Issues in Financial Sector Reform: To improve monetary control; to mobilize savings
  • 1, International Monetary Fund

Contributor Notes

Reforms usually aim at improving the monetary control system, and mobilizing and fostering more effective allocation of domestic savings

This paper examines the policy implications of structural changes in financial markets. Domestic financial markets have become less segmented, and the major financial centers more integrated. At the same time, the structural changes in financial markets have improved efficiency by lowering intermediation costs, increasing the ability to hedge financial risks associated with currency, interest rate, and price volatility and opening up access to new sources of savings. The widespread application of computer and telecommunications technology to financial markets has permitted markets to process a significantly larger volume of transactions.


This paper examines the policy implications of structural changes in financial markets. Domestic financial markets have become less segmented, and the major financial centers more integrated. At the same time, the structural changes in financial markets have improved efficiency by lowering intermediation costs, increasing the ability to hedge financial risks associated with currency, interest rate, and price volatility and opening up access to new sources of savings. The widespread application of computer and telecommunications technology to financial markets has permitted markets to process a significantly larger volume of transactions.

Delano Villanueva

Experience suggests that trade reforms alone cannot lead to efficient industrialization and improved economic performance. Other policies that constrain domestic supply also need reform. Among these critical policies are those relating to financial markets, institutions, and the regulatory framework. Interest rate and credit controls and other restrictive policies tend to discourage savings, distort investment patterns, and exacerbate distortions in the financial sector. Reform of the financial sector is required in order to promote an efficient allocation of financial resources in line with the incentives brought about by trade reforms. By reducing incentives to import-substitution activities through trade liberalization, trade reforms can have a serious adverse impact on firms producing for the domestic market. Financial sector reform is also required to mitigate this impact on banks’ portfolios. Macroeconomic management also stands to gain, because structural reforms in the financial sector are likely to increase the effectiveness of financial policies required for adjustment.

Many countries have adopted policies to reform the financial sector. These policies fall into two broad categories:

• Those that improve the monetary control system.

• Those that improve the mobilization and allocation of domestic savings.

Both types of policies have been covered in varying scope and depth in Fund programs of financial and technical assistance (see table). With the objective of stimulating private saving and improving its allocation, most programs under the recently established structural adjustment facility (SAF) feature an active interest rate policy, either in the form of interest rate liberalization (e. g., Bolivia, The Gambia, Haiti, and Sierra Leone) or a more flexible management of administered rates (e.g., Bangladesh, Burundi, and Mauritania). In The Gambia and Sierra Leone, where interest rates in the recent past were the most negative in real terms, interest rate liberalization was accompanied by other supporting measures such as a system of regular treasury bill auctions to move quickly toward a market-oriented structure of interest rates. In two other countries, Bangladesh and Mauritania, a comprehensive financial and legal reform of the banking system was also undertaken. (For a discussion of experience with SAF programs, see “Helping Structural Adjustment in Low-Income Countries” by Michael Bell and Robert Sheehy, Finance & Development, December 1987.)

In reforming the financial sector, three broad issues need to be addressed:

• The adequacy of instruments to improve the implementation of monetary policy and to facilitate increased reliance on indirect, rather than direct, controls.

• Institutional and regulatory reforms to improve the efficiency and soundness of the financial system.

• The adequacy of the level and structure of interest rates. The rest of this article analyzes these issues and, in the light of Fund experience, identifies structural policies in the financial sector that could help achieve macroeconomic objectives and the needed growth-oriented adjustment.

Monetary control

In general, adjustment programs are designed to achieve a certain growth target in some credit or monetary aggregate. In countries where financial innovations or a shift to a market orientation of the economy are taking place, the target for a particular institutions, improved supervision of the financial institutions, introduction of deposit insurance, development of term finance and capital markets, and creation of new financial institutions and instruments.

