Safe and Sound Financial Systems: What Works for Latin America

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What Works for Latin America Edited by Liliana Rojas-Sudrez

Published by the Inter-American Development Bank Distributed by The Johns Hopkins University Press Washington, D.C.

1997

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Safe and Sound Financial Systems

The authors would like to thank Michael Treadway for his contribution during the editorial process; Erik Wachtenheim and Yoshiaki Hisamatsu for their research assistance; and Norelis Betancourt and Graciela Thomen for coordination support. Transcription and word processing support by Luisa Choy-Luy and Kelly A. Kubiak are also gratefully acknowledged.

Cataloging-in-Publication data provided by the Inter-American Development Bank Felipe Herrera Library Conference "Safe and Sound Financial Systems : what works for Latin America" (1996 : Washington, D.C.) Safe and sound financial systems: what works for Latin America / edited

by Liliana Rojas-Suarez. p. cm.

Includes bibliographical references.

ISBN 1-886938-20-2 1. Finance—Latin America—Congresses. 2.Latin America—Economic policy—Congresses. 3. Capital markets—Latin America—Congresses.

4. Banks and banking—Latin America—Congresses. I. Rojas-Suarez, Liliana. II. Inter-American Development Bank. III. Title.

332 C78—dc20 97-77121

© 1997 Inter-American Development Bank 1300 New York Avenue, N.W. Washington, D.C. 20577 Produced by the IDbPublications Section Distributed by The Johns Hopkins University Press 2715 North Charles Street Baltimore, Maryland 21218-4319 The views and opinions expressed in this publication are those of the authors and do not necessarily reflect the official position of the Inter-American Development Bank.

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Acknowledgements

This volume presents the proceedings of the conference "Safe and Sound Financial Systems: What Works for Latin America," held at the Inter-American Development Bank in September 1996. The conference in part marked the continuation of a discussion begun at an IDB conference the previous year (the proceedings of which were published in Hausmann and RojasSuarez, 1996) on an issue of urgent concern—the prevalence of banking crises in Latin America.

The countries of Latin America have undertaken a series of profound reforms—opening their economies, restructuring the state, and, in general, reconfiguring economic and social policies. The result has been visible change throughout the region, with much progress on many fronts, including the ongoing process of strengthening institutions to shoulder the task of coping with market forces and the opening up of our economies.

This sweeping change, however, generated a major shock for the banking systems of Latin America. As was made clear by the Tequila crisis of 1994, financial systems have had a difficult time adapting to the new conditions that have been ushered in by changing economic policies. Some analysts have even feared that the stability of our economies, threatened for so long by inflation and financial repression, would instead fall victim to the side effects of disinflation and deregulation. Banking crises have not been unique to Latin America in recent years, but there are indications that their costs may have been higher in Latin America than in other parts of the world.

The IDB's 1995 conference was held just after the Tequila crisis, and at about the time of the annual meetings of the World Bank and the International Monetary Fund. Participants at those meetings expressed serious concern about the eventual outcome of that crisis, which had spread to other countries of the region. Today, we see some impressive results. The crisis was successfully managed by the affected countries, which, with international cooperation, frontally tackled the problems posed for their banking systems. This took courage and determination on the part of policymakers throughout the region and beyond, and set a new standard of political maturity for managing this kind of problem.

One of the conclusions from the 1995 conference was that there was a clear link between the region's banking crises and macroeconomic factors. In particular, the banking crises had their origins in the economic boom that followed the initiation of the reform process. In those expan-

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Preface

PREFACE • ENRIQUE V. IGLESIAS

sionary times, banks took risks beyond what was prudent, and when the tide turned, the economies paid a high price. We at the IDB continue to examine the history of this period of boom and bust to see how such risks can be avoided in the future.

The discussion at the 1995 conference also made it clear that the structure of regulatory and supervisory systems is crucial. We now know that, in practice, our regulatory systems work very differently than they do on paper. It is one thing to have good rules and regulations in place; how they are applied is something else entirely. Another lesson that our deliberations revealed was that when matters come to a crisis, they must be corrected quickly. A crisis that is allowed to linger tends to be much more costly than one that is settled quickly, even if painfully.

