Countries remain poor partly because their financial institutions are weak, and their economies are therefore unable to use capital efficiently. Problems such as the lack (or poor allocation) of capital, bad debt, ineffective regulation of the financial sector and rampant corruption could be solved if those countries were to adopt some of the banking and market systems that have worked in the West.

However, investors in emerging markets who are eager to see these reforms take hold should bear in mind that many aspects of the financial systems in developed economies are not applicable to poor countries. A crash program of deregulation and liberalization can have negative consequences that are difficult to predict. If the proper bank regulatory and supervisory structures, accounting and disclosure requirements, restrictions on connected lending and well-functioning legal and judicial systems are not in place when liberalization occurs, the appropriate constraints on risk-taking behavior will be far too weak. Bad loans will multiply, with potentially disastrous consequences for bank balance sheets.

This is not to say we should throw up our hands and give up on helping poor countries reform their systems. A nation can make reforms that will put it on the path to wealth, but, in every case, the reforms have to be adapted to local economic, political and cultural conditions. Consider, for example, four areas that are particularly ripe for rethinking in every emerging market:

Minimum Capital Requirements
The 1988 Basel Accord, a set of global bank regulations devised by a group of national bank regulators, requires banks to set aside more capital when holding higher-risk assets than they do when holding lower-risk assets, as a hedge against the possibility of default. But the accord (and its more complex successor, Basel II, which is being phased in over the next couple of years) was designed primarily for advanced countries’ banking systems. It is not as effective for emerging market economies.

For example, the original accord classifies government bonds as having the lowest risk of all bank assets, and therefore requiring the least capital. This classification may make sense in the United States, where the Treasury is extremely unlikely to ever default on its bonds, but it makes little sense when applied to lower-grade government bonds issued by emerging market countries. A major factor in the 2002 banking crisis in Argentina was the sharp fall in the value of banks’ holdings of Argentine government bonds when these bonds went into default.

A crash program of immediate deregulation and liberalization can have negative consequences that may be difficult to predict.

Emerging market economies are also subject to greater economic shocks than are advanced economies. The increased risk that banks in these countries face suggests that the amount of capital they hold should be even larger than is necessary in developed countries. Thus, bank capital requirements in emerging market economies need to be even more stringent than the international standards adopted by bank supervisors in advanced countries.

Currency Mismatches
One of the biggest dangers to emerging economies is caused by the fact that much of their debt is denominated in the dollar or some other foreign currency, while the value of their production and assets is denominated in the domestic currency. Any event that seriously devalues the local currency is likely to trigger a full-fledged financial crisis by decimating the balance sheets of local banks and nonfinancial businesses. The 2002 banking crisis in Argentina, the Asian financial meltdown of the late 1990s and the Mexican "tequila crisis" of the mid-1990s were exacerbated by this sort of currency mismatch.

Reducing foreign-currency-denominated debt is difficult because it means some local businesses will not be able to borrow at all. Nevertheless, excessive liability dollarization is detrimental to the overall health of developing economies. It creates a vicious circle: Governments are more likely to bail out businesses and banks when they all fail together, so that a government safety net encourages financial and nonfinancial industries to borrow in foreign currencies, despite the fact that this leaves the economy more vulnerable to financial crises.

Residents of emerging market economies have their debt denominated in currencies of industrialized countries because these currencies have more stable purchasing power, and therefore less inflation risk, than their domestic currencies. If these residents had access to debt indexed to inflation, it would provide an alternate way to lower their inflation risk, and liability dollarization would be less likely. Debt contracts would be denominated in an index unit tied to a price-level measure such as the Consumer Price Index so that, when the price level rose, the nominal value of debt would rise one for one, while the real value of the debt in terms of goods and services would remain unchanged. In the 1960s, after Chile developed an indexing unit (the Unidad de Fomento), indexation of debt and other contracts became widespread. As a result, Chile was able to avoid liability dollarization, despite having high and variable inflation rates similar to those in other Latin American countries.

Having an exchange rate pegged to a foreign currency such as the dollar provides a more stable value for the currency and therefore attracts investment. Yet, in the longer term, the capital inflow can lead to a lending boom, an explosion of nonperforming loans and an eventual financial crisis. A pegged exchange-rate regime can also make it easier for a country to tap foreign markets for credit and, with access to additional markets for its debt, lure the government into irresponsible fiscal policy. Argentina provides a graphic recent example of this problem: When the country’s fiscal policy became unsustainable, it provoked a disastrous crisis that pushed Argentina into a serious depression.

