP increased, reflecting the faster growth of nonbanks’ deposits. The ratio of currency to deposits was sensitive to nominal interest rates and fluctuated without any strong trend. At the same time, the growth of financial sector credit to the private sector was faster than the growth of private claims on financial institutions, and the ratio of private credit to GDP rose sharply. The proportion of total bank credit to the private sector financed through central bank credit to financial institutions also increased.

Financial reform: 1980-88

The financial reforms in Korea were part of a broader economic adjustment program that included currency devaluation, tight monetary policy, contractionary fiscal policy, strict wage guidelines, and increases in administered prices. Simultaneous with the stabilization and financial reform programs, the Korean authorities also liberalized international trade and rationalized public investments. The Korean economy, assisted by an improving world economy, responded well to the adjustment program. Export-led GDP growth averaged 8 percent and inflation averaged 6 percent a year during 1981-88. The current account registered a surplus starting in 1986, which permitted a substantial improvement in the external debt situation.

The decision to liberalize the financial markets reflected concern that imbalances in the economy were aggravated by the misallocation of financial resources. The objectives of the reforms were to develop financial management systems that would promote more effectively free enterprise and private initiative. Officials proceeded slowly with financial liberalization for a number of reasons. They were concerned that if interest rates were liberalized too quickly persisting expectations of inflation would raise interest rates sharply and damage the highly leveraged industrial sector. They were also concerned that too liberal a financial system could result in interrelated ownership of banks and a concentration of lending to large industrial conglomerates.40 The financial reform measures included institutional reform to improve financial sector competition, limited liberalization of interest rates and credit allocation, and some shift toward indirect monetary control procedures. The reforms and their sequencing are summarized in Table 3.4.

Table 3.4.

Korea: Sequence of Financial Reform

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Interbank call rates and corporate bond rates were freed.

Interest rate control is reintroduced in 89-90, and gradual deregulation reinstated in 91-92.

Between 1981 and 1983, all five nationwide government-owned commercial banks were privatized.41 Simultaneously, approvals were given for the establishment of two new nationwide commercial banks and one specialized bank. In addition, especially after 1982, a large number of foreign bank branches and nonbanks were allowed to be established and some regulations limiting competition among various types of financial institutions were eased, mostly by allowing all institutions to deal in the newly introduced financial instruments.42 In 1980, rules regulating bond transactions and repurchase agreements were instituted. Between 1981 and 1984, several measures were taken to integrate and activate money markets, such as measures to widen participation in the interbank call market and to liberalize the discount rate of commercial paper. In 1987, an over-the-counter market for shares of small- and medium-sized firms was established, and laws governing the capital market were revised. The emphasis of bank supervision shifted from monitoring routine operations to monitoring procedures of credit analysis, bank portfolios, and the enforcement of prudential ratios. In addition, each financial institution became subject to both annual and unannounced visits by regulators.

Between 1980 and 1986, rediscount mechanisms, directed credit, and interest rate ceilings remained the major tools of monetary control, to be supplemented by sales of stabilization bonds later on. In 1981 the central bank substantially reduced reserve requirement ratios to 3.5 percent and unified them for different financial institutions and types of deposits. Until 1986, reserve requirements were changed only once after their reduction and unification in 1981. In 1982, individual credit ceilings on nationwide commercial banks were abolished, directives influencing the daily operations of financial institutions were discontinued, and beginning in 1982 directed credit to priority sectors was progressively reduced. Overall ceilings on credit established by the Monetary Board remained in effect, however, and the authorities continued to exercise window guidance on the allocation and overall growth of credits. Moreover, a large part of the central bank’s loans to commercial banks carried low interest rates and supported the financial assistance schemes for ailing industries.43 After 1986 the rediscount mechanisms and directed credit policies became insufficient for monetary control because the accumulation of net foreign assets threatened monetary stability. In 1986 and 1987, the central bank sold stabilization bonds (equivalent to 108 percent and 76 percent of the increases in net foreign assets in each year, respectively), increased reserve requirements, and tightened its rediscount mechanisms to manage the foreign inflow. Also, since 1989 repurchase operations have been used to influence money market rates.44

The interest rate liberalization measures included the following: In 1982, the interest rate differential between general and preferential loans was reduced and some preferential rates were eliminated. In 1984, to allow banks to better differentiate credit risk, loan interest rate ceilings were replaced by an allowable range for interest rates. (The range between the maximum and minimum rates varied from 1.5 percent to 3 percent during the period 1984-88.) In 1986, interest rates on CDs were raised to higher levels than those on ordinary time deposits. In December 1988, the authorities announced an interest rate liberalization package, which included the liberalization of most bank and nonbank lending rates, long-term deposit rates, money instruments, and trust accounts. Most of the reforms were not implemented, however, because of unfavorable economic and financial conditions that had developed in early 1989. In August 1991, the government announced a new four-phased program for the full liberalization of interest rates, commencing with the deregulation of interest rates for most money market instruments and banks’ large-denomination CDs. Subsequently, interest rates on loans were liberalized first, before proceeding to a step-by-step liberalization of deposit rates—with long-term rates and those on larger deposits being freed before rates on short-term and smaller deposits.

Consequences of liberalization

The size of the formal financial sector expanded, with the addition of two nationwide commercial banks, a sharp increase in total bank branches, and the opening of other financial institutions (see Appendix II, Table 3.25). Financial intermediation in the formal sector grew sharply, although because of more restrictive controls on banks, the expansion continued to favor nonbanks (see Appendix II, Table 3.26). The ratio of M2 to GDP increased from 33 percent in 1981 to 36 percent in 1987, while the ratio of private financial assets to GDP increased from 39 percent to 48 percent in the same period (see Appendix II, Table 3.28). A major part of the increase in both ratios occurred in 1982 as a reaction to the problems in the curb market.45 In addition, the size of the Korean capital market grew rapidly, especially after the capital market reforms of 1987. By 1988, the ratio of the total value of stocks and bonds traded on the Korean Securities Market to private financial assets had reached 85 percent (see Appendix II, Table 3.26).