Money market development. The development of the money market contributes to the efficiency of the financial sector by allowing financial institutions to transfer surplus funds to other financial institutions instead of directly financing inefficient borrowers or discouraging depositors; and by facilitating the management of bank liabilities through refinancing, thereby increasing the availability of long-term finance for investment. In addition, open-market operations could be conducted more effectively and their effects on banks’ marginal cost of funds felt more rapidly. Specific policies to develop and strengthen money markets have been addressed in Fund programs of technical assistance in, for example, Indonesia, Malaysia, Nepal, Oman, Sri Lanka, and Yemen Arab Republic. Such policies include strengthening broker-dealer services and their regulation, introducing money market instruments, reforming the central bank’s discount window operations to support money market development consistent with monetary control, setting up auction systems in the primary market for money market financial instruments, and favorable tax treatment of interest income from financial assets.

Selective credit policies. Policies such as loan rate ceilings and restrictions on the portfolios of financial institutions constitute implicit subsidies or taxes. They can be very complex. The implicit taxes could fall on depositors through low deposit interest rates, thus affecting savings. Interest subsidies by the central bank may reduce transfers to the budget, thus affecting the stance of fiscal policy. Banks’ lending to nonpriority sectors at below-market interest rates affects resource allocation. To the extent that they rely on unconditional refinancing by the central bank of loans to favored sectors, selective credit policies reduce the flexibility of monetary policy. The accumulation of a whole range of contingent liabilities to the government resulting from its guarantees of the repayments of priority credits makes the government the ultimate guarantor of the financial system’s stability. The long-term solution to these problems is to limit the scope of selective credit and guarantee policies as much as possible, and to transfer to the budget the associated implicit subsidies and taxes. This action will limit the monetary impact of these policies and make it possible for the government to compare the costs of credit subsidy programs with those of other budgetary expenditures.

Integrating financial markets. A segmented financial system complicates the conduct of monetary policy and adversely affects resource allocation and growth. To illustrate, suppose that interest rate ceilings are set at higher levels for nonbank financial institutions than for banks. A policy of credit restraint would then encourage the outflow of funds from the banking system. The income velocity (that is, ratio of GNP to money) of broad money (currency and demand deposits plus savings and time deposits) may increase, while that of narrow money (currency and demand deposits), which is used as reserve asset of nonbank financial institutions, may fall. A redefinition of monetary and credit targets for purposes of financial management cannot sufficiently counteract the possible negative impact on the intermediation capability of a financial system that is segmented by excessive and inappropriate regulations. A long-term solution is to reform the domestic regulatory framework to eliminate the major causes of segmentation, such as inadequate licensing regulations, burdensome reserve requirements and portfolio restrictions, unrealistic interest rate ceilings, and the operating inefficiencies of the regulated markets.

Supervision and deposit insurance. Improved supervision and regulation of financial institutions and creation of properly designed deposit insurance schemes protect depositors and prevent financial crises by maintaining public confidence, and they discourage institutions from taking excessive risks. Inadequate supervision often leaves undetected a weakening of the loan portfolios of financial institutions, with serious consequences. An unexpected failure of individual institutions can lead to systemic crises and undermine stabilization efforts. As banks keep problem loans current by capitalizing overdue interest, the monetary authorities often find it difficult to contain the expansion of credit; the allocation of credit is also distorted.

In recent years, in response to requests from member countries, Fund technical assistance has offered specific advice on how to restructure, merge, or liquidate insolvent institutions, and establish new ones. Among other things, this has required an analysis of the quality of the portfolio of existing institutions; drafting of legislation and regulations to improve debt collection; identification of accounting and auditing deficiencies in both the central bank and the commercial banks; assessment of the bank supervision capabilities of the authorities; and establishment of a central credit information bureau to coordinate risk information and share updated credit records of individual borrowers. Examples of this approach can be found in Bangladesh, Bolivia, Chad, Chile, Dominican Republic, Madagascar, Mauritania, Panama, and Trinidad and Tobago.

