Financial Restraint: Towards a New Paradigm

This paper examines a set of financial policies, called financial restraint, that address financial market stability and growth in an initial environment of low financial deepening. Unlike with financial repression, where the government extracts rents from the private sector, financial restraint calls for the government to create rent opportunities in the private sector. These rent opportunities induce outcomes that are more efficient than either financial repression or laissez-faire policies. It is argued that deposit rate controls and restrictions on competition create franchise value in financial markets that curtails moral hazard behavior among financial intermediaries. Lending rate controls may also increase the efficiency of intermediation by reducing agency cost in loan markets.