The increasing depth of the financial system was reflected in greater financial sector competition. The allocative efficiency of financial resources, as measured by the uniformity in the rates of return on capital in different sectors, showed considerable improvements over the period 1981-88. The structure of interest rates also became more uniform following the interest rate reforms, with a narrowing in differentials between nonbank and bank deposit rates, between curb and official market rates, and between interest rates on credits to priority sectors and maximum loan rates (see Appendix II, Table 3.27). Nevertheless, the interest rate structure remained closely controlled, continuing to limit banks’ ability to differentiate among maturities and risks when setting interest rates. With successful disinflation, the whole interest rate structure turned positive by 1982 and remained so through 1988.

Various legislative barriers between banks and nonbanks precluded the complete elimination of segmentation. Nonbank financial intermediaries continued to be subject to higher interest rate ceilings, and the burden of directed credit was heavier on the banks than on the nonbanks. Following the reforms, central bank domestic currency credits to financial institutions rose initially, reaching 22 percent of total bank credit to the private sector in 1985, compared with 18 percent in 1980, as the authorities used this to support their directed credit policies (see Appendix II, Table 3.28).


Financial sector reform in Korea was a gradual and managed process. Overall, financial sector intermediation increased sharply following the financial reforms, and there was an improvement in the efficiency of credit allocation in the context of a successful stabilization program, supported by interest rates that were maintained substantially positive in real terms. The authorities did not allow a complete liberalization of interest rates, and they continued to direct credit, to provide substantial refinance to the banking system in support of the industrial sector, and to differentiate between different types of financial institutions. The banks remained under tighter control compared to nonbanks and increasingly lost market share to these nonbanks. As a result, traditional instruments of monetary policy that relied on control through the banks became less effective, and, with a sharp increase in net foreign assets, the Bank of Korea had to resort increasingly to indirect monetary control instruments for effective monetary control. Major issues of financial institution stability did not arise, partly because the regulation and control of credits and interest rates generally remained significant.

The Philippines

The Philippines’ experience with financial sector reform between 1980 and 1984 illustrates the interrelationship between financial sector reforms, financial sector weakness, and macroeconomic management.

Prereform: 1915-81

Between 1975—81, GDP growth averaged 5.5 percent a year, reflecting expansionary domestic policies. Gross domestic investment averaged about 30 percent of GDP, compared with gross domestic savings of 25 percent of GDP. Private investment constituted the major component of total investment and was financed by subsidized and directed credit. The peso followed a managed float since 1973, and its rate to the U.S. dollar was kept stable between 1975 and 1980.

The financial sector included several types of banks—commercial, thrift, rural, and specialized—and nonbank financial institutions (see Appendix II, Table 3.29).46 As a result of strict barriers to entry, the total number of commercial banks remained essentially unchanged between 1975 and 1980.47 By 1980, there were 28 domestic commercial banks and four foreign banks. The domestic commercial banks were free to pursue an aggressive branching policy, and their total number of offices increased by 50 percent between 1975 and 1980. Barriers to entry were lower for thrift banks and rural banks, which mostly serviced small customers and farmers, and between 1975-80 their number grew rapidly. Nevertheless, their share in total assets remained small.

Commercial banks were the largest component of the financial sector, accounting for around 45 percent of total assets (see Appendix II, Table 3.30). Within the commercial banks, the importance of government-owned banks’ was declining, and their share of financial sector assets fell from 14.6 percent in 1975 to 11.3 percent in 1981. The specialized banks’ share of total assets increased from 9.7 percent to 11.9 percent between 1975-81, while the share of financial assets accounted for by nonbank financial intermediaries declined by about 4 percent over this period.48

The activities of different financial institutions were closely defined by law. Rural banks had to limit their activities to “small” clients, while the operations of thrift banks and specialized banks were strictly defined in terms of purpose, collateral, and maturity. A strict separation existed between investment and regular banking activities, with only investment houses allowed to underwrite government and corporate securities. With few exceptions, commercial banks were the only entities allowed to accept and manage demand and checking accounts.

All interest rates—deposit, lending, and interbank rates, including those of nonbanks—were subject to ceilings, which together with the central bank discount rate, were altered in response to shifts in inflationary pressures. Rates were lowered in 1978 as inflation abated, and increased in 1979 with the resurgence of inflation (see Appendix II, Table 3.31). In 1979 and 1980, interest rate adjustments were not sufficient to compensate for increasing inflation, and real interest rates became highly negative as a result. Interest rate determination became more flexible after 1980, when the usury laws, which mandated a maximum of one interest rate change per year, were abolished.

The Central Bank of the Philippines issued a number of directives to influence bank lending activities, and its rediscounts were used primarily to execute selective credit policies at highly subsidized rates. Financial activity was also directed through minimum loan ratios to selected sectors—mostly agriculture and agroindustries—and involved high degrees of government influence in the credit program of state-owned commercial and specialized banks. Liquidity was controlled mainly through operations in central bank certificates of indebtedness, beginning in the mid-1970s.49 These certificates had a final maturity of seven years and were issued through a monthly auction. The central bank also entered into repurchase agreements in these certificates. Treasury bills existed but were not used extensively for monetary control. Reserve requirements were not varied for monetary control. (Reserve requirements for the banking sector against the peso-denominated demand, time, and savings deposits were 20 percent.)

The central bank performed bank supervision, but the Securities and Exchange Commission supervised some nonbanks. Supervision efforts focused on ensuring that each financial institution was operating within its prescribed domain of activities. Prudential regulations included a high minimum capital requirement for commercial banks, capital to risk asset ratios for all institutions, limits on equity investments in enterprises as a ratio of a financial institution’s capital and reserves, and limits on borrowing by directors, officers, stockholders, and their related interests (known as “DOSRI” requirements). Limited deposit protection was provided with an insurance limit of P10,000 per depositor (equal to $1,300 in 1980). However, during the 1970s, supervisory regulations were relaxed. Capital to risk asset ratios were lowered from 15 percent in 1972 to 10 percent in 1973, and after 1980 ratios as low as 6 percent became permissible as the authorities sought to provide banks with greater leverage to expand their asset portfolios. The rules regarding maximum credit to DOSRIs—set in 1973 equal to a bank’s total capital—were also relaxed.

