Risk management and stable financial structures

Andrew Sheng and Yoon Je Cho

No 1109, Policy Research Working Paper Series from The World Bank

Abstract: Conventional development economics has focused mainly on generating economic growth by mobilizing savings and allocating them wisely among investment opportunities. Savings (external and domestic) were to be mobilized through tax incentives, income, and interest rate policies. Their allocation often involved direct government intervention in the investment process. After the disastrous results of the 1980s, the new wisdom is to let the private sector generate growth, while the government provides the regulatory and supervisory framework for competitive markets, ensures the existence of level playing fields, and removes obvious cases of moral hazard. But the private sector working under an inappropriate financial structure may do no better than the government in making right investment choices for long-term growth. So governments (which in a financial crisis are responsible for all national debts) should have an effective national risk management strategy, with an understanding of the national balance sheet, and the necessity of a stable financial structure for steady long-term economic growth. The authors argue that it is not only how much investment is mobilized and allocated but also how investments are financed that matters for an economy's long-term growth. Finance and development are inextricably linked with risk management (both at the sectoral and national levels). Development is a function not just of promoting the right industries and allocating capital for the high-return investments (asset management) but also of choosing the right financial structure (liability management) - and of the related risks arising from the liability mix chosen. The authors argue that one of the ingredients of the East Asian success is prudent risk management by these governments. They present five rules for national risk management, concluding, among other things, to: (a) establish fiscal discipline and price stability as the anchor of overall financial stability; (b) encourage asset diversification through industrialization and export orientation, financed by foreign direct investment; (c) avoid sectoral imbalances, such as excessive domestic or external borrowing, including the development of instruments and institutions to absorb shocks; (d) establish strong institutional capacity to assess and contain systemic risks; and (e) when the above conditions are not adequately met, retain some policy measures to handle the risk.

Keywords: Environmental Economics&Policies; Financial Intermediation; Public Sector Economics&Finance; Banks&Banking Reform; Economic Theory&Research (search for similar items in EconPapers)
Date: 1993-03-31
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