The World Bank and financial sector reform

5 October 2007 | Inside the institutions

Financial sector reform constitutes a major area of work for the World Bank. The financial and private sector development vice presidency – which is jointly run by the International Finance Corporation (IFC), the private-sector funding arm of the Bank, and the main part of the Bank – undertakes reform work in the sector through its financial sector operations and policy department. Additional private sector work is undertaken separately within the IFC by the global financial markets department within the industries vice presidency.

Banking markets as focus of reform

The financial sector operations and policy department has 49 staff. Financial sector reform work is also coordinated by the Bank’s financial sector board, a cross-departmental body, and the financial sector network, an informal group of staff from across all departments and regional units. In total the Bank has 125 staff mapped to this sector, in comparison to just over 200 staff mapped to the health sector.

Bank support for financial sector reform was first underpinned by the 1989 World Development Report on financial systems and development.In 1992 the Bank developed its first operational directive on the financial sector. This was replaced in 1998 by an operational policy on lending to financial intermediaries. Lending for financial sector reform was covered under a 2000 financial sector strategy paper. A subsequent private sector development strategy paper from 2002 also covered aspects of the Bank’s work in the financial sector. Lending for financial sector reform is now covered by a revised financial sector strategy paper approved by the board in April 2007.

40 countries took Bank loans or sector adjustment packages aimed at the privatisation of banks.

The IEG report described the 2000 strategy paper:: “The financial sector strategy draws on the literature in arguing for strong banking systems based on good governance of banking institutions and a reliable legal and judicial environment. Also consistent with research findings on competition is the strategy’s point that increasing competition in the financial sector may be inappropriate for small financial systems, which characterize many of the Bank borrowers. The strategy is arguably less consistent with the literature in promoting capital market development, to the extent that the literature is ambiguous on this point.”

The central goals of the new strategy are to build financial systems that “do a good job of allocating funds and allocating risks” by improving investment opportunities, accessibility, transparency and risk management. The Bank plans to do this by “building and strengthening financial market and institutional infrastructure – the enabling environment for financial market transactions – and actively facilitating the development of well-regulated, diversified financial institutions and markets.”

While the World Bank’s work in financial sector reform covers many areas – i.e. credit markets, payments systems, insurance regulation – the banking sector has been the dominant area of work. A 2005 Independent Evaluation Group analysis of financial sector reform at the Bank found three main pillars for the Bank’s work: privatisation of state-owned banks, improvement of regulatory frameworks and strengthened supervision of banks. Between 1993 and 2003, 40 countries took Bank loans aimed at the privatisation of banks. Another key thrust of World Bank work in this area is to allow market forces to determine interest rates and to eliminate the practice of governments directing the allocation of credit. Additionally the World Bank sought to increase competition and efficiency in the banking sector. The new strategy paper proposes a shift in emphasis from banking markets to more systemic issues like capital markers, regulation and oversight.

Lending for adjustment in the financial sector comes through both financial sector-specific loans and multi-sector loans that include some financial sector component. Between 1993 and 2003 the Bank funded 53 financial sector-specific adjustment programmes, now called ‘development policy loans’, to the tune of $19.7 billion. ‘Investment lending’, which finances technical assistance or involves support for bank privatisations, comprised 83 loans for a total $5.1 billion in the period. Most lending was in response to financial crises, meaning that volumes in the sector varied wildly from year to year. A further 115 multi-sector adjustment loans between 1993 and 2003 contained financial sector components, but it is impossible to attribute a specific amount of resources to the financial sector reform elements. Including adjustment and investment lending, 14 per cent of all Bank loans, representing 24 per cent of the Bank’s entire portfolio had some financial sector component. In 2006 the Bank’s spending on non-lending activities such as analytical and advisory work totalled $48.5 million, about 30 per cent of which was directed at the Africa region.

Private financial sector work at the IFC

At the IFC the global financial markets department “builds local financial institutions, develops local equity and debt markets, and introduces new financing instruments. The goal is to develop efficient financial systems that will fuel economic growth in developing countries.” The department, known publicly as GFM but internally by the acronym CFG, is growing quickly in size because of the IFC’s aggressive investment in the sector. As of mid-2006 it was comprised of 188 core staff who also work with 35 staff members assigned to specific regions. As the IFC’s mandate is to invest in and lend to the private sector, the GFM is not generally involved in the regulatory or supervisory aspects of financial sector reform. Most of its activity is investment in both privately and publicly owned banks or other non-bank financial institutions. That involvement can come through loans, equity investments or purchase of bonds. The IFC also has 78 staff in the regional units dedicated to financial sector technical assistance.

The GFM works in 14 sub-sectors including consumer finance, insurance, housing finance, and microfinance. Like the public-sector arm of the Bank, the largest volume of work is in the banking sub-sector, accounting for 48 per cent of the department’s investment portfolio of $7.4 billion as of mid-2006. The portfolio has been rapidly expanding with average annual growth from 2000 to 2006 of nearly 31 per cent. Fiscal year 2007 was a bumper year for the department as by mid-2007 the IFC had committed an additional $3.4 billion to the sector to bring the total invested to $9.4 billion. In 2007, 54 per cent of the commitment was in the form of loans, 26 per cent in loan guarantees and 20 per cent equity investments. The $9.4 billion represents 37 per cent of the IFC’s total portfolio. The GFM’s portfolio is most heavily invested in the Latin America & Caribbean region, which accounts for 25 per cent of the department’s investments. It largest investment in the sector is a $275 million equity stake in the medium-sized Turkish bank Finansbank to support on-lending to small- and medium-sized enterprises.

Joint Bank-Fund programmes – FSAP

Because of the Asian financial crisis and previous lack of collaboration in financial sector reform, the Bank and IMF jointly launched the Financial Sector Assessment Programme (FSAP) in May 1999. With the assistance of experts from other agencies, the Bank and Fund are invited by member countries “to identify the strengths and vulnerabilities of a country’s financial system; to determine how key sources of risk are being managed; to ascertain the sector’s developmental and technical assistance needs; and to help prioritise policy responses.” An FSAP assesses the financial sector on its adherence on up to six standards or codes in the areas of: transparency in monetary and financial policies, banking supervision, securities, insurance, payment systems, and anti-money laundering and combating the financing of terrorism.

FSAPs are vital elements in the financial sector reform efforts of the Bank and Fund. According the IMF “In low- and medium-income countries, the FSAP is also seen as a tool that helps identify gaps and issues that need to be addressed to develop a more diversified, competitive and inclusive financial sector.” The IMF continued: “Managers in the Fund and the Bank use the FSAP recommendations as a key input in planning technical assistance activities in consultation with country authorities. Substantial resources, especially in developing countries, are devoted to FSAP follow-up through TA.” Aside from Bank and Fund TA, FSAP recommendations also inform the development and review of the Bank’s Country Assistance Strategies which then give rise to Bank lending for the financial sector reforms identified. Bilateral donors also fund TA based on FSAP recommendations through the Financial Sector Reform and Strengthening (FIRST) initiative.