Certain indicators point to financial deepening during the prereform period. Between 1976 and 1981 the ratio of currency to deposits declined from 13.5 percent to 10 percent; the ratio of M2 to GDP increased from 21.5 percent to 28.8 percent; and the ratio of M3 to GDP increased from 35.2 percent to 39.9 percent. The ratio of private credit to GDP also rose (see Appendix II, Table 3.32).

The segmented financial sector, interest rate controls, and directed credit all restricted financial sector efficiency and competition. The main objectives of financial sector reform were to improve competition and to rationalize financial decisions by making them sensitive to market forces. These would be pursued through liberalizing interest rates and reducing operationally restrictive policies.

Financial reform: 1980-84

During the period 1980-84, financial reform measures included a breakdown of the segmentation of the activities of different financial institutions, a gradual liberalization of interest rates, and the move toward an indirect system of monetary control. The main elements and the sequencing are summarized in Table 3.5.

Table 3.5

Philippines: Sequence of Financial Reform

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A number of functional distinctions between the different financial institutions were removed in July 1980. A commercial bank with a minimum capital of

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million could become a universal bank (unibank), thereby becoming authorized to engage in a greatly expanded range of financial services, most important of which was to invest in the equity of nonfinancial enterprises. Smaller commercial banks were also permitted to engage in equity financing through the creation of venture capital subsidiaries. Rural banks were granted access to the central bank rediscount facility in certain circumstances.

A phased liberalization of interest rates began in 1980, with the removal of interest rate ceilings on deposits with maturities greater than two years. Over the next few years, ceilings on interest rates were removed from loan rates with a maturity greater than two years (1981), from remaining deposit rates (1982), and from remaining loan rates (1983). In 1982, a prime rate monitoring system was instituted and the compilation of a deposit reference rate (the Manila Reference Rate) was initiated.50 In 1983, the central bank rediscount rate was brought into line with the 90-day Manila Reference Rate.

The reform of monetary policy instruments began in 1981 with a decision to phase out certificates of indebtedness—a move designed to rationalize the government securities market and to give primacy to treasury bills as the monetary control instrument. This was not initially successful and, in 1984, two new central bank bills were issued. In 1982, a plan was instituted to reduce reserve requirements on peso deposits by 1 percent every six months to 16 percent by 1985. Due to the financial crisis, however, the plan was frozen in 1983 and reserve ratios were raised in 1984 to 24 percent to contain liquidity pressures. In 1983, limits on financial institution access to central bank rediscounts were introduced; the number of rediscount facilities was substantially reduced; and a new liquidity window was designed to meet the day-to-day liquidity needs of financial institutions. In 1984, and following the adoption of a floating exchange rate regime, base money replaced net domestic assets of the central bank as the principal intermediate target of monetary policy.

Consequences of reforms and financial crisis

The immediate results of the financial liberalization were sharp increases in the number of financial institutions and in financial sector credit to the private sector. In the period 1981-83, the growth of credit far outstripped the growth of deposits in the financial system, despite the increase in interest rates to positive real levels (see Appendix II, Table 3.31). The more rapid growth of credit than deposits was associated with a fall in gross domestic savings to GDP and an increase in banks’ gross lending margins (see Appendix II, Table 3.32). Combined with weaknesses in the postreform supervisory framework, the rapid credit expansion contributed to the subsequent financial crisis. Concurrently, the ratios of financial assets, M2, and M3 to GDP increased and a larger proportion of private savings was intermediated through the financial system (see Appendix II, Table 3.33).

During 1981-86, the Philippines faced a major financial sector crisis (see Appendix II, Table 3.34).51 The difficulties began in 1981 as a crisis of confidence when fraud in the commercial paper market resulted in large-scale defaults by borrowers in this market and in bankruptcies among a number of nonbank financial intermediaries and their holding companies. This crisis spread to rural and thrift banks as investors shifted their funds into higher quality assets, and caused a number of these institutions to fail.52 These failures were followed in 1982 and 1983 by intensified government assistance to financial and nonfinancial institutions, including emergency lending and equity contributions to public financial institutions and the takeover of troubled private financial and nonfinancial institutions by government financial institutions.

In 1984 a sharp deepening of the crisis occurred. An unstable political environment in the first half of 1983 was followed by a balance of payments crisis and a government-announced moratorium on external debt payments to foreign commercial banks. A financial panic followed that resulted in runs on financial institutions, including commercial banks, a flight to currency, large-scale capital outflows, and a contraction in financial intermediation. Between September 1983 and September 1986, private sector credit fell in real terms by 53 percent. A further contraction of banking system credit occurred when some 30 percent of the banking system’s total assets, representing the nonperforming loans of two government-owned commercial and development banks, were transferred to a government agency, the Asset Privatization Trust. In all, three commercial banks, 128 rural banks, and 32 thrift institutions failed during the crisis, while two large government-owned financial institutions were declared insolvent, requiring restructuring supported by the transfer of nonperforming assets. Thus, the increase in the number of financial institutions following the reforms was reversed (see Appendix II, Table 3.29).53 The fiscal and real sector consequences of the crisis were substantial.

Following the crisis, the central bank increased its credit to financial institutions. The amount provided by the central bank rose from about 19 percent of total credit to the private sector in 1981-82 to 32 percent in 1985. This proportion fell back to 19 percent in 1986 as nonperforming assets of banks were transferred to the Asset Privatization Trust, a government agency. Despite the increase in central bank assistance, the growth of reserve money was kept under control through money market operations in central bank and treasury securities.