The present volume concentrates on three major questions that follow from those lessons. First, what kind of financial regulatory system is appropriate for the Latin American economies today? The question implies that systems in each region must have certain elements that are specific to the region. Therefore, it is important for policymakers to become familiar with the specific conditions under which regulatory systems in Latin America must be implemented.

Second, what kind of structure is needed to ensure that the region has a sound, efficient and creative financial system capable of responding to changing conditions? How will the system be affected by the integration of local financial systems into the world market? And what will take the place of the national development banks, which, although inefficient and a sinkhole for subsidies, were often the only means of channeling finance to certain parts of the economy?

Third, what kind of financial safety net is appropriate for a region undergoing the kind of transformation that Latin America is experiencing now?

All of these issues are being addressed by the Inter-American Development Bank through technical assistance programs and projects supporting financial sector reform, both in individual countries and at the regional level. We firmly believe that the attainment of strong financial systems in the region is a responsibility to be shared between countries and multilateral organizations. While much has already been achieved, the "to do" list is still long and will involve significant resources. I have no doubt, however, that the returns on countries' investment in financial sector strengthening will justify the sacrifices. Safe and sound financial systems are a necessary requirement for the achievement of one of the most important goals of the region: high and sustained economic growth.

Enrique V. Iglesias President, Inter-American Development Bank

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iv

Preface Enrique V. Iglesias

iii

Introduction Liliana Rojas-Sudrez

1

Part One International Perspectives on Strengthening Financial Systems Promoting Safe and Sound Banking Systems Michel Camdessus Separate but Converging: International Financial Standards and National Financial Systems Andrew D. Crockett Strengthening Financial Systems in Emerging Markets: An Agenda for Action Lawrence H. Summers

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Part Two Supervision and Regulation Toward an Effective Financial Regulatory and Supervisory Framework for Latin America: Dealing with the Transition Liliana Rojas-Sudrez and Steven R. Weisbrod

35

Comments Charles A. E. Goodhart AugustO de la Torre Eduardo Fernandez Garcia

75 79 81

Panel Discussion: Adopting Capital Adequacy Requirements William A. Ryback Pedro Pou Charles H. Dallara

85 87 92

Part Three Approaches to Financial Market Structures How Should Financial Institutions and Markets Be Structured?

Options for Financial System Design George G. Kaufman and Randall S. Kroszner

97

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Contents

Toyoo Gyohten

123 126 129

Make or Buy? Approaches to Financial Market Integration Michael Gavin and Ricardo Hausmann

133

Comments Guillermo de la Dehesa Guillermo O. Chapman, Jr. George J. Benston

163 168 170

Part Four Approaches to Credible Safety Nets The Transition to a Functional Financial Safety Net Peter M. Garber

177

Comments Michael Foot Miguel Mancera Miguel Urrutia Edwin M. Truman Ricki Heifer

202 204 208 209 214

Part Five Conclusions and Policy Debate Liliana Rojas-Sudrez

221

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Comments Brian Quinn Richard Lang

Liliana Rojas-Sudrez

Achieving safe and sound financial systems is not a new goal among policymakers in Latin America. Indeed, its importance has been recognized at least since the 1920s and 1930s, when a series of missions led by Professor Edwin Walter Kemmerer proposed legislation to create or restructure central banks in several Latin American countries.1 In each of these countries, central bank legislation and rules for the conduct of monetary policy were accompanied by legislation establishing the bank superintendency and the regulation of financial institutions. Policymakers perceived an intrinsic complementarity between these reforms: monetary and price stability could not be achieved without a strong and healthy financial system.

