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#15 - JRL 7214
From: "Vlad Ivanenko" <vivanenk@uwo.ca>
Subject: 7212-20: World Bank on banking reform
Date: Sat, 7 Jun 2003

My interest in the problem of financial intermediation dates back to the time when the concept of virtual economy was popular among Russias watchers. The resulting work has found that non-monetary trade in that country followed closely the cost of using money in trade (an earlier version of the paper is available at http://economics.ca/2003/papers/0159.pdf). In particular, there is evidence that Russian banks failed to cover short-run fluctuations in demand and producers had to finance changes in inventories by resorting to trade credit. Thus the point that the World Bank makes on the problem of intermediation in Russia is well taken.

However, the posted note fails to show what the Bank proposes specifically to correct for detected deficiencies. For example, the Bank is supposedly concerned about the inflow of speculative funds in Russia. So what does it suggest? It appears that the Bank chooses to play it safe and bundles together incompatible pieces of advice. On one hand, it hints that capital controls might be put in place to restrict capital inflows. On the other hand, the message of capital controls is expressed in terms that clearly convey Bank's displeasure with this idea. It is understandable why: if there is a danger of a financial bubble, control over international portfolio flows should be imposed but it goes contrary to the concept of capital mobility as expressed in WTO documents. The Bank reconciles the difference by rejecting both outcomes. Thus whatever happens in Russia -- financial crash or introduction of capital controls -- it comes out clean.

Bank's advice to speed up a banking reform is similarly superficial. The trouble is that financial intermediation is based upon mutual trust. The Bank understands perfectly well that trust takes time to be developed. Commercial banks would not lend to customers whom they hardly know. Depositors would not keep their savings in long-term banking obligations if they are uncertain about the prospect of repayment. What does the Bank think the Russians should do under the circumstances? The report states that the law on deposit insurance is unlikely to be discussed before the elections implying that the Bank endorses this idea and worries about the delay. On second reading, it becomes clear that the Bank does not say so and with a good reason. Mandatory insurance would solve the informational problem, which is what drives mistrust in the first place, but at the expense of creating another and potentially more damaging problem of moral hazard. Again, whatever trouble happens next -- delay or acceptance of the law -- the Bank is not to be blamed.

Vlad Ivanenko
Dept. of Economics
Univ. of Western Ontario

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