The extensiveness of the crisis can be traced partly to a failure to enforce supervisory rules on credit meeting DOSRI requirements; inadequacies in the rules on provisioning for overdue loans; various banking irregularities exacerbated by the political environment; and excessive risk taking by bank holding companies through newly created and inexperienced subsidiaries. The central bank did not establish firm provisioning rules, and practices regarding the accrual of interest on overdue loans varied greatly between banks. There was asymmetry in the supervision of various categories of financial institutions: banks were supervised by the central bank, while many nonbank subsidiaries were afforded weaker monitoring by the Securities and Exchange Commission. The liberal entry policies for rural and thrift banks created a vulnerable component of the banking sector. Lending rules to customers associated with banks were effectively ignored and excessive interrelated and risky lending occurred. Accounting and operating rules, including those for the provisioning for bad debt, were not codified or transparent. Troubled banks exploited this weakness by accruing interest on nonperforming loans and distributing book profits.

Following the financial crisis there was a dramatic fall in the ratio of bank credit to the private sector—from 51 percent of GDP in 1983 to 25 percent in 1985. Explanations for the fall—that bank runs caused a drop in the supply of deposits or that demand for bank loans fell because of the economic recession—leave a large part of this decline unexplained (see Appendix II, Table 3.35). For example, the decline in the supply of loanable funds available to banks that can be attributed to deposit withdrawals and a reduction in central bank credit amounts only to one-third of the decline in banking system credit during 1984-85. Similarly, while the ratio of banking system credit to GDP fell by 26 percent during 1984-85, the ratio of total investment to GDP fell by only 11 percent, while private consumption did not fall as a percent of GDP.

The dramatic fall in private credit from financial institutions seems even more surprising given the estimated size of overdue bank loans, which amounted to 13 percent of total loans in 1981, and rose to 19 percent by 1986 (see Appendix II, Table 3.34). This amount is not high compared with other countries that have faced financial crises and does not imply severe insolvency of the banking system.54 Moreover, real lending rates became negative in 1984 and 1985.

The “unexplained” portion of the decline may reflect voluntary credit rationing by financial institutions. The interest rate developments in the period seem to substantiate this hypothesis. Even though between 1984 and 1985 nominal loan rates rose sharply, the spread with the rate on the treasury bills was negative in 1984 (see Appendix II, Table 3.31). For prudential reasons, banks seemed to prefer to invest in safer government securities and to ration credit to the private sector rather than raise their loan rates—an apparent case of concern about “adverse selection.”55 By 1986, the growth of credit to the private sector had begun to recover (after taking account of the transfer of bad loans to the Asset Privatization Trust) and banks’ gross interest margins, which had risen sharply during the crisis, began to fall.


The postreform developments in the Philippines reflect a complex set of circumstances. Initially, the liberalization was associated with a sharp increase in financial intermediation and in the number of financial intermediaries, and with an expansion in credit to the private sector. Considering the weak supervisory arrangements that accompanied the liberalization, these developments increased the vulnerability of the financial system to a shock in confidence. The subsequent financial crisis resulted in substantial portfolio shifts between assets and a severe interruption to financial sector development.

Perhaps the most striking feature of the Philippines’ experience was the drastic reduction in banking system credit following the crisis. The drop was much more dramatic than in either Argentina or Chile, both of which appeared to face a more severe situation with problem loans than did the Philippines. Following the financial crisis banks in the Philippines appeared to become very cautious about extending new credits. At the same time, the central bank’s capacity to moderate this by easing monetary policy appeared limited by the immediate domestic stabilization and external adjustment objectives. The excessive contraction in credit eventually caused the real economy to undershoot. The Philippines’ experience, therefore, again illustrated the dynamic interrelationships between financial sector reform, financial sector weaknesses, and macroeconomic management.

Lessons in Managing Financial Liberalization

This section seeks to draw out the major lessons for managing and sequencing financial sector liberalization from the experiences in the five countries examined in the previous section. It examines the implications of financial liberalization for the various financial aggregates and indicators of the financial sector, and presents a stylized model of the dynamic adjustments following financial liberalization and the implications for managing the macroeconomic risks following liberalization.

Monetary Dynamics of Financial Reforms

Financial indicators and aggregates

Table 3.6 presents the differences between the average values of indicators of financial sector development for the three years before and after the initiation of major financial sector reforms. Table 3.7 shows the average values of the indicators for the three years after the reforms were introduced. In all of the countries for which a comparison is possible, financial reform was accompanied by increases in real interest rates and in the ratios of money, financial assets, and credit to the private sector to GDP, and a fall in the ratio of currency to deposits (prereform data are not available for Chile). The first conclusion is that policy design has to anticipate and allow for the shifts in financial aggregates that accompany financial sector reforms. For example, a failure to allow for the increased financial intermediation following financial liberalization could result in a policy that is tighter than anticipated when targets are set at the level of the banking or financial system. Another approach—setting targets at the level of the central bank—carries its own risk, however, because it does not allow for a possible shift out of currency into bank deposits, and a change in the behavior of excess reserves could result in a looser than anticipated policy.

Table 3.6.

Change in Financial Indicators Between Pre- and Postreform Periods

(Differences in averages for three years before and after reforms, in percent)

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Sources: Various country authorities; IMF, International Financial Statistics.

Prereform data are not available for Chile.

In real terms, that is, after deflation by CPI.

Table 3.7.

Development of Financial Indicators in the Postreform Period

(Averages for three years following the reforms, in percent)

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Source: Various country authorities; IMF, International Financial Statistics.

In real terms, that is, after deflation by CPI.

In all of the countries studied, financial liberalization was followed by a period in which credit growth exceeded the growth of deposits with financial institutions (see Table 3.7). In two of the countries (Argentina and the Philippines), the difference between the growth of credit and the growth of bank deposits increased following the reforms.56 A second conclusion is that financial reform may initially reduce net private savings and increase the pressure on resources. Maintaining macroeconomic balance during financial sector reforms may, therefore, require a reduction in the fiscal deficit, and/or an initial attraction of foreign resources to cover the balance of payments deficit.