Long-term finance and institutional development. The promotion of long-term finance and capital markets is essential to improve investment incentives consistent with external adjustment, as well as to avoid excessive reliance on short-term funds to finance investments—a practice which in the past led to liquidity crises (and at times bankruptcies) of enterprises and financial institutions. Because of their expertise in development finance, the World Bank Group and, in particular, the International Finance Corporation have played a leading role in this area. In a supplementary role, recent Fund technical assistance has addressed technical and economic issues relating to policies aimed at lengthening the maturities of loans and deposits, such as introduction of variable rate loans and negotiable certificates of deposit (e.g., in Costa Rica, Dominican Republic, Indonesia, Malaysia, and Papua New Guinea). On request, technical assistance has also been provided by the Fund in the area of institutional development, such as establishing joint-venture banks, regional banks, finance companies, and insurance companies; developing secondary securities markets and the stock exchange; and creating new financial assets, such as trade and commercial notes (e.g., in Hungary and Nepal).

Interest rate reform

Policies on the level and structure of interest rates have implications for both monetary control and savings mobilization and allocation. While Fund-supported programs typically focus on the level of interest rates, which should reflect market conditions, monetary aggregate may become inappropriate and therefore may have to be revised.

In planned economies, for example, currency targets may be appropriate where use of deposits is strictly limited to plan transactions. Once the economy becomes more market-oriented, the monetary target may have to be changed and the program modified. Market economies that use direct controls on interest rates and bank-specific credit ceilings to achieve monetary and credit targets may suffer from undesirable effects of such policies on resource allocation. These include low deposit rates and additional loan fees or service charges, disincentives to savings (once the credit targets are reached), and underdevelopment of interbank money markets. For these reasons, it is desirable to switch to indirect monetary control through reserve money management. The Fund, through its technical assistance, has assisted Costa Rica, Indonesia, and Mauritius in making this switch, which can take place with or without interest rate liberalization. Where liberalization of interest rates is contemplated, the switch to indirect controls is particularly important to enhance competition in the banking industry.

Policy instruments. Effective monetary control through reserve money management requires the development of adequate instruments and their proper use and coordination. For instance, reserve requirements for banks and other financial institutions may be ineffectual because penalties for reserve shortfalls are set too low. In any case, the lack of coordination of reserve requirements with the management of the discount window allows banks to borrow easily and cheaply from the central bank to meet reserve needs. (Credit is channeled by the central bank through its discount window by rediscounting particular types of eligible bills and securities.) If required reserves earn little or no interest, an increase in reserve requirements may cause banks to raise effective loan rates, for example, through higher service charges and/or lower deposit rates, with adverse effects on savings mobilization and allocation. Structural measures to tighten penalties for reserve shortfalls, to improve coordination with the discount window, and to pay appropriate interest rates on required reserves will make reserve requirements an effective instrument of monetary control and promote the efficiency of financial intermediation.

A reform of the discount window operations of central banks can also enhance the efficiency of short-term bank liability management, and encourage the use of money markets. With Fund technical assistance, in China, Indonesia, Malaysia, and Sri Lanka, such a reform has included reductions in the scope of selective credit windows. Other reforms have included market-related pricing of rediscounted commercial notes and introduction of new windows with appropriate maturities, rates, and eligibility criteria. Reform of the discount window would in turn facilitate the use of open-market operations, which can be the most effective instrument of monetary control with minimal distortionary effects. A central bank engages in open-market operations when it purchases and sells government notes and bonds in the market. In some cases (e.g., the Philippines), this operation takes place in bonds issued by the central bank itself. In order to facilitate such operations, money market instruments appropriately designed and coordinated have been introduced in several developing countries, such as Indonesia, Malaysia, Oman, Sri Lanka, and Yemen Arab Republic.

Structural policies in the financial sector

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Source: International Monetary Fund.

The list under each category comprises countries which have received advice in the indicated areas, either in the context of the use of Fund resources and consultation missions, or direct Fund technical assistance. Countries receiving technical assistance through the placement of experts are not covered in the list.

