Financial Instability in the Transition Economies: Lessons from East (Asia) for (East) Europe

Abstract

The design of an appropriate regulatory framework for banks is one of the crucial aspects for the development of financial markets in transitional economies. Banking policies are usually invoked to deal with moral-hazard problems. We believe that banking policies (and the exchange rate regime) should also be designed with the aim of ensuring an adequate provision of liquidity in the event of self-fulfilling bank runs. We reconsider some of the issues discussed in Chang and Velasco (1998a; 1998b) within a different version of the Diamond and Dybvig model (1983). We argue that the stability of the domestic banking sector should be treated as an issue distinct from that of capital account liberalisation. Fixed exchange rates are vulnerable to sudden capital reversals but benefit from long-term inflows. By contrast a deregulated domestic bank sector remains illiquid even when foreign debt is entirely long-term. We also discuss the impact of an external (interest rate) shock on the fragility of the domestic banking system. Our basic point is that the choice of the exchange rate regime and of the policy mix cannot neglect the need to ensure the financial stability issue. More precisely an external shock requires a redistributive policy that subsidises banks Under a fixed exchange rate system an appropriate fiscal intervention must be designed. The same result can be obtained by means of a monetary surprise if the exchange rate is flexible and the deposit contract is not indexed.