Banking Sector Reforms: Recovery Prospects and Policy Issues

Abstract

The importance of banks is premised on the ground that banks are the main channels of savings and the allocators of credit in an economy. The efficiency of banks therefore affects the financial system and the entire economy. Their failures can erode public wealth and confidence in the economy. Bank failures or sys¬temic banking crises occur almost invariably due to distorted management incentives, bad governance, weaknesses in macroeco-nomic policies, weak supervision, problems in the real sector, or a combination of these. Banking failure cuts both ways. It can be the cause of macro-economic instability, particularly when it contributes to fiscal deficits and also when it drains foreign exchange reserves. On the other hand, macroeconomic instability can cause banking failure as a result of, for example, currency devaluation, rise in interest rates, and fall in asset prices leading to corporate losses and insolvency. In addition, lack of market discipline or sufficient competition, proper regulation and oversight, and weak legal framework and en-forcement are other possible factors contributing to structural weaknesses in the banking system.