This paper builds an analytic framework for analyzing the effects of financial reforms in developing countries and the costs of maintaining official safety nets under the financial system during such reforms. A multiperiod general equilibrium framework is used to explore the interactions between three types of economic agents—firms, which borrow to finance production; households, which provide labor and hold deposits; and banks, which accept deposits and make loans—in the presence of production uncertainty, financial repression, and an official safety net that encompasses deposit insurance provided (explicitly or implicitly) by the authorities. Both the credit risks incurred by banks and the expected deposit insurance obligations of the official sector that arise during a financial reform are linked explicitly to the degree of production uncertainty, the financial positions of nonfinancial firms, and the nature of prudential supervision.
The analysis suggests a number of policy conclusions. First, the macroeconomic effects of a financial liberalization will depend critically on the perceived creditworthiness of the nonfinancial sector. If banks regard lending to firms as highly risky, for example, then increasing or removing ceilings on loan interest rates may reduce both the scale of financial intermediation and economic activity. Second, even with strong prudential supervision, financial liberalization may increase the authorities’ expected deposit insurance funding obligations, especially when the credit-worthiness of the nonfinancial sector is low. Third, given the distortions that are likely to exist in a repressed financial system, an increase in the required capital-asset ratio may have the perverse effect of increasing the expected funding obligations associated with deposit insurance, particularly when the debt-servicing capacity of nonfinancial firms is low. The paper finds that, even with good prudential supervision and enhanced capital adequacy requirements, countries undertaking financial reforms may confront a trade-off between financial efficiency and the risk of larger safety-net-funding obligations.