The rapid growth of credit is perhaps not surprising following the removal of interest rate and credit controls that had previously restricted credit growth, with the extent of adjustment reflecting the speed of the reforms. In Korea and Indonesia, the growth of private credit relative to deposits slowed in the postreform period compared to the prereform period, and the reforms therefore appear to have reduced the private resource imbalances compared to the prereform situation. Financial reform in Korea was a much more gradual process than in other countries in the sample and the authorities continued to maintain extensive control over credit through the national commercial banks. Also, in Indonesia the central bank continued to exercise significant influence on overall credit growth through selective refinance and other policies that initially limited the extent of competition in the banking system.

A third conclusion is that financial liberalization can have important effects on the cost of funds to borrowers (see Table 3.6). Generally, real interest rates increased and banks’ gross lending margins widened initially following the reforms. These margins reflected a number of influences. The removal of interest rate controls allowed banks to price credits and risks more appropriately, possibly serving to raise margins, since controlled lending rates were usually set too low. Against this, reserve requirements were normally lowered as part of the reforms—reducing the cost wedge between deposit and lending rates. In addition, the reforms generally sought to increase financial sector competition through the reduction of barriers to entry and segmentation between different types of financial institutions; in some cases, however, the improvements in competition did not materialize owing to greater concentrations of ownership.

The speed of adjustment of financial indicators following the liberalization is examined in Table 3.8. This table compares the average value of the indicators for the first and three postreform years. The maintenance of real interest rates was quite critical in the reform dynamics. In the three countries that maintained positive deposit interest rates on average in the postreform period, credit growth slowed down after the first postreform year; whereas in Argentina, where real deposit and lending rates were negative on average, credit growth accelerated following the reforms. Credit growth also accelerated in Chile, despite very high and positive real lending rates that coincided with negative deposit rates.57 High real interest rates also helped countries to attract capital inflows, and thus to finance the balance of payment implications of the more rapid credit expansions following the financial liberalizations.

Table 3.8

Difference in Financial Indicators Between Three-Year Averages After the Reforms and One Year After the Reforms

(In percent)

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Sources: Various country authorities; IMF, International Financial Statistics.

In real terms, that is, after deflation by CPI.

Dynamics of deposit and credit growth with financial liberalization

Country experiences suggest some stylized dynamics for the growth of deposits and credit following financial liberalization. These are illustrated in Figure 3.1. In the prereform period, deposit growth declines because of the negative real deposit rates and the overall repressed nature of the financial system at this time. Credit growth is usually maintained through increasing liquidity support from the central bank. The lower deposit than credit growth is associated with increasing resource pressures in the prereform period.

Figure 3.1.
Figure 3.1.

Dynamics of Credit and Deposit Growth with Financial Liberalization

After financial liberalization, both credit and deposit growth tend to increase. The response of credit growth is initially more rapid than deposit growth. The decline in the real value of deposits that generally occurs in the prereform period reflects a voluntary portfolio response to financial repression rather than a reaction to specific controls. In the postreform period, however, there is usually a gradual portfolio adjustment by depositors to the new liberal financial situation. Credit growth, in contrast, is likely to be limited by direct controls with an excess demand for credit in the prereform period. Once the direct controls are removed, however, financial institutions respond by meeting the excess demand for credit—usually by running down excess reserves that have built up under the direct credit controls or by attracting capital inflows—with the result that credit expands rapidly.

The subsequent development in deposit and credit growth depends on the structure of real interest rates. If real interest rates are maintained at a positive level by the authorities, the growth of credit slows down compared to the initial postreform credit boom. The growth of credit may still remain higher than in the prereform period because of the general increased role of the financial sector in mobilizing and allocating resources following financial liberalization. The growth of deposits usually continues to increase, reflecting the lagged portfolio adjustment to the financial liberalization measures, the development of new financial instruments and institutions, and the reduction in central bank liquidity support of financial institutions, which are therefore forced to mobilize deposits to meet credit demand. After some point, the growth of deposits and credit tend to converge, allowing for balanced growth with a higher level of overall resource mobilization than in the prereform period.

If real interest rates are kept negative by the authorities in the postreform period, this most often encourages a more rapid growth of credit and slower growth of deposits. The maintenance of negative real rates then requires expansionary central bank policies that finance the faster growth of credit than deposits. As a result, the growth of deposits generally does not catch up with the growth of credit, and resource imbalances remain—sometimes expanding from the level of the preliberalization period.

Even with the maintenance of positive real interest rates, there is likely to be an initial postliberalization credit boom. The management of the credit boom is a critical element of successful financial liberalization. To the extent that the initial credit growth reflects a one-time stock adjustment to a new equilibrium position—or reflects low or perverse interest elasticity of credit demand on account of distress borrowing and loans to related interests—an attempt to limit credit demand solely through interest rates could result in very high real interest rates with attendant risks for the real economic growth and stability of the financial sector. Chile’s experience in 1981 illustrates these risks. Therefore, other options may need to be considered to manage the credit expansion. As already noted, these could include a reduction in the fiscal deficit, thus reducing the need to raise interest rates to maintain overall macroeconomic stability, or an accommodation of the credit expansion by attracting capital inflows. The latter approach, however, carries its own risks if the financial sector is weak so that the capital is not invested efficiently and in ways that can cover the debt service costs (see Chapter 6 for an analysis of the relationship between capital account liberalization and financial sector reform).

Another option, therefore, would be to constrain the credit growth through the temporary continuation of some types of credit controls. While the postliberalization stock adjustment in credit probably cannot be avoided, it could be phased in using direct controls to be more closely aligned with the otherwise lagging growth of bank deposits. Credit ceilings that allow banks to increase credit only in response to increases in deposits might achieve the desired gradual approach, while reducing disincentives to deposit mobilization. To be effective, these ceilings would have to be supported by positive real interest rates, an adjustment in the indirect instruments of monetary policy, the development of suitable intermediate targets of monetary policy, and a strengthening of financial institutions and their capacity to assess and manage risks.

