Designing Financial Regulatory Policies that Work for Latin America: The Role of Markets and Institu

1
Designing Financial Regulatory Policies that Work
for Latin America The Role of Markets and
InstitutionsViews of the Latin American Shadow
Financial Regulatory Committee

• Pablo E. Guidotti, Liliana Rojas-Suárez and
  Roberto Zahler
• Updated March, 2003

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After a Decade of Financial Reform in Latin
America, What have We Learned?

• In spite of significant progress in financial
• reforms...

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After a Decade of Financial Reform in Latin
America, What have We Learned?

• and the internationalization of the financial
  system, both of
• the banking system

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After a Decade of Financial Reform in Latin
America, What have We Learned?

• and of the pension fund business.

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After a Decade of Financial Reform in Latin
America, What have We Learned?

• ... the degree of financial intermediation in
  Latin America remains
• well below that of industrial countries, and in
  some cases, as in
• Venezuela, it has deteriorated significantly
  since 1980.

2001
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After a Decade of Financial Reform in Latin
America, What have We Learned?

• Investors concerns about the capacity of
  domestic financial
• systems to yield a positive and stable rate of
  return over an
• extended period of time are verified by the
  behavior of real
• interest rates, which have remained very
  volatile

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After a Decade of Financial Reform in Latin
America, What have We Learned?

• ... and the volatility of bank deposits (as
  percentage of
• GDP) is much higher than that in industrial
  countries

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After a Decade of Financial Reform in Latin
America, What have We Learned?

• Moreover, contrary to the objectives of economic
  policy, the
• government has remained a very large debtor to
  the banking system

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After a Decade of Financial Reform in Latin
America, What have We Learned?

• These disappointing results do not mean that
• embarking on a process of financial reforms was
• wrong. Instead, we believe that
• The reforms were incomplete in some cases and
  poorly designed in others.
• In spite of recent events in Argentina, foreign
  banks have helped to stabilize a region severely
  hit by adverse shocks.
• Reforms at the international level need to avoid
  exacerbating fragilities in the Latin American
  financial systems.

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I. Strong Financial Systems Require Strong
Regulatory Institutions and Effective Market
Discipline

• Strong Regulatory Institutions need
• Independence from political interference.
• Drastic improvements of enforcement capabilities.
• Strengthening of processes of banking crisis
  resolution, including strictly-enforced exit
  rules.
• Strengthening and modernization of the judicial
  system.
• Protection of creditors rights.
• Coordination among regulatory agencies to ensure
  transparency and avoid regulatory arbitrage.

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I. Strong Financial Systems Require Strong
Regulatory Institutions and Effective Market
Discipline

• How Political Interference Can Weaken Financial
  Systems
• The Case of Argentina
• Government measures
• Exchange of government bonds held by banks for
  illiquid government bonds
• Controls on interest rates on deposits
• Freezing of deposits Corralito (transactional
  deposits) and corralon (time deposits)
• After devaluation and default, the government
  imposed an asymmetric pesification on bank assets
  and liabilities
• Suspension for 6 months of all legal actions by
  creditors to collect their debt.

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I. Strong Financial Systems Require Strong
Regulatory Institutions and Effective Market
Discipline

• How Political Interference Can Weaken Financial
  Systems
• The Case of Argentina
• Lessons
• A banking system cannot survive a set of
  interventions that destroy the franchise value of
  banks and expropriate its capital. Therefore,
  good financial regulation, while necessary, is
  not sufficient to protect banks from crises.
• The importance of the integrity of the payment
  system cannot be overstressed. When this system
  fails, the costs in terms of economic activity
  and fiscal solvency are enormous.

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I. Strong Financial Systems Require Strong
Regulatory Institutions and Effective Market
Discipline

• Effective Market Discipline in Latin America
  Needs
• Indicators of Financial Fragilities that are
  market based, especially since high concentration
  of asset ownership severely limits the
  effectiveness of traditional international
  standards, such as the capital to asset ratio.
• Development of enhanced corporate governance and
  risk management practices in financial
  institutions.

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• The Need for Market-Based Indicators of
• Financial Fragility Assessing Capital
  Requirements

Unlike in industrial countries, where real
capital diminished before the emergence of a
crisis, in Latin America real capital increased
significantly in the immediate period before the
crisis. This ratio, therefore, did not contain
excessive risk-taking by banks.
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• The Need for Market-Based Indicators of
• Financial Fragility Assessing Capital
  Requirements
• Why have Capital Requirements not always been
  effective?
• For capital requirement to work, two sets of
  conditions must be met
• The well-known condition of appropriate
  accounting, regulatory, supervisory, and judicial
  frameworks.
• Capital requirements need to reflect the true
  risk of a banks portfolio. Concentration of
  asset ownership provides incentives for bank
  owners to supply low-quality bank capital.

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• How can the Effectiveness of Capital
• Requirements be Improved?
• The answer depends on a countrys degree of
• development
• For the least developed countries
• Implementation of appropriate accounting,
  regulatory and supervising frameworks.
• Development of indicators of banking problems
  that work. This can be done through
• Promoting offering of uninsured CDs
• Publishing interbank bid and offer rates
• Avoiding excessive bank access to central bank
  liquidity
• Encouraging the process of financial
  internationalization

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How can the Effectiveness of CapitalRequirements
be Improved?

• For the relatively more developed countries in
• Latin America
• The trick is the design of an adapted Basel I
  that should
• Include risk-based regulations in loan-loss
  provisions.
• Design appropriate risk categories that include
  an adequate risk assessment of government paper
  and distinct capital charges for borrowers in the
  tradable and non-tradable sectors.

