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ries is often characterized by a non-competitive financial system in which banks make good profits by paying low interest on deposits and charging high interest rates on loans which are only paid to super-safe borrowers. Shareholders and bank managers are highly satisfied with rents emerging from limited competition, but the financial system is hardly conductive to investment in fixed capital and to economic development. Credits will limited and unlikely to flow to potentially high-return investment projects in the productive sector. The task of reforming the financial system will not be an easy one. Even if policymakers recognize that financial instruments that may have high social returns in a more developed countries may not be appropriate for their less developed economy and try to target the reform process to the real needs of their country, financial regulators will soon start facing new problems. By reducing bank margins, the reform process leads to a whole new set of incentive problems.

Although the old system was inefficient, it was easy to control. A more competitive environment changes the incentive structure of bank managers in two ways (Ragan, 2005). First, as their compensation now depends on ROI, bank managers are prone to face more upside risk-taking. This is problematic if bank officers are used to operating under the '3-6- 3 risk management rule' (borrow at 3 %, lend at 6%, and be on the golf course by 3 PM) and end up assuming risk that they don’t understand. Along similar lines, regulators used to an inefficient but stable banking system may not understand the new risks and vulnerabilities. Second, since bank managers know that they are evaluated against their peers, they have incentives to herd and take hidden tail risk. Detecting this behavior, which has the potential for generating large systemic shocks, requires sophisticated regulators.

On the investment bank side, the loss of stable income from brokerage activities may provide incentives for increasing leverage and entering into activities that involve maturity transformation. Regulators may not be ready this new structure of the financial system and still work under the assumption that only commercial banks have systemic importance.

Developing countries face a difficult trade-off regarding the design and regulation of their financial systems. On the one hand, access to finance is necessary for economic development. On the other hand, as seen above, a more sophisticated financial sector is also likely to lead to an increase in total risk. In case the second effect dominates the first, financial development may lead to an increase of systemic risk. It was believed that good financial regulation could be a solution to this trade-off and most countries could build financial systems that are both sophisticated and systemic. However, the current financial crisis indicates that this objective may not be within the reach of most developing countries, at least in the near future. Therefore, developing countries should recognize that there is no model that suite all countries at all times. Each country should find the model is that most appropriate for its current level of development.

Countries which have stronger regulatory and institutional capacity may choose a more aggressive process of financial liberalization and adopt a more market-based financial system. Other countries which have weaker regulatory cap