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Gerard Caprio and Ross Levine

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James R. Barth and Gerard Caprio, Jr.

This chapter re-examines the role of financial regulation and supervision in economic development, which, given concerns over international agreements and skepticism about the efficacy of regulation in banking in particular, seems timely. Historically, banking has developed and attempts have been made to stabilize it through a few rules, notably those that encouraged diversification and contained disincentives toward excessively risky activities, so that bankers were not just gambling with “other people’s money”. After reviewing the economic rationale for interventions in finance and briefly discussing the role of political economy factors in the policies adopted, the chapter reviews regulations to assess what has worked or failed, both historically and recently. It also examines differences in bank structure and regulatory environment across countries at different income levels and discusses recent innovations in finance that might affect the role banks play in the years ahead, noting significant variation in many conditioning factors and outcomes. Last, the chapter puts forth some principles and approaches that bank regulators might adopt to achieve the goal of deep, liquid and stable banking systems, avoiding the overly complex, one-size-fits-all approach that is now popular in high-income countries. Changing technology offers new possibilities to increase access to financial services for people worldwide and with it financial and economic development. While the regulatory community views safety and soundness considerations as primary, those without access to finance understandably want to gain entry, and officials should be alert to increasing the benefits to such persons from new financial technology and not just focus on the risks.