However, despite the good intentions of these and many subsequent initiatives throughout the region, the recent history of Latin America is replete with long periods of financial instability in many countries, including severe banking crises and an accompanying loss of confidence in domestic financial markets, with disintermediation the result. The literature on the origins of these financial disturbances is voluminous, and although some controversy remains about which factors predominated, there is today a broad consensus that both macroeconomic disequilibria and deficiencies at the microeconomic level, especially poor bank management and failures of regulation and supervision, have been at the root of banking crises.2 Nor has consensus been hard to reach on the proposition that liberalized financial markets can be rendered safest and most efficient by the implementation and enforcement of an appropriate regulatory and supervisory framework. The region's history offers numerous examples of deficiencies in regulatory and supervisory procedures that have led newly liberalized financial institutions to operate under a system of distorted 1 From 1923 to 1931, Edwin Walter Kemmerer, a professor of economics and finance at Princeton University and a distinguished international economic adviser, led a number of missions that resulted in profound reforms of the fiscal, monetary and banking systems of Bolivia, Chile, Colombia, Ecuador and Peru. Known as the "money doctor," Kemmerer also assisted significantly in the restructuring of financial systems in Mexico and Guatemala. For a comprehensive analysis of these missions and the resulting reforms, see Drake (1989). A detailed presentation and analysis of Kemmerer's mission to Peru is contained in Banco Central de Reserva del Peru (1997).

2 See Hausmann and Rojas-Suarez (1996) for a comprehensive discussion of the causes of banking crises in Latin America, methods of solving them, and means of prevention. A review and discussion of the experience with banking crises around the world can be found in Lindgren et al. (1996).

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Introduction

LILIANA ROJAS-SUAREZ

incentives—a sure recipe for failure. This conclusion, so clearly stated by Diaz Alejandro (1985) in his analysis of banking crises in the Southern Cone in the early 1980s, is as valid now as it was then, as evidenced by the banking crises of Mexico and Venezuela in the 1990s.

Of course, the need to balance financial liberalization with adequate regulation and supervision is not unique to Latin American countries. Liberalization has confronted regulators in industrial countries with new challenges as well. Faced with the rapid globalization of financial markets, technological development at breakneck speed, and increasing competitive pressures, policymakers in industrial countries have had to revise their traditional methods of regulation and supervision and develop new approaches to keep pace with the new ways in which international financial markets operate.3 Why do countries, developed as well as developing, need regulation and supervision of their financial markets in the first place? There are different justifications for "external" regulation and supervision (i.e., by government or quasi-government institutions rather than by the financial industry itself), but in one way or another all come down to two central issues: protecting investors (mainly small depositors) and averting systemic risk (including risks to the stability of the payment system).

For example, an approach to financial market regulation recently popularized by Tirole (1994) and Dewatripont and Tirole (1994) argues that bank regulation arises from the need to protect small depositors in a market characterized by informational asymmetries and sharply differing incentives. By the very nature of their investment, equityholders in a bank take greater risks than do the bank's depositors, for whom deposit accounts are simply a place to safely store their funds. They lack both the means and the incentives to monitor the risky behavior of bank owners and managers: depositors are not privy to detailed inside information about the riskiness of the bank's loans, and the large number of depositors leads most to free-ride on the monitoring activities of a few large depositors. Under these circumstances, regulation and supervision of banks' activities become necessary to protect the interests of depositors. In other words, small depositors need to have their interests represented, and in most countries around the world, this representative function is performed by the public sector.

The second approach bases the need for regulation and supervision on the empirical observation that financial institutions have access to a public safety net in the form of deposit insurance or the central bank as a lender of last resort. Very often these safety nets are intended to prevent 3

See Goodhart et al. (1997) for a discussion of these issues in both industrial and emerging market economies.

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the failure of one or a handful of banks from leading to a generalized bank run, and thus to a systemic crisis. The result could be a domino effect, as depositors, lacking sufficient information to distinguish solvent banks from insolvent ones, rush to withdraw their funds from all banks indiscriminately. Under this approach, the argument for regulation relies on the notion of moral hazard: access to the public safety net allows bank owners to transfer some of the risk in the bank's asset portfolio to the taxpayers, without compensation to the latter. Since this arrangement creates incentives for banks to take additional risks, banks need to be regulated and supervised to prevent abuse of the safety net.