Assessment of the adequacy of financial instruments is an integral element in any growth-oriented stabilization strategy. While relatively crude instruments can achieve quantitative credit and monetary targets, the cost will be an inefficient use of resources. For instance, administered interest rates often do not reflect the relative scarcity of resources, while selective credit controls and bank-specific credit ceilings can cause severe problems for particular institutions, thus hampering their performance as financial intermediaries. The Fund’s technical assistance over the years suggests that monetary control instruments can be substantially improved in a relatively short time with the necessary technical and institutional reforms.

Mobilizing and allocating savings

While adequate monetary control instruments improve the effectiveness of monetary policy and promote efficient use of resources, additional structural measures may be required to strengthen the financial sector’s role in enhancing the generation and allocation of domestic savings. Such measures include the development of money markets, streamlining of selective credit controls, integration into the formal system of unregulated financial reform of the interest rate structure increasingly receives more attention, because such reforms could help improve the allocation of credit. Bad debt and high operating costs can lead to low deposit rates and high lending rates, often with inappropriate distribution of risk. For example, distortions in credit allocation result from prime customers paying for risks of default arising elsewhere in the system. A term structure of interest rates that offers insufficient returns to longer-maturity deposits could reduce the availability of term finance for investment. Policies to improve the structure of interest rates include measures to reduce interest subsidies, based on an assessment of their incidence and effectiveness (in redirecting resource flows); modify the sectoral distribution of subsidies to ensure consistency with external adjustment objectives; introduce a prime rate or base lending rate system; improve the operating efficiency of financial institutions; and minimize the incidence of bad debt through legal, regulatory, and institutional changes.

A full-scale liberalization of interest rates requires prior implementation of structural policies to eliminate or substantially reduce selective credit policies based on below-market interest rates; homogenize portfolio regulations; modify rules and regulations on mergers, licensing, and branching; and improve the soundness of the banking system and the adequacy of bank supervision. Without these policy changes, there would be inefficient and unequal competition in the loan and deposit markets. Interest rate liberalization under such circumstances could produce excessive fluctuations and significant distortions in the level, structure, and responsiveness of interest rates. Moreover, in the absence of a well developed money market and of measures to strengthen the monetary policy instruments, the national authorities would be hard-pressed in influencing the marginal cost of funds to banks, much less its speed of response to monetary policy.


The design of growth-oriented adjustment programs can benefit from a systematic review of financial sector issues. Three broad areas for such review are: an analysis of how well the instruments work in order to improve the effectiveness of monetary policy and facilitate a switch away from direct controls; the formulation of institutional and regulatory reforms to improve the efficiency and soundness of the financial sector; and an examination of the adequacy of the level and structure of interest rates. Significant measures to reform the financial sector in these areas have been introduced in one form or another in a number of countries, resulting in major shifts in the balance sheet positions of savers and investors. The monetary policy component of a growth-oriented adjustment program with financial sector reform has two elements:

• In choosing monetary and credit targets, the effects of the reforms themselves on the demand for money and domestic savings are taken into account.

• Appropriate benchmarks are devised to monitor the progress of financial sector reform and developments in the efficiency of financial intermediation. Both elements are featured in an increasing number of programs involving the use of Fund resources under the SAF.



by Richard Hemming and Ali M. Mansoor

The substitution of private for public sector activities has been one of the more striking features of the 1980s. Why has it occurred? Is there an economic case to be made for it? How has it been done? And will it live up to the goals set for it? These questions are addressed in O.P. 56 in the context of a general evaluation of the potential role of privatization for achieving greater efficiencies.

Price: 7.50 (22 pages: ISBN 1-55775-005-X) Available from: Publication Services, Box A-881, International Monetary Fund, 700 19th Street N.W., D.C. 20431, U.S.A. Telephone: (202) 623-7430

Finance & Development, March 1988
Author: International Monetary Fund. External Relations Dept.