Banking system failures in developing and transition countries: Diagnosis and predictions

by Patrick Honohan

Understanding what caused the recent costly wave of banking system failures in developing and transition economies is the key to preventing a recurrence. It is important to distinguish between epidemics of the macroeconomic and micro-economic varieties, and between these and the syndrome of endemic failure, associated with pervasive government involvement. Each type has its characteristic warning signs - the availability of the relevant indicators is discussed in some detail - and a comprehensive prevention policy must take account of each.

Thus, for example, it is unwise to defer macroeconomic stabilisation in the hope of concealing banking sector weakness. Likewise, a rigorous application to developing and transition economies of the consensus approach to microeconomic regulation should not be deferred. Political interference is the Achilles heel of any regulatory system: among other mechanisms, it may be possible to use disclosure rules and the pressures of globalisation to increase the political attraction of regulatory enforcement.