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.