Focusing on the moral hazard problem of banks can also be extended to nonbank financial institutions. Even in the absence of an explicit safety net, the public often relies on the government to assess the riskiness of such institutions, because it is these authorities who grant licenses for institutions to operate and who set the rules that determine the scope and nature of their activities. The public tends to assume that any institution that the authorities permit to operate must be a safe institution. Without appropriate scrutiny from the public at large, financial institutions have an incentive to take on greater risk, under the implicit presumption that they will be rescued in the event of a threatened insolvency, since the public would perceive the failure of such an institution as a default on the authorities' promise to protect consumers. As in the case of banks, this behavior gives rise to the need for supervision (see Goodhart et al., 1997).

Whatever the merits of these alternative explanations of financial crises, recognition of the need to regulate and supervise financial institutions is now worldwide and is here to stay. But the regulatory and supervisory techniques actually used differ by country and region, reflecting a dynamic and evolving interaction between policymakers and markets. Because this interaction mirrors the economic conditions specific to each country, the issues that arise are not always the same from country to country. For example, the current focus in industrial countries is on how to develop and implement techniques that shift at least some of the responsibility for regulation and supervision from the regulators to the internal control systems of individual financial institutions. Meanwhile, most emerging markets are still grappling with how to strengthen the methods and procedures used by regulators and supervisors.

These differences in emphasis reflect, to a large extent, sharp differences in levels of economic development. Industrial countries have gone a long way toward securing economic stability and building an institutional framework that guarantees the appropriate implementation of existing rules. Here the challenge for regulators is to further reduce the moral hazard problem by having financial institutions themselves collaborate with

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INTRODUCTION

LILIANA ROJAS-SUAREZ

the authorities in supervision. The task at hand is to design a coherent system of benefits and penalties—carrots and sticks—that creates an incentive for financial institutions to adhere to the rules. This method, known as "incentive-compatible" regulation (compatible, that is, with the private objectives of financial institutions) can work in these countries because their institutions and markets work.

In contrast, most emerging markets are still consolidating their achievements in the direction of economic stability and have a long way to go in building institutions that work. Supervisory agencies have serious deficiencies, some of the most important of which are a lack of qualified personnel and a lack of independence from political interference. Inadequacies in the legal system—another key institution—further complicate the capacity of financial authorities to enforce regulations and impose penalties. Not surprisingly, in such an environment the moral hazard problem is exacerbated.

Therefore the relevant question for emerging markets in general, and for Latin American countries in particular, is not whether an appropriate regulatory and supervisory framework should be put in place, but rather what sort of framework is appropriate. Should Latin American policymakers adopt the same framework now being used in industrial countries, or should they design alternative frameworks that may be better suited to the particular features of their economies?

This basic but urgent question motivated this book and the conference on which it is based. But the issues need further definition before they can be effectively addressed. As with most policy debates, the issues are not black and white. There is certainly wide agreement about the principles that should guide the design of regulation, so the debate instead focuses on the sequencing and timing of reforms and on the transitional procedures that may be needed before the regulatory and supervisory frameworks adopted by Latin American countries fully converge to the international standard. But resolving these issues is not just a matter of logistics; how they are resolved may make the difference between success and failure.

Just as Latin Americans found to their chagrin that financial liberalization without appropriate supervision was not an appropriate sequencing of reforms, so the hasty importation of a regulatory framework appropriate for industrial countries into countries that may lack the preconditions that make such a framework effective may give supervisors a false sense of security. The challenge for Latin American policymakers is therefore twofold. First, how can they improve the effectiveness of regulatory and supervisory standards that have proved appropriate for industrial countries? And second, what should they be doing in the transition period during which time some international standards may not be entirely effective?

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The section that follows briefly summarizes the general consensus on objectives, principles and methods of implementing regulatory and supervisory procedures in Latin America. The subsequent section identifies the policy issues that are the subject of the book, and in so doing outlines how the book is organized.

The Consensus: Where Should Regulation and Supervision Be Heading?