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II. Foreign Banks Have Strengthened Latin
American Financial Systems

• Contributions to Financial Stability and
  Efficiency
• Since foreign banks willingness (or legal
  obligation) to support subsidiaries or branches
  depends on the actions of local authorities, the
  latter must carefully consider the effect that
  their property rights policies could have on
  headquarters decisions.
• If the authorities do not interfere with
  judicial or legal institutions during a crisis,
  foreign banks could minimize systemic runs
  because depositors tend to transfer deposits to
  these institutions. Ex Argentina 1995, Jamaica
  1996-97.
• Empirical studies suggest that the participation
  of foreign banks promotes competition and
  technological innovation in the domestic banking
  system.

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II. Foreign Banks Have Strengthened Latin
American Financial Systems

• Challenges for Regulators and Supervisors
  -Some Recommendations by the LASFRC
• Equal treatment of domestic and foreign capital
  should guide the authorization of entrance of new
  institutions to the financial system.
• There should be reciprocity on the part of
  industrial countries for authorizing the opening
  of subsidiaries or branches of Latin American
  banks with an adequate system of consolidated
  supervision.
• The incorporation of foreign banks as a
  subsidiary or branch should depend on the
  bankruptcy laws of the host country Under a
  bankruptcy law based on the principle of single
  entity, we recommend that foreign banks be
  established as subsidiaries. Under a bankruptcy
  law based on the principle of separate entities,
  we recommend that foreign banks be established as
  branch offices.

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II. Foreign Banks Have Strengthened Latin
American Financial Systems

• Further Recommendations by the LASFRC
• Banking supervision regimes and prudential
  regulations of foreign banks also should take
  into account the type of bankruptcy law that
  banks operate under.
• The Committee supports the development of joint
  inspection agreements of the activities of
  branches and subsidiaries of foreign banks
  between Latin American and industrial countries.
• If local operations of a foreign bank are subject
  to local prudential regulations, there should not
  be discrimination between foreign and domestic
  banks when providing liquidity assistance.

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III. Reforms at the International Level need to
avoid Exacerbating Fragilities in Latin
American Financial Systems The Case of
Basel II

• A. External Potentially Adverse Effects
  (uncontrolled by
• Emerging Markets)
• 1. Implementation of Basel II by industrial
  countries may exacerbate the already high
  volatility of capital flows to emerging markets
• a. If banks in industrial countries use the
  internal rating-based approach it may be easy to
  game the rules and there is a risk of a
  potential weakening of supervisory practices.
  If an underestimated (overestimated) risk to
  emerging markets materializes, international
  banks will quickly reverse (increase) the flows
  to micro-manage capital requirements.

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III. Reforms at the International Level need to
avoid Exacerbating Fragilities in Latin
American Financial Systems The Case of
Basel II

• External Potentially Adverse Effects
  (uncontrolled by Emerging Markets)
• 1. Implementation of Basel II by industrial
  countries may exacerbate the already high
  volatility of capital flows to emerging markets
• b. If banks in industrial countries apply the
  Standardized approach, volatility of capital
  flows to emerging markets also gets exacerbated
  as
• Credit rating agencies have a track record of
  lowering ratings AFTER the eruption of problems
  in emerging markets.
• De facto, sovereign ratings constitute a ceiling
  for ratings to the private sector.

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III. Reforms at the International Level need to
avoid Exacerbating Fragilities in Latin
American Financial Systems The Case of
Basel II

• External Potentially Adverse Effects
  (uncontrolled by Emerging Markets)
• 2. Implementation of Basel II by industrial
  countries may contribute to shortening the
  maturity of emerging markets external debt
• Basel II lowers the maturity-threshold of
  inter-bank loans subject to lower capital charges
  (preferential treatment). This implies that
  international banks will have an incentive to
  shorten the maturities of loans to emerging
  markets. This adversely affects current efforts
  of emerging markets to extend the maturity
  structure of their foreign liabilities.

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III. Reforms at the International Level need to
avoid Exacerbating Fragilities in Latin
American Financial Systems The Case of
Basel II

• B. Internal Effects (Created if Latin America
  Adopt
• Basel II)
• 1. Issues Related to the Measurement of Risk
• - A potential advantage is that banks risk of
  holding government paper could be determined by
  market conditions. However, an opt-out clause
  allows countries not to follow this
  recommendation. Will governments be prepared to
  let the markets assess the risk of their
  liabilities for the purpose of computing banks
  capital ratios?
• - If Basel II is implemented, most small and
  medium companies in emerging markets will lose
  credit access (capital charges would be too
  high). This is an important issue for governments
  in these countries.

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III. Reforms at the International Level need to
avoid Exacerbating Fragilities in Latin
American Financial Systems The Case of
Basel II

• B. Internal Effects (Created if Emerging Markets
  Adopt Basel II)
• 2. Supervisory Issues
• - If foreign banks are allowed by their
  industrial-country supervisors to follow the IRB
  approach, would domestic supervisors rely on
  foreign supervisors? The issue of home vs.
  host supervision becomes relevant.
• - With the standardized approach, the use of
  credit rating agencies may bias ratings of
  borrowers who have the incentive to hire the
  agency that offers the best rating the race to
  the bottom problem.

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III. Reforms at the International Level need to
avoid Exacerbating Fragilities in Latin
American Financial Systems The Case of
Basel II

• B. Internal Effects (Created if Emerging Markets
  Adopt Basel II)
• 2. Supervisory Issues
• - With the standardized approach, most companies
  will remain unrated and with a 100
  risk-weight.
• - There is no appropriate regulatory framework
  for credit rating agencies in emerging markets.