Financial Reform and Financial Sector Stability

In three of the countries, financial liberalization was followed by a financial crisis that seriously disrupted the financial sector and was accompanied by a sharp contraction in real GDP. These crises reversed the financial deepening that had followed the initial financial liberalization and resulted in a complete reversal of the reforms in one country (Argentina).

The timing and intensity of the crises, the timing and scope of financial sector reform, and the linkages between reform and these crises differed considerably in the cases examined in this chapter. In Argentina and Chile, the deregulation of interest rates had been completed and branching restrictions relaxed by the mid- to late 1970s. The financial crises were concentrated in the early 1980s, coinciding with major shifts in macroeconomic adjustment policies and external shocks. In the Philippines, entry regulations had been eased in the mid- to late 1970s, and the deregulation of interest rates began in 1981, just preceding the first episodes of the financial crisis. The weaknesses of problem banks that surfaced during the crisis, however, had originated much earlier, but it took some time for the problems to be discovered because of the normal tendency of banks to reduce the transparency of their accounts in situations of distress, and because of regulatory forbearance by the supervisory authorities.

The connection between financial sector reform and financial crisis is complex. The crises derived from an unstable macroeconomic environment; the development of unsound liability structures of nonfinancial firms prior to reform (due to subsidized credit and, following reform, due to insider loans, loans to related interests, and similar causes); changes in relative prices that influence the viability of borrowers; and weaknesses in the institutional structure of banking (a bank ownership structure that facilitated risk taking, weak prudential regulations, and banking supervision that condoned excessive risk taking).

The financial crises have features in common, particularly the insolvency of a number of financial institutions that were involved in lending to interrelated entities and the rapid growth of bank credit following the liberalization. Rapid credit growth itself strains the credit approval process and often results in an increase in lending to more high-risk projects. When this was combined with extensive lending to interrelated entities and the lack of rules regarding classification and provisioning for bad debts and interest capitalization, the result was banking insolvency. With a proper sequencing of financial sector reforms—including an early and timely attention to developing vigilant bank supervision and well-designed prudential regulations—the buildup of financial fragility might have been detected and contained. Concomitantly, the addressing of bank portfolio problems and the prevention of the growth of banking distress, supported by sound financial policies (timely and adequate fiscal adjustment, maintenance of real interest rates, and relative price adjustments), would have helped to reduce the vulnerability of the financial system to the vagaries of the macroenvironment.

In two countries—Argentina and Chile—financial reform was, in fact, accompanied by a strengthening in prudential regulations, but implementation was ineffective and some critical regulations did not even exist, such as lending to interrelated entities, loan classification and provisions, and accounting rules on interest accruals. Other regulations were rescinded because of the inability to implement them. This situation underlines the importance of having not only adequate regulations but also an implementing capacity. (Such capacity is in part technical, but also requires the absence of political interferences.) The achievement of this ability takes time and often involves the strengthening of key public institutions, particularly the central bank. In Argentina and Chile, financial liberalization was essentially a one-time change that did not permit the ongoing development of an implementing capacity. Moreover, the large number of other modifications that were occurring in the financial systems may have distracted attention from monitoring financial institutions’ detailed operations—for example, the frequency of on-site inspections declined in Argentina following the reforms. The abruptness of the financial liberalization also did not give the private financial institutions themselves the time to develop internal monitoring, credit appraisal, and risk management processes that would have been necessary safeguards in the more liberal financial environment, nor did banking supervision ensure that bank management had the appropriate capacity for such monitoring and appraisal.

There was also evidence of “market failures.” In practice, financial liberalization was not always associated with a reallocation of credit to new and more productive sectors. In some cases, existing borrowers, who already had access to preferential credit, were granted even larger facilities. In Argentina, explicit deposit guarantees existed, and in Chile, there appears to have been a general perception that deposits were implicitly guaranteed. Because of the guarantees, depositors did not take account of the riskiness of banks when placing their deposits. At the same time, financial disclosure rules and markets in bank equity were poorly developed so that there was no adequate market signal of the risk level of different financial institutions. This was a problem especially in those countries where ownership concentration was high and there was lending to interrelated entities, since owners had little incentive to disclose the true valuation of their institutions.

The situation in the Philippines may have differed from that in Argentina and Chile insofar as deposit guarantees and the settlement of deposit insurance claims were inadequate. In the Philippines, the banks were initially perceived as less risky than nonbank financial intermediaries, and deposits were shifted toward the banks during the initial phase of the crisis. However, once confidence was lost in the banks, the inadequacy of deposit guarantees may have resulted in more severe deposit withdrawals and contraction in bank credit than in either Argentina or Chile. As discussed in the second section of this chapter, “adverse selection” may have played a role in the Philippines, with banks voluntarily rationing credit and maintaining loan rates at low levels relative to market rates in the expectation that this would improve the quality of their loan portfolio.

Financial System Soundness and Financial Sector Reforms

The soundness of financial institutions carries significant implications for the effectiveness of macroeconomic policies and the sequencing of reforms. The existence of weak banks—and the resulting contingent liabilities of the government due to implicit insurance of deposit liabilities—has two major policy implications. Interest rate policies and real sector reforms face difficult constraints and lose their effectiveness if a significant group of financial institutions has sizable nonperforming loans and faces persistent cash flow problems. This is because a weak banking system, burdened with rolling over the loans of weak firms or otherwise supporting them, cannot readily shift lending priorities to new activities and investments; higher interest rates on deposits will compound the cash flow problems, with higher lending rates merely worsening the bad debt problem. Insofar as banks are free to compete for deposits, weak banks will be pushed into borrowing to pay interest on deposits. Weak institutions also become a greater source of pressure on central bank credit or on money market funds, thereby affecting monetary control. In such an environment, a restructuring of weak institutions—through recapitalization, mergers, liquidation, provision of interest subsidies, and similar measures—and a concomitant strengthening of key prudential regulations are needed simultaneously with, or even prior to, monetary control and money market reforms, the timing depending upon the seriousness of the bank’s condition. Fiscal reforms have to be expedited to make room for the budgetary or monetary effects of various recapitalization and restructuring schemes that might be needed; and flexible monetary policy instruments should be developed—if not already in place—to absorb the excess liquidity that might be generated by the recapitalization measures.