Most emerging market countries would be far better off to avoid exchange-rate pegs and instead adopt a flexible regime in which the exchange rate is allowed to float on a daily basis. The daily fluctuations in the exchange rate in a floating regime make clear to investors, banks and governments that there is substantial risk involved in issuing liabilities denominated in foreign currencies. Furthermore, a depreciation in the exchange rate may provide an early warning signal to policymakers to enable them to adjust their policies to limit the potential for a financial crisis.

Deposit Insurance
The concept of insuring depositors at the national level against losses when banks go broke originated in the United States in the aftermath of the Great Depression. By the 1990s, more than 70 countries had instituted deposit insurance, among them Ecuador, El Salvador and members of the Central African Currency Union. Most of the Eastern European countries adopted it shortly after the end of communism. Despite its popularity, deposit insurance is a mixed blessing. It prevents bank panics in industrialized countries, but it also increases the incentive for banks to take on excessive risk. Emerging markets generally lack the level of government scrutiny that keeps banks from taking on too much risk; without these controls, deposit insurance can increase, rather than decrease, the likelihood of a banking crisis. Research conducted primarily at the World Bank has found that, on average, the adoption of explicit government deposit insurance is associated with greater instability in the banking sector, a higher incidence of banking crises and impediments to financial development.

Banking Supervisors
One of the aims of the new Basel II Accord is to strengthen government bank supervision. (It also seeks to make the capital requirement regime more risk-sensitive, and to enhance the ability of the market to oversee banks.) The accord suggests that banking supervisors should be given stronger statutory discretionary powers, such as the legal ability to issue cease-and-desist orders to force a bank to change its internal organizational structure, suspend dividends, stop bonuses, decrease management fees or remove and replace managers and directors. These powers provide supervisors with a weapon to force banks to comply with regulations and to restrain them from engaging in risky behavior.

Lack of money flowing to investments is often not the problem; indeed, too much money flowing in has often resulted in bad loans . . . .

However, giving supervisors these powers is beneficial only if they are acting in the public interest. That proposition is fair to assume in countries that have a strong rule of law, an active free press that holds supervisors accountable for their actions and relatively high wages for supervisors. An important book by James Barth, Gerard Caprio Jr. and Ross Levine, Rethinking Bank Regulation and Supervision: Till Angels Govern, presents findings from a World Bank database on bank supervisory practices throughout the world. The authors conclude that in rich countries, supervisors generally help, while in developing countries, they generally grab. The book’s statistical evidence suggests that strengthening the discretionary powers of supervisors in developing countries has led to lower levels of bank development, greater corruption in lending and banks that are less sound.

In many developing countries, banking regulators and supervisors are not given sufficient resources to do their jobs effectively. In close to 40 percent of these countries, supervisors can be held personally liable for their actions in civil lawsuits, making it less likely that they will take the appropriate actions. Their salaries are generally low relative to those paid in the private sector, and thus they tend to be easily bribed by the institutions they supervise, either directly or through promises of high-paying jobs. And if they do not have sufficient resources to monitor financial institutions, particularly in terms of information technology, they will be unable to spot excessive risk taking.

Given the problems with bank supervision, it may be better to allow the impartial market to discipline financial institutions when they take on too much risk. Requiring them to disclose their balance sheets encourages them to hold more capital because individual depositors and creditors will be unwilling to put their money into an institution that is thinly capitalized. In this case, supervisors may need to focus less on telling banks what to do and more on encouraging market discipline by making sure banks comply with disclosure rules. Supervisors might also be charged with the task of evaluating how banks manage risk and disclose this information to the public. By giving poor rankings to banks that are not up to par on risk management, banking supervisors can make sure that best practices for risk management will spread throughout the banking industry in their countries.

Lack of money flowing to investments is often not the problem in emerging market countries; indeed, too much money flowing in has often resulted in bad loans and investments, which have led to disastrous financial crises. A well-conceived plan for financial development promotes the allocation of investment funds to where they can do the most good for the economy, promoting growth by ensuring that the country uses its capital to increase productivity.

Frederic S. Mishkin is a professor of banking and finance at the Graduate School of Business, Columbia University. After writing this article, in September he became a governor of the Federal Reserve System. This article is based on material in his recently published book, The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems to Get Rich.