Policymakers in industrial and developing countries alike broadly agree that, in the long run, national frameworks of regulation and supervision need to converge toward a universal model. It is generally recognized that this convergence will allow the benefits of financial liberalization to be maximized by taking advantage of the internationalization of financial markets, which implies cross-border movements of both financial flows and financial institutions. However, it is also acknowledged that domestic financial markets need to be strengthened before they can safely intermediate financial flows originating abroad.

As Enrique Iglesias stated in his preface, an important set of conclusions derived from an earlier book published by the IDE, Banking Crises in Latin America (Hausmann and Rojas- Suarez, 1996), took the form of policy recommendations to improve the resilience of banking systems to unanticipated shocks. Among that volume's policy prescriptions, the achievement of macroeconomic stability was considered essential to maintain the soundness of banks. The experience of Latin America clearly demonstrates that extreme volatility of key macroeconomic variables subjects banks to severe and adverse shocks to their liquidity and asset quality.

With respect to the regulatory and supervisory framework, Banking Crises in Latin America made recommendations for the direction of regulatory and supervisory policies that are fully in accordance with international best principles and practices. One recommendation called for implementation of appropriate accounting and reporting systems. It was recognized that supervisors would not be able to detect problem loans in a financial institution—a principal source of banking crises—without adequate procedures for classification and valuation of assets. Inadequate accounting systems and poor reporting methods were also identified as major constraints in assessing the "true" value of bank capital. A second recommendation called for regulations limiting the concentration of loans by sector or region as well as lending to related parties. Proper enforcement of these rules can only be achieved, however, through frequent and comprehensive on-site inspections of banks, their holding companies, and other related financial institutions. A third recommendation, related to the

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INTRODUCTION

LILIANA ROJAS-SUAREZ

first two, was to achieve and maintain an adequate level of capitalization for all financial institutions. As will be discussed below, however, Latin American policymakers are now engaged in debate about what constitutes appropriate capitalization and how to achieve it. At a minimum, there is agreement that without compliance with the first and second recommendations, discussion of adequate levels of capital is meaningless.

A fourth recommendation called for improvement of the legal system, including establishment of clear bankruptcy procedures to ease loan recoveries. A fifth dealt with rules for the entry of new institutions into the banking system and for their orderly exit. On the entry side, stricter criteria for the granting of licenses was recommended. On the exit side, there was a unanimous call for clearer rules regarding the procedures under which the authorities would intervene in—and when necessary close—a failing institution. A sixth recommendation dealt with the improvement of bank disclosure procedures. Proper information, through compliance with adequate reporting methods, should be made available not only to the supervisors but to the public in general. This would allow the discipline of market forces to operate and complement the efforts of the official supervisors. The support of markets in monitoring banking systems can be enhanced by the final recommendation that financial regulation should allow for the functioning of external auditors and private rating agencies.

More recently, the Basel Committee on Banking Supervision and the Group of Ten4 formed working groups, with representatives from both industrial and developing countries, to identify principles and best practices that would ensure the appropriate functioning of domestic financial sectors around the world (Basel Committee on Banking Supervision, 1997; Group of Ten, 1997). While the Basel Committee focused on principles that would apply uniformly to all countries, the Group of Ten emphasized regulatory and supervisory procedures for emerging markets. Not surprisingly, the recommendations put forward by these working groups are in full agreement with those advanced in Banking Crises in Latin America and other recent publications on the subject (e.g., Lindgren et al, 1996). Indeed, perhaps one of the most important contributions of the recent abundance of literature in this area is the development of a "consensus approach" toward what regulatory and supervisory frameworks should look like at the end of the day. An additional and crucial contribution is the increased awareness among both policymakers and the general public of the key role that supervisors of financial markets play in ensuring a country's economic 4

Also known as the Paris Club, the Group of Ten consists of the wealthiest members of the IMF that provide most of the money for lending. It currently has 11 members: Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States.

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and financial stability: political interference has been a significant problem in many emerging markets, depriving supervisors of the independence they need to take appropriate action when needed.

