By Gerard Caprio Jr. (Williams College) & Dimitri Vittas (World Bank)
The environment in which financial institutions operate has changed greatly, but the history of financial development offers important lessons for today. Among the lessons financial history offers:
Macroeconomic stability – low inflation and sound public finance – is important for creating the right incentives for banks and for facilitating the development of securities markets. High inflation and large fiscal deficits distort economic behavior in favor of short-term speculative projects and discourage the long-term investment projects conducive to sustainable economic development. Central bank independence may contribute to economic stability. One way to increase it is by lengthening the term of central bank governors.
There must be incentives for bank owners to behave prudently – a requirement that they have capital commensurate with the risks they assume, for example. Unlimited liability and double liability limits may be less feasible now than in the past, but banks in developing countries that face higher risks should maintain higher capital ratios than banks in the more advanced OECD countries. Effective supervision is also essential.
Banks run into solvency problems because they fail to diversify – often because of regulatory (especially geographic) restrictions, but also because of excessive connected lending or genuine mistakes. Regulators must ensure that banks diversify their risks, which means ending geographic or sectoral restrictions (including prohibitions against holding foreign assets) and restricting connected lending.
Developing effective supervision (to ensure meaningful and effective compliance with prudential rules) is difficult and time-consuming but essential.
The difficulty of supervising universal banks and financial conglomerates is an argument used against them in developing countries. But universal banks may generate efficiency gains as they overcome the problems of inadequate reliable public information on industrial and commercial companies. Holding small equity stakes and being involved in corporate governance may be productive. The risk of overlending to related firms is likely to be small when banks hold small stakes in industrial firms; it is high when firms control banks.
Pension funds and other institutional investors have grown in importance in many countries over the past thirty years or so, because of longer life spans and longer retirement. These funds started as labor market institutions and personnel management tools, but have become important financial intermediaries. Pension funds offer developing countries an alternative both for restructuring their public finances and for promoting their capital markets.
Pension funds can play the role that thrift deposit institutions – such as savings banks, credit cooperatives, and building societies – played in developed countries in the nineteenth century. But thrift institutions can still contribute to financial and economic development by promoting thrift and facilitating credit in rural areas and among low-income groups. They will contribute more if they involve a three tier structure that combines the benefits of local involvement and monitoring with centralized auditing and supervision.
This paper – a joint product of the Finance and Private Sector Development Division, Policy Research Department, and the Financial Sector Development Department – was presented at a Bank seminar, Financial History: Lessons of the Past for Reformers of the Present, and is a chapter in a forthcoming volume, Reforming Finance: Some Lessons from History, edited by Gerard Caprio, Jr. and Dimitri Vittas.

Full Content: SSRN