Financial Systems in Latin America: Where are they going? Where do we want them to go? Liliana Rojas-Suarez Washington, October 2002

Two Key Features of Latin American Financial Systems 1.They remain “bank dominated” (with Chile having the relatively most developed capital markets). 1.The participation of foreign banks has displayed an upward trend.

The Similarities, however, Disguise Important Differences 1.The degree of financial intermediation differs significantly across countries with ratios in Chile approaching those in industrial countries, while others’, like Venezuela’s, show a significant deterioration.

The Similarities, however, Disguise Important Differences 2.The degree of “internationalization” of banking systems shows important differences with Mexico displaying the highest participation of foreign banks. * 2001

But, in the Pension Fund Business: a) Foreign participation is very high and….

But, in the Pension Fund Business: b) …. foreign control is dominated by international banks!

What Makes a Financial System Strong? Regardless of the structure of the financial system, sound banks is a necessary condition –Banks are sound when their franchise value is high; namely, when they can exercise their unique power to provide means of payments in non-cash transactions. –In fact, when other liability issuers promise to deliver payments, they promise to deliver bank deposits. Ex.: If an investor wants to use mutual fund shares to purchase goods and services, the fund must deliver payments from its bank deposits to the bank deposit account of the investor.

In emerging economies, markets for non-bank short-term assets, such as commercial paper, are illiquid because the institutional framework is insufficiently developed to permit investor to evaluate corporate cash flows and their legal standing in the event of default. Thus, issuers of substitutes of bank deposits, such as money market mutual funds, remain underdeveloped. Banks’ claims to deliver means of payments is more credible than claims of other liability issuers because of their access to the discount window of the central bank for liquidity purposes and/or because of their own holdings of liquidity. However, this credibility requires no excessive borrowing of banks from the central bank: inflation, by reducing the real value of banks’ liabilities, destroys banks’ franchise value. What Makes Banks “Special” in Emerging Markets?

How can central banks preserve the franchise value of banks (keep deposits liquid) without lending funds to banks on a sustained basis? –By ensuring that banks have procedures in place to monitor the ability of their loan customers to deliver cash. Proof of liquidity by borrowers is a requirement for solvency of banks. An adequate payment system and an appropriate monitoring of liquidity of banks’ borrowers go hand in hand. What Makes Banks “Special” in Emerging Markets?

What Threatens the Franchise Value of Banks in Latin America? In a nutshell: Incorrect Pricing of Risks

Incorrect Pricing of Risk: Example 1: Increase of government paper in banks’ balance sheets without appropriate risk weighted capital ratios. Governments in Latin America have increased their debtor position with banks.

Incorrect Pricing of Risk Example 1: The absorption of government paper by banks, however, depends on the ownership of banks. –For example, in Argentina, state-owned banks held a much larger proportion of government paper than the average of the banking system; foreign banks held a smaller proportion.

Incorrect Pricing of Risk Example 1: The role of commercial public banks in financing governments is not unique to Latin America It appears that the pricing of risk is more distorted in public than in private banks.

Incorrect Pricing of Risk Example 2: Inadequate provisioning fails to reflect the expected probability of default. In Latin America, the non-tradable sector tends on average to be riskier than the tradable sector because these economies are subject to sudden stops of capital inflows that adversely affect the relative prices of non- tradable goods. This, of course, does not imply that the tradable sector is risk-free. Credit risk of the non-tradable sector is exacerbated if this sector has significant debts in foreign currency because its revenue is in domestic currency. Increased expectations of exchange rate depreciation increases the default risk and therefore call for increased provisioning. In Latin America, exchange rate risk transforms into credit risk.

The lesson, therefore, is that Latin American financial systems need to have distinct provisioning requirements for loans to the tradable and to the non-tradable sector. This, of course, implies the implementation of risk-based regulations. Absent risk-based provisioning requirements, a fixed exchange rate system is equivalent to a “free” guarantee provided by the government to the banks. In good times when the sustainability of the exchange rate system is not questioned, the free guarantee induces excessive risk taking position by banks (excessive lending to the non-tradable sector). In bad times, when severe pressures on the exchange rate develops, the guarantee will “haunt” the government by limiting its policy options: If it does devalue, it will severely damage the banks. Incorrect Pricing of Risk

Will a Framework with Narrow Banks plus Capital Markets Do a Better Job? Not in Latin America: –Transferring lending capabilities to institutions lacking tools to monitor borrowers’ liquidity would increase the riskiness of the system. –Without reforms aimed at improving the pricing of risks, fragilities in the overall financial system could be exacerbated.

Will a Framework with Narrow Banks plus Capital Markets Do a Better Job? Not in Latin America: –In economies with long experience of financial difficulties, investors need to observe that borrowers can meet the exacting standards of sound banks before they can be trusted with long-term funds. –Sound banks provide the necessary source of liquidity to long-term markets. –Banks are a major source of investment for incipient institutional investors, such as newly created private pension funds.