The Policy Debate: How to Deal with the Transition The current policy debate in Latin American countries is not about whether these economies should move toward adopting international regulatory and supervisory standards. Everybody agrees that they should. Instead, the unresolved issue is how to design the pathway toward that state of convergence. This implies that, at least in the immediate term, there should be consideration of additional—sometimes more stringent and sometimes alternative—regulatory procedures besides those currently prevailing in the industrialized countries. In this regard, this book should be seen as providing a complement to the "consensus approach." The value that its editor and contributors hope to add is in moving the agenda one step forward by discussing the specific problems that arise in implementing international standards under the specific circumstances of Latin American financial markets.

The book is organized in five parts. Part One centers on the consensus approach by presenting the views of key international financial leaders on the contribution that international guidelines and standards can make toward achieving safe and sound financial systems in emerging markets.

Part Two focuses on identifying factors that limit the effectiveness of traditional regulatory and supervisory standards when applied to Latin American countries. The chapters and comments advance suggestions for improving the effectiveness of these traditional standards and propose additional standards that may be more effective in the short run, while constraints on the effectiveness of the former are being removed. Part Two also pays special attention to issues surrounding the effective implementation of one of the most widely used supervisory ratios, the capital adequacy requirement.

Parts Three and Four deal with some policy issues that are top priorities among Latin American financial regulators today. The two issues analyzed in Part Three relate to the structural design of financial systems in the region. The first is the scope of activities that banks in the region should be allowed to undertake in order to maximize the efficiency and stability of the sector. In this connection, this part of the book analyzes the benefits and costs of alternative banking system structures, ranging from more narrow systems, in which banks offer a very limited but safe range of products, to the "universal banking" model in which banks broadly diver-

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INTRODUCTION

LILIANA ROJAS-SUAREZ

sify their products and their risks. The second issue concerns the degree of Latin America's integration with international financial markets. The central policy question here is whether "importing" safe and sound banking (through the establishment of foreign banks in the domestic economies) and other financial services from abroad (including the regulatory and supervisory services of foreign governments) might be an efficient solution to the instabilities and severe financial constraints currently faced by users of financial services in the region.

Part Four turns the focus to a third policy issue directly related to the prevention of systemic financial crises: the design of an effective safety net. Alternative deposit insurance schemes are discussed and their characteristics assessed in the context of the specific features of Latin American financial markets. Part Five concludes the book by summarizing the policy debate, underlining areas of agreement and identifying those issues where further research and discussion are needed.

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INTRODUCTION

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Banco Central de Reserva del Peru. 1997. La Mision Kemmerer en el Peru: Informes y Propuestas, Vol. I. Lima.

Basel Committee on Banking Supervision. 1997. Core Principles for Effective Banking Supervision. Consultative Paper, Bank for International Settlements, Basel, Switzerland.

Dewatripont, Mathias, and Jean Tirole. 1994. The Prudential Regulation of Banks. Cambridge, Mass., and London: MIT Press.

Drake, Paul. 1989. The Money Doctor in the Andes: The Kemmerer Missions, 1923-1933. Durham, N.C.: Duke University Press.

Diaz Alejandro, Carlos. 1985. Good-bye Financial Repression, Hello Financial Crash. Journal of Development Economics 19(1): 1-24.

Group of Ten. 1997. Financial Stability in Emerging Market Economies: A Strategy for the Formulation, Adoption and Implementation of Sound Principles and Practices to Strengthen Financial Systems. (April).

Mimeo.

Goodhart, Charles, Philip Hartman, David T. Llewellyn, Liliana RojasSuarez, and Steven R. Weisbrod. 1997. Financial Regulation: Why, How and Where Now? London: Routledge. Forthcoming.

Hausmann, Ricardo, and Liliana Rojas-Suarez, eds. 1996. Banking Crises in Latin America. Washington, D.C.: Inter-American Development Bank.

Lindgren, Carl-Johan, Gillian Garcia, and Matthew I. Saal. 1996. Bank Soundness and Macroeconomic Policy. Washington, D.C.: International Monetary Fund.

