"Franchise Value and the Dynamics of Financial Liberalization"
Designing Financial Systems in Transition Economies: Strategies for Reform in Central and Eastern Europe
Editor(s): Anna Myendorff and Anjan Thakor
© MIT Press, 2002
Publication type: Chapter
Over the last three decades, there has been a substantial shift in financial market policy towards the promotion of financial liberalization. Policy makers around the globe have been preoccupied with deregulating interest rates, lifting restrictions on bank portfolios and enticing competition in financial services. Financial deregulation is typically accompanied with a change in the system of prudential regulation. As the volume and complexity of transactions has increased, there has been movement away from monitoring individual transactions and more emphasis has been placed on evaluating the risk monitoring systems used by banks. As a part of this trend, greater emphasis has been placed on the use of capital requirements as a tool of prudential regulation, typically using the BIS standards developed in the Basle Accord. While this trend in financial regulation has lead to some notable improvement in the provision of financial intermediation, it has also been marred with a surprisingly large number of banking crises. The question then is whether there is a causal link between financial liberalization and banking crises? Are there particular difficulties created during the process of liberalization that make it more likely that crises will follow in the aftermath of a liberalization episode? In this paper, we argue that the announcement of liberalization in the future causes an immediate decline in franchise value today with a potential adverse effect on bank incentives to invest prudently. The main objective in this paper is to provide an intuition of the mechanics of capital requirements and deposit rate controls that we have studied elsewhere, and to explore the implication of these dynamics on the particular problem of transitions to a more liberalized system. In the first section of the paper we explain the logic of capital requirements and deposit rate controls in a steady state, i.e., where banks expect continuity of the policy regime. In the second part of the paper, when we examine the transitional dynamics, the importance of deposit rate controls becomes even more evident.
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