Banking and Regulation in Emerging Markets: The Role of External Discipline

This article reviews the main issues of regulating and supervisingbanks in emerging markets with a view toward evaluating thelong-run options. Particular attention is paid to Latin Americaand East Asia. These economies face a severe policy commitmentproblem that leads to excessive bailouts and potential devaluationof claims of foreign investors. This exacerbates moral hazardand makes a case for importing external discipline (for example,acquiring foreign short-term debt). However, external disciplinemay come at the cost of excessive liquidation of entrepreneurialprojects. The article reviews the tradeoffs imposed by externaldiscipline and examines various proposed arrangements, suchas narrow banking, foreign banks and foreign regulation, andthe potential role for an international agency or internationallender of last resort.