In any event, a minimal set of prudential reforms—including proper accounting rules for suspension of interest on nonperforming loans, a good loan classification system and associated provisioning rules, capital adequacy guidelines, and limits on loan concentration—are very desirable, if not essential, to support real sector liberalization, to improve the allocative effects of interest rate policy, and to maximize the growth content of stabilization policies. This is because such prudential rules and guidelines have significant side effects on credit allocation and credit expansion and, therefore, could be utilized to support both expenditure reduction and switching policies that typically accompany adjustment programs. For example, it is easier to implement tight credit policies—and minimize any output loss associated with such policies—if nonperforming loans are written off promptly, and poor loans are recognized quickly, thereby improving the mobility of credit. Fairly tight regulations on provisioning and interest accounting, based on loan performance and other appropriate criteria, could thus contribute both to a strengthening of the banking system and to ensuring greater efficiency and flexibility in credit allocation. Also, appropriate capital adequacy rules can complement stabilization policies by limiting asset expansion by banks in line with the availability of capital funds. These arguments suggest that certain key prudential reforms should accompany any move to liberalize or otherwise raise interest rates, and should ideally precede major real sector reforms.

Prudential regulations and banking supervision objectives could interact with monetary policy goals, an aspect that could influence the sequencing of reforms. The strengthening of capital adequacy ratios, implementing limits on loans to single borrowers, and, more generally, any tightening of supervision of loan quality could slow down growth in bank credit. This strategy could complement monetary policy goals at times, but could counteract monetary policy intentions at other times. A properly phased introduction of reforms to tighten banking supervision and subsequent maintenance of a steady-as-you-go approach to banking supervision would help to minimize conflicts with monetary policy. The timing of interventions in problem banks could be constrained by the macroeconomic situation and could conflict with the objectives of monetary policy reforms. Any large injection of bank reserves in the course of interventions in problem banks could weaken monetary policy and slow the pace of reform in monetary policy instruments. Prudential rules on liquidity management by commercial banks typically have an impact on the demand for liquid assets (treasury bills and other short-term paper) and interbank funds, and such rules could well be designed to complement the reforms of money markets. Rules to limit foreign exchange exposure of commercial banks could act to limit capital flows and influence the extent to which domestic short-term interest rates could be set independently of foreign rates.

Interest Rate Liberalization and Reform of Monetary Instruments

The experience of countries reviewed here suggests that reforms of monetary control procedures and the measures to develop money and interbank markets should be pursued together and be implemented fairly early in the reform sequence. First, the development of indirect instruments of monetary policy to replace direct credit controls contributes to efficiency and strengthens the adjustment effort. Second, interest rate liberalization—defined as the management and control of interest rates through indirect and market-oriented instruments of monetary policy rather than through direct administrative fixing of a wide range of interest rates—also calls for reforms of monetary control procedures. Third, the development of indirect monetary instruments becomes critical for effective monetary control once countries become more open to capital flows (see Chapter 6 for a discussion of the links between monetary policy instruments and capital flows).

The development of a money market in any case requires an active involvement of the central bank because only the central bank can ensure that there is a two-way market in bank reserves and short-term funds by avoiding situations of protracted excess reserves and alleviating shortages of reserves. In doing so, the central bank should learn to switch gradually from being the market to creating and supporting a market. That is, the central bank should not simply react to the initiatives of individual institutions to obtain funds or invest their excess reserves, but should anticipate the surpluses and deficits developing in the market and provide reserves at its own initiative, leaving the market participants to seek each other out for funds during normal times. Since such reforms of operating procedures take time, certain initial steps should be in place early in the reform sequence—such as the development of new monetary instruments (treasury bills or central bank bills), selling procedures for the instruments, changes in rules of access to central bank credit, reforms of the reserve requirements system, and liquid asset ratios (these reforms are discussed in detail in Chapter 2).

The introduction of indirect instruments typically stimulates the volume of transactions in money and interbank markets, and makes it opportune to carry out technical reforms to foster money market institutions and trading arrangements. For example, operations at market-related rates, the choice of securities that are eligible as collateral for refinance of repurchase operations, the specification of eligible liquid assets, the structure of the reserve requirement system, and the choice of instrument mix (particularly the mix between liquidity absorption by security sales and liquidity injection by refinance) are factors that influenced the demand and supply of securities, the growth of interbank markets, and the relative depth of various segments of the market. This is well illustrated by the country cases, and suggests that an early start in the interactive reforms of monetary operations and money market structures would be highly effective in supporting both stabilization and financial liberalization.

The feasibility of interest rate liberalization depends not only on the existence of an adequate set of monetary policy instruments and the development of appropriate operating procedures, but also on the broader institutions and regulatory environment. The country experiences suggest that the macroeconomic effects of interest rates and the ability to control rates following the liberalization will be affected by (1) the degree of competition in the financial system, particularly in banking markets; (2) the degree of openness of the economy to capital flows; (3) the soundness of financial institutions; and (4) the financial structure of nonfinancial firms.

With the oligopolistic banking systems found in all of the sample countries, the speed of adjustment of deposit and lending rates to monetary policy was often slow, as was the adjustment of the margin between deposit and lending rates. This was probably because the banks tended to price their loans based on average cost of funds, which adjusted to changes in the marginal cost of funds with a considerable lag. Typically, competition-enhancing policies based on changes in entry regulations, unification of regulations, mergers, and divestitures can be pursued over time. Indeed, the liberalization of interest rates and the absence of direct credit controls are likely to provide an environment most conducive to an increase in financial sector competition and innovation. There is no pressing need to alter the banking industry structure as a precondition for initiating interest rate liberalization, although it is probably desirable that it occur simultaneously with the liberalization to reinforce competition in interest rate setting and financial services. In such situations, moral suasion or regulatory limits might be useful initially to guide developments in banks’ spreads, while competition is strengthened over time through other policies.

