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November 1999 - Three approaches to regulatory frameworks for financial systems - and a scenario for development of the world financial system that assumes a market solution. In developing the architecture for a financial system, the challenge is to combine deregulation and safety nets against systemic failure with effective prudential regulation and oversight. Klein analyzes three approaches to choosing an adequate regulatory framework for a financial system; Those most worried about panic and herd behavior tend to favor relatively extensive controls on financial institutions' activities, including controls on interest rates and on the volume and direction of lending; Those most concerned about moral hazard advocate abolishing controls and safety nets, seeing the solution in stronger market discipline and reduced powers and discretion for regulators; Mainstream opinion advocates a mix of measures, to both strengthen market discipline and improve regulatory oversight. The approach a country opts for depends on (1) which monetary and exchange rate regime it chooses, (2) whether it is more concerned about moral hazard or about panic and herd behavior, and (3) how the politics of reform shape its solutions. Klein suggests a scenario for development of the global financial system over the next two or three decades that assumes that the final outcome will resemble the market solution - not because that is the optimal policy choice but because of how political weaknesses will interact with advances in settlement technology. In Klein's scenario, the world moves toward a monetary system in which fixed exchange rate systems or de facto currency competition limit the power of central banks. This limits options for discretionary and open-ended liquidity support to help deal with systemic financial crises. The costs of inflexible exchange rates are moderated by new types of wage contracts, using units of account that are correlated with the shocks a particular industry or kind of contract faces - thus maintaining the positive aspects of monetary systems with flexible nominal exchange rates. Mistrust in monetary authorities and the emergence of private settlement systems lead to a return of asset-backed money as the means of payment. The disciplines on financial systems come to resemble somewhat those of historical free banking systems, with financial institutions requiring high levels of equity and payments systems protected only by limited, fully funded safety nets. This paper - a product of Private Participation in Infrastructure, Private Sector Development Department - is part of a larger effort in the department to understand regulatory issues. The author may be contacted at michael.u.klein@si.shell.com.

Banks and Banking Reform --- Central Banks --- Currencies and Exchange Rates --- Currency --- Debt Markets --- Economic Theory and Research --- Emerging Markets --- Exchange --- Exchange Rate --- Finance and Financial Sector Development --- Financial Institutions --- Financial Literacy --- Financial Systems --- Fixed Exchange Rate --- Future --- Interest --- Interest Rates --- International Financial System --- Lending --- Macroeconomics and Economic Growth --- Market --- Market Discipline --- Moral Hazard --- Private Sector Development --- Prudential Regulation --- Regulatory Framework --- Regulatory Oversight --- Safety Nets --- Settlement