February 1996 The success of financial reform and the stability of financial systems depend partly on a regulatory framework that rewards prudent risk-taking and is attuned to both institutions and the structure of the economy. Such a framework should be developed and reshaped while participants in the financial system are adjusting to changes in incentives. Financial reform of one type or another has been increasingly popular since the early 1970s, but disappointment with the fruits of reform has been common. Reformers in Africa and in transitional economies have been especially disappointed, perhaps because of their high expectations. Reform may also disappoint partly because of perverse sequencing. Often the more visible aspects of reform (such as complete deregulation of interest rates, recapitalization of banks, and more recently the creation of stock exchanges) are pursued before basic financial infrastructure (including auditing, accounting, and legal systems and basic regulations) are established. Caprio focuses here on regulatory options in banking. He argues that for reform to succeed and for financial systems to remain stable, there must be a regulatory framework that encourages prudent behavior and is attuned to both institutions and the structure of the economy. Bank failure may reflect poor management, but poor management in turn reflects regulation that is not incentive compatible. Caprio reviews options that would align bankers' incentives with society's preferences for safe and sound banking. Adopting a framework that rewards prudent risk-taking will produce a more stable banking system. And because participants in the financial system -- both individuals and organizations -- take time to adjust to changes in incentives, it is important to begin reshaping the regulatory environment early in the reform process, at the same time as other measures are being taken to develop institutions. This paper -- a product of the Finance and Private Sector Development Division, Policy Research Department -- was presented at a Brookings/KPMG conference on the Sequencing of Financial Reform.