Nevertheless, the speed and nature of interest rate liberalization—and the phasing in of various prudential regulations—may have to be adjusted, taking into account the financial structure of nonfinancial firms and the pace with which problem banks and their borrowers could be restructured. If the nonfinancial firms are highly leveraged, any sharp increase in real interest rates, or a sluggish fall in nominal rates while inflation falls, could further weaken the repayment capacity of these firms and aggravate the bank’s condition. Under such circumstances, and if the resources are not available to recapitalize the banks and restructure their portfolios (which would be the preferable option), the ability to control interest rates may become a critical issue. It may then be desirable to liberalize bank interest rates only gradually, while encouraging greater competition and more rapid liberalization in other segments of financial markets.

Country practices show wide variations in terms of speed and sequencing of interest rate liberalizations. The Philippines preferred to liberalize long-term rates first, before moving on to short-term rates.58 Indonesia and Korea, in contrast, liberalized interest rates of one group of intermediaries before proceeding to more complete liberalization. Korea proceeded gradually, liberalizing loan rates first before embarking on a gradual freeing of deposit rates; long-term deposit rates and larger deposits were freed, before moving on to shorter rates and smaller deposits, in hopes that this would prevent sudden portfolio shifts. Other countries (see Chapter 2) have preferred to liberalize both loan and deposit rates simultaneously. A gradual approach to interest rate liberalization involves continuing the inefficiency in resource allocation over a short period of time, but this appears to offer a better opportunity to put in place the range of supporting reforms that would ensure the longer-term effectiveness of interest rate liberalization. Most countries have liberalized money market rates first, even while pursuing a more gradual approach to liberalization of bank deposit and lending rates.

As regards reforms of selective credit policies, generally, it is better to shift interest rate subsidies offered through the central bank to the budget, and to reduce the range of refinance facilities to a minimum needed for monetary control purposes. Instruments and markets to facilitate maturity transformation—longer-term capital markets in particular—may have to be developed to avoid major disruptions in investment finance due to withdrawal of central bank support. In the meantime, if banks are to be induced to continue to lend to certain high-risk sectors that are supported by central bank refinance policies, it may be necessary to increase the interest rate flexibility offered to banks, and reduce the costs of information and debt recovery. The timing of Indonesian reforms of refinance policies illustrates these approaches. In Indonesia, central bank support for term lending by commercial banks was only withdrawn gradually while alternative policies to increase the supply of long-term capital were put in place. Insofar as the existence of such selective refinance policies cause significant expansion in the reserve base, the authorities would have to strengthen the instruments to absorb excess reserves and make sure that interest rates on selective refinance facilities are promptly adjusted in line with market rates. Moreover, policies to improve the allocation of selective refinance between financial institutions, such as through auctions, can help mitigate the allocative efficiencies and institutional distortions of the refinance.

Some countries have first developed money markets for short-term instruments before developing ones for long-term securities. This is because money markets provide a more convenient vehicle to implement monetary policy in a market-oriented way.59 Also, the development of well-capitalized dealers in securities is easier in short-term instruments, such as treasury bills and bankers’ acceptances, where the price risks are lower in comparison with long-term instruments. The dealership skills developed through short-term instruments can then be translated to long-term instruments over time. In any case, central banks should play a major role in developing money and capital market intermediaries (brokers, dealers, and market makers) through liquidity and regulatory support—Indonesia and the Philippines are examples—and through fostering efficient clearing and settlement systems for payments (e.g., Malaysia, as discussed in Chapter 2).


Appendix I: Definition of Data Measures Used for Each Country

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Appendix II: Country Tables

Table 3.9

Argentina: Structure of Financial System

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Sources: World Bank (1984); International Finance Corporation (1989); Central Bank of Argentina, Memoria Annual.

Quarterly averages; in millions of 1985 australs. On June 14, 1985, the austral replaced the peso at the rate of 1 austral to 1,000 pesos. On January 1, 1992, the peso replaced the austral at the rate of 10,000 australes to one peso.

Between 1978-80, includes variable interest rate and fund mobilization bonds. Between 1981-83, includes monetary absorption and consolidation bonds.

Table 3.10.

Argentina: Selected Financial Indicators

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Sources: Central Bank of Argentina; IMF, International Financial Statistics; and IMF staff estimates.

On June 14, 1985, the austral replaced the peso at the rate of 1 austral to 1,000 pesos. On January 1, 1992, the peso replaced the austral at the rate of 10,000 australes to one peso.

Table 3.11.

Argentina: Interest Rate Structure

(Annual percent)1

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Sources: IMF, International Financial Statistics; Central Bank of Argentina.

For 1976-82, quarterly average. For 1983-88, monthly average.

Quarterly average of second half of 1977.

From July 1982-November 1987, rates reported are the regulated rates.

Loan rates: monthly average of January-October 1987.

From November 1987-December 1988, deposit rates are the average paid on interest free deposits of various maturities.

Data for 1976 are from Gaba (1981) as reported by Balino (1987).

Deflated by average annual CPI inflation. Real=(1 + nominal) / (1 + inflation) − 1

Adjustment formula used: (1 + LIBOR) * (1 + actual devaluation) − 1.

Table 3.12.

Argentina: Summary of Financial Sector Operations

(In millions of australes valued at 1985 prices)1

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Sources: IMF, International Financial Statistics; and IMF staff estimates.

On June 14, 1985, the austral replaced the peso at the rate of 1 austral to 1,000 pesos. On January 1, 1992, the peso replaced the austral at the rate of 10,000 australes to one peso.

For 1981, data for time deposits include savings deposits. After 1982 includes accrued interest payments.

Includes net credit to central government and to the rest of the public sector. For commercial banks (after 1979), includes foreign exchange loans to official sector.