Answer to Question #52990 in Management for Alexander

Question

Explain the challenges of banking and finance in developing countries.

Answer 1

Regulation and supervision play an important role in the banking sector. Competition can promote the development of regulatory and supervisory systems in developing countries and countries with transition economies.
In developing countries, the need for regulation of the institutional and structural weaknesses can be felt more sharply, exacerbating the problems in the banking system and complicate it. The recent trend toward a weakening of the state financial control (deregulation) and liberalization ushered in a new era in the development of the banking sector in developing countries due to the introduction of advanced information technologies and the growth of competition from foreign countries.
Despite the persistence of the role of external regulation, becomes more and more important the use of internal management turnover based on risk assessment (risk management), as the complexity of the modern banking system often creates obstacles to effective banking regulation and supervision. In this sense, the expansion of the competition may be particularly important factor in ensuring a market-based support and strengthen the internal management of the banking sector.
Problems in the field of regulation arise mainly due to the fact that the lack of information within the banking system may lead to an unexpected collapse of the banks and the banking crisis, which could have serious consequences for the real economy. In the absence of regulation because of disruptions in the basic market mechanisms banks are inclined to excessive risk, thus endangering the safety and soundness of the banking system in the absence of regulation. Although, the banking problems exist not only in developing countries, institutional and structural weaknesses are not formed until the end of the financial systems in these countries, usually leads to an exacerbation of these problems.
During the last two decades around the world observed a significant trend towards deregulation and liberalization of the banking system. Although deregulation helped to improve profitability and reduce costs through the abolition of regulatory restrictions and stimulate competition, many countries, including some countries with economies in transition have been victims of banking crises. Financial liberalization in emerging economies is also often associated with the fragility of the banking system, coupled with intense competition from foreign countries and at the same time with the abolition of the pre-existing mechanisms of protection from the state. Although there is little doubt of the benefits of financial liberalization to long-term perspective, cases of banking crises and their disastrous consequences are of concern due to the possibility of compromise between the expansion of competition and preserving the solvency of the banking industry.
In most countries, both developed and developing countries, there are mechanisms of intensive regulation of banking activities. The main reason for bank regulation and supervision were fundamental flaws in market mechanisms and rather unique position of banks in the financial system.
According to generally recognized market imperfections arising in the preparation of asymmetric information can lead to systemic instability in the banking sector. Taking into account the fact that the banks are the main financial intermediaries occupy a central place in the payment and clearing systems of many countries, infringement of normal functioning of the banking system can lead to more serious negative consequences for the real economy than failures in the work of other financial and non-financial firms. Thus, the banking regulation and supervision are introduced in order to reduce systemic risk and to ensure the stability of the banking system.
Potential defects of market mechanisms in the banking system in the first place associated with asymmetric information. In support of this can result in the following main reasons:
In extreme cases of information asymmetry investors are not able to distinguish solvent banks from insolvent. As a result, investors do not require banks to go on additional risk compensation in the form of higher interest rates on deposits. Thus, the owners of the banks can increase their profits at the expense of research investments with high incomes and a higher risk. In addition, if investors are not able to distinguish solvent banks from insolvent, they can rush to pull their deposits for fear of losing them all in the case of any negative shocks or receipt of the information concerning the profitability of banks or trust.
Information asymmetry can lead to excessive risk-taking by banks, and perhaps to the fact those banks' activities will be carried out in the absence of regulation and supervision. Although prior experience of banking crises suggests that macroeconomic instability, including internal and external shocks may contribute to undermining the stability of the banking system, namely the gaps in prudential supervision at the micro-level and institutional defects inevitably give rise to systemic crises.
Importantly, that the banking regulation and supervision should also complement and support the system of disciplinary measures market. 
In order to ensure the effectiveness of market discipline measures should be sought disclosure of information and perform other legislative and legal norms that underlie the culture of sustainable lending. Accordingly, it should impose strict accounting standards, to ensure public awareness and develop a legislative and legal and regulatory provisions aimed at ensuring financial transparency. Strengthening corporate governance can also contribute to the stabilization of the banking system by strengthening controls designed to ensure sound and prudent conduct of banking activities.
Increased competition caused by the deregulation and liberalization of finance have occurred in the past twenty years has had a significant impact on the pricing policy and the level of willingness to take risks in the banking sector. Wide recognition of the fact that competition improves efficiency and reduces costs of financial intermediation, experts still do not agree on how the competition affects the degree of risk to individual banks and how it affects their financial stability. 
Competition complements measures of banking regulation and supervision of the financial stability of banks in two ways. Firstly, greater competition allows potential investors and investors shy away from contact with the banks that do not have a reliable system of controls. Thus, more intense competition creates incentives for the creation of an effective institutional control circuit and increases the effectiveness of market regulation mechanisms. From this it follows that the creation of a reliable system of supervision by the owners and other bank depositors helps wide dissemination of proven methods of risk management and other useful elements of banking. Second, the impact of market-based measures can not only encourage banks to prudent management of affairs, but also to impart the necessary staff skills in banking and financial spheres. Increased competition is able to force the banks to compete with each other in an effective risk management to earn the respect of the market. In addition, the use of advanced information technologies and innovations developed in the course of the deregulation and liberalization of the financial sector will serve as mechanisms for improving risk management and strengthen the stability of the banking system with the necessary market incentives.
When considering the incomplete liberalization of domestic banks, led by inexperienced managers, quite free to engage in risky investment projects, but they are very well protected from foreign competition. Therefore, do not block the process of financial liberalization, leading to increased competition from foreign banks.
In developing countries, the competition in the banking sector plays a particularly important role. Banking regulation and supervision should complement, rather than replace market disciplinary measures. Prudential supervision at the micro level, promotes competition by creating institutional conditions for full awareness and effective external supervision during the transition period. Competition, in turn, complements the system of banking regulation and supervision, increasing the effectiveness of market discipline measures and internal controls. Thus, the development of competition is particularly important for countries with economies in transition, where institutional and structural elements of the previous economic system destroyed by market incentives and thus undermine the effectiveness of discipline of market mechanisms.