Tirole, Jean. 1994. On Banking and Intermediation. European Economic Review 38: 469-87.

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References

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International Perspectives on Strengthening Financial Systems

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PART ONE

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Michel Camdessus

Building safe and sound financial systems is a critically important undertaking for Latin America and for the world. Banks form the core of financial systems, so whether a country's financial system is safe or unsafe, sound or unsound, depends in large measure on the safety and soundness of its banking system. Since the late 1970s virtually every country in Latin America has experienced problems in its banking sector; so, indeed, have more than two-thirds of all the members of the International Monetary Fund—industrial, developing and transition economies alike. Banking problems can be quite costly for the country concerned, both to the financial system and to the broader economy. But they can also involve high costs for the international community, because problems in one country can easily spill over into others. The soundness of banking systems is, therefore, a matter of great concern for both our institutions and all of our member countries.

I am often asked, "Where will the next international economic crisis erupt?" My candid answer is, "I don't know, but I do know that it is likely to begin with a banking crisis. And even if it does not, a banking crisis will almost certainly follow and make matters worse." If I am correct, it is all the more reason to seek to understand the causes of banking problems and find effective ways to address them, preferably before crises occur. Thus, I would like to outline how the IMF sees the problem, how we believe that banking systems could be strengthened, and how the IMF can contribute.

What are the factors that lead to unsound banking systems? We at the IMF have had many opportunities to observe the causes of banking system problems in our 181 member countries. For the most part, what we have seen are variations on a few common themes. The trigger for the crisis is often a situation of macroeconomic imbalance, which is, of course, a principal area of concern for the IMF. The underlying problems, however, usually begin with lax management within individual banks. Of course, poor bank management is by no means confined to developing countries; indeed, the financial press has chronicled a number of stunning bank management failures in industrial countries. But lapses in sound banking practices do appear to be more pervasive in developing countries, in large part because bank owners and managers lack strong incentives to act prudently.

The legal and judicial infrastructure is also often lacking, and this tends to lead to a breakdown in credit discipline.

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Promoting Safe and Sound Banking Systems

PART ONE • MICHEL CAMDESSUS

In turn, incentives are weak largely because of a lack of transparent reporting of banks' operations and their financial condition. This makes it difficult for market participants, and even for bank supervisors, to distinguish the weak institutions from the strong. In many developing countries, as in many industrial countries, loan valuation and loan-loss provisioning standards are not rigorous enough to prevent banks from concealing the full extent of nonperforming loans. The lack of reliable data and uniform disclosure rules makes it difficult for market participants, including deposit holders, to compare banks' performances. In such circumstances, the market cannot perform its essential role of rewarding the good performers and sanctioning the poor ones.

The problem is compounded when domestic banking supervision is also weak, either because laws and regulations are not sufficiently comprehensive, or because the supervisory authority lacks the necessary human and financial resources to carry out its responsibilities. Government involvement in the banking sector also distorts incentives, especially when the normal profit-making objectives of banks must take a back seat to political goals, such as channeling financial support to ailing industries. The creation of strong expectations of public bailouts of owners and creditors, often combined with weak policies regarding the exit of unsound banks and overgenerous use of lender-of-last-resort facilities, can further distort incentives, thwart the free play of market forces, and shortchange the work of supervisors.

As I have just noted, macroeconomic imbalances play an important role. The volatile economic and financial climate in which banks in developing countries typically operate further undermines an already precarious situation. Large swings in real exchange rates and interest rates, in private capital flows, and in the terms of trade—at least in relation to the size of these economies—expose banks in these countries to greater risks than what their counterparts in less volatile industrial economies must face. Regrettably, banks in developing countries have not for the most part responded to their different circumstances with appropriate prudence, nor have supervisory authorities required them to build sufficiently strong capital cushions against these higher risks. In addition, many developing countries that have recently liberalized and privatized their financial systems have done so without simultaneously taking the necessary steps to ensure that banks and supervisors have the expertise and the resources needed to cope in the new environment. Under these circumstances, many banks are assuming unwarranted exchange rate, interest rate, and other market risks.

