1. June 7th, 20071 Ample Stable Credit & Adequate Financial Regulation: Finding the Balance for Emerging Countries. José Luis Escrivá Chief Economist BBVA Research Department June 7th 2007

2. June 7th, 20072 Outline 1. From turmoil to stability: linkages between the macroeconomy and the financial sector. 2. Financial Regulation and performance: assessing the links. a. Institutional challenges to regulatory success. 3. Priorities for regulatory reform

3. June 7th, 20073 A VOLATILE ECONOMIC PATH In the past, drastic credit expansions have been associated with boom-bust cycles in the region, which shows a greater tendency to suffer crises… …and higher volatility on its macroeconomic aggregates, particularly growth.

4. June 7th, 20074 Financial Sector Effects This pattern of economic growth has constrained the stability and development of the financial sector, which has inherited the same volatile pattern...

5. June 7th, 20075 …and a tendency to suffer crises. Financial Sector Effects

6. June 7th, 20076 Crises have also had a persistent deferring effect over the growth of the financial sector, taking several years to recover. Credit Index (real terms) 0 100 200 300 400 500 600 135791113151719212325 (years after crises) Chile 1981=100 Colombia 1998=100 Venezuela 1994=100 Brasil 1994=100 Argentina 2001=100 Perú 1999=100 Financial Sector Effects

7. June 7th, 20077 …which has resulted in a banking sector in Latin American that is both smaller than OECD or East Asian averages, as well as unable to follow their upward trend. Financial Sector Effects

8. June 7th, 20078 Macroeconomic Stability In contrast to previous decades, Latin America faces today a much more stable macroeconomic scenario: Inflation has plunged, GDP growth rates are higher while less volatile…

9. June 7th, 20079 …in the context of current account and fiscal surpluses, and along with a significant partial liquidation of its external debt. Macroeconomic Stability

10. June 7th, 200710 Improved Financial Indicators …events that have elicited a reduction of bank spreads and default rates. Default rates in Latin America fall since 2002, and currently are lower than in emerging Asia.

11. June 7th, 200711 Credit Surges …with financial depth ratios generally growing, except in the cases of Argentina and Venezuela. Source: BBVA from IMF data Credit/GDP ratio 0 10 20 30 40 50 60 ArgentinaBrasilChileColombiaMéxicoPerúVenezuela 1976-1990 1991-2006III * Venezuela average 1991-2004 In sum, a macro and financial scenario that fostered a credit expansion in the last few years...

12. June 7th, 200712 Financial institutions perceive a much better scenario for credit development. 1- A more stable and favorable macroeconomy 2- Interest rates are lower than previous years. 3- Risk premiums have declined. Greater and more solvent credit demand Credit Supply expansion enhances the balance sheets of financial institutions.

13. June 7th, 200713 Outline 1. From turmoil to stability: linkages between the macroeconomy and the financial sector. 2. Financial Regulation and performance: assessing the links. a. Institutional challenges to regulatory success. 3. Priorities for regulatory reform

14. June 7th, 200714 What is the role of policy reform in the current expansion of the financial sector? Prior to the current benign macroeconomic environment, reform of the financial sector has been extensive in the region In many instances, however, reforms have not precluded financial crises. Particularly in Latin America, the link between financial reform and performance is not clear.

15. June 7th, 200715 Regulation “per se” does not achieve financial stability. Financial sector performance Institutional Endowment Financial regulation Macroeconomic Stability A key conclusion that emerges from the wave of reforms in Latin America is that regulation is an imperfect substitute of other determinants of financial sector performance. A minimum threshold of institutional quality and macroeconomic stability are also requirements for achieving a sound financial sector.

16. June 7th, 200716 Consequently, there is not a linear relation between regulation and financial stability In Latin America, the stricter regulation does not necessarily deliver better financial performance. Chile, while having a less repressive financial sector than most Latin American examples, is among the most stable financial sectors in the region.

17. June 7th, 200717 Outline 1. From turmoil to stability: linkages between the macroeconomy and the financial sector. 2. Financial Regulation and performance: assessing the links. a. Institutional challenges to regulatory success. 3. Priorities for regulatory reform

18. June 7th, 200718 The Institutional Challenge In all, and especially after the progress on the macroeconomic front, consolidating the current expansion of the financial sector in Latin America requires enhancing the institutional endowment. Positive relationship between size of domestic financial sector and institutional quality.

19. June 7th, 200719 The Institutional Challenge Latin America is in a discouraging situation regarding governance, especially regarding rule of law and control of corruption

20. June 7th, 200720 The Institutional Challenge Financial systems in particular lack larger protection on borrowers and lenders rights…

21. June 7th, 200721 Outline 1. From turmoil to stability: linkages between the macroeconomy and the financial sector. 2. Financial Regulation and performance: assessing the links. a. Institutional challenges to regulatory success. 3. Priorities for regulatory reform

22. June 7th, 200722 Given the vulnerabilities embedded in the institutional framework, and the resulting tendency of the region to suffer financial crises, some Latin American nations have opted for a strong regulation of the banking sector. Regulation as a response to domestic vulnerabilities Yet, some harsh regulatory aspects may stand against the establishment of an efficient financial system, reinforcing the ambiguous relation between regulation and performance. Weak Institutions Exposure to crises Strict Regulation

23. June 7th, 200723 A case in point is vetoing foreign entry in the banking sector, a measure that has been increasingly eradicated. In Latin America, foreign banks have been a crucial way to increase competition and efficiency. Foreign Bank Presence

24. June 7th, 200724 Credit Promotion Credit promotion to sectors deemed strategic has translated into an inefficient allocation of resources, crowding more profitable (generally private) investment out. *Max ** In effect during 2007 Source: BBVA Other regulatory measures that reduce the efficiency of the financial sector are on the other hand, still present.

25. June 7th, 200725 Public Banks Share Most Latin American countries have a structure of public banks that competes directly with private banks. A reduction in the market share of public institutions is desirable, as well as a stronger orientation towards underbanked segments of the population. Source: National Central Banks A similar problem occurs with the share of public banks, which in some countries still comprise a sizeable share of the domestic credit market.

26. June 7th, 200726 Increasing market-regulated arrangements. Further reform should reduce measures resulting in greater interventionism, while fostering those based on market-regulated arrangements. The attachment of Latin American banking systems to Basel II is an example of the right path to follow.

27. June 7th, 200727 Conclusions. Volatility and exposure to crises have traditionally limited the growth of the financial sector in Latin America, which has remained underdeveloped compared to East Asian emerging economies. Easing foreign presence or following Basel II prescriptions are examples of the effort that Latin America is doing towards a good regulatory framework of the financial sector. Nevertheless, examples of inadequate measures still exist (e.g., compulsory credit, large public bank presence, etc.) The consolidation of the current financial development requires minimum thresholds of macroeconomic stability, institutional quality, and an adequate regulatory framework. The absence of any of these is likely to deter further financial development. The current macroeconomic scenario has helped to revert the above tendency, facilitating an intense growth of local credit markets.

28. June 7th, 200728 Ample Stable Credit & Adequate Financial Regulation: Finding the Balance for Emerging Countries. José Luis Escrivá Chief Economist BBVA Research Department June 7th 2007