In this chapter, I show how a common understanding has emerged that lax bank regulation presents immense dangers for countries operating under liberal capital flows. I begin by presenting the neo-classical case for capital flow liberalization. I then describe the attack on this case following the Asian crisis. Finally, I describe how even prominent proponents of liberalization now accept that the success of liberalization may be contingent on stringent bank regulation.

Prior to the 1980s, most developing countries maintained a significant body of regulations limiting the inflow and outflow of capital across national borders. Foreign exchange transactions had to be approved by government officials and were subject to stringent limits, domestic banks were tightly restrained from borrowing from private sources overseas, and stock markets faced significant legal obstacles to accessing international funds. Starting in the 1980s, the International Monetary Fund (IMF) began to place immense pressure on developing countries to dismantle these and other barriers to the inflow and outflow of international capital. Four arguments, which are sometimes jointly referred to as the neo-classical case for liberalization, were offered in justification for this pressure.

First, it was argued that environments with liberal capital flows, referred to in short as environments with open capital accounts, would help developing countries gain access to funds from developed countries. This would enable them to achieve investment levels that exceeded their domestic savings rates, and thus help them grow faster in the long run.