In many countries, including a number in Latin America, increased international capital flows have put new strains on unsound banking systems. In particular, a rapid extension of credit fueled by capital inflows

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tends to lead to poor credit decisions and eventually to problems in the loan portfolio. Prudential policy alone cannot prevent this; monetary and fiscal policy action is needed as well—and must be taken promptly, before the situation deteriorates to the point where policymakers become reluctant to tighten policies for fear of making matters worse. Otherwise, delays in policy action can set the stage for a loss of market confidence in domestic economic policy, which in turn can trigger capital outflows and put further pressure on weak banks.

If weaknesses in the banking sector can thus be traced to a variety of sources, it stands to reason that a successful campaign against the problems of banking systems must be waged on several fronts. In fact, a number of constructive steps are already under way.

Many countries, including a number in Latin America, have taken or are taking steps to strengthen the institutional framework of their banking systems. Banking laws have been updated throughout the region, and many countries have made efforts to upgrade their supervision of banks. Chile, in particular, considerably strengthened supervision following its banking crisis of the early 1980s, and its supervisory system is now often used as a model for reforms in the region and beyond. Latin America has also begun to see a wave of bank consolidations. For example, Argentina and, to a lesser extent, Brazil have witnessed extensive bank restructurings, mergers and privatizations.

Most of the countries in the region have adopted the standards and guidelines developed for the Group of Ten countries by the Basel Committee. But the work of regional supervisory bodies in developing regional standards beyond those originating in Basel should also be recognized.

For example, the Association of Banking Supervisory Authorities in Latin America and the Caribbean has developed regional standards on loan classification and provisioning and on the role of external auditors, and the Caribbean Group of Banking Supervisors is working to harmonize the regulatory framework and supervisory practices within the Caribbean Community (CARICOM).

The IMF, for its part, helps to promote bank soundness through its surveillance, lending and technical assistance. In the area of surveillance we are striving to improve the macroeconomic environment and the structural framework within which banks operate. In its discussions with member countries, the Fund calls attention to emerging macroeconomic problems and structural deficiencies and recommends appropriate policy action. The Fund's efforts to strengthen member countries' banking systems are also reflected in the design of Fund-supported lending programs and technical assistance; in recent years such assistance has focused increasingly on banking legislation, regulation and supervision. In response to the Mexican crisis, the Fund

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PROMOTING SAFE AND SOUND BANKING SYSTEMS

PART ONE • MICHEL CAMDESSUS

has strengthened its surveillance, making its discussions with country authorities more continuous and probing and paying greater attention to banking sector issues, the sustainability of capital flows, and countries where crises could spill over into other markets. Recently the Fund's Executive Board and Interim Committee have stressed the importance of bank soundness for macroeconomic stability and policymaking, and thus we intend to continue with, and build upon, these efforts.

Nevertheless, it is clear from the extent of banking problems in Latin America and elsewhere that major gaps remain in national and international efforts to strengthen banking systems. At the national level, many of the fundamental causes of unsound banking systems persist, including poor internal governance and a lack of transparency about banks' operations and financial condition, inadequate supervision, and excessive official complacency about problem banks. All too often, efforts to strengthen domestic banking systems, although welcome, are undertaken only after crisis has struck. It is unfortunate if sufficient momentum for real reform can be gathered only in time of crisis, because reform then comes at a terrible price. For example, when all the direct and indirect costs are accounted for, the banking crisis in Chile exceeded 30 percent of that country's GDP, and the recent crisis in Venezuela 20 percent. We must do better and avoid such exorbitant costs. jNunca mas!

At the international level, meanwhile, banking standards are not as comprehensive as they should be. In some areas, such as accounting rules, there is still debate even among the industrial countries. And in some crucial areas such as loan valuation, provisioning rules, and especially exit policies, there is no consensus among the Group of Ten or even among the members of the European Union.

Standards adopted by the Basel Committee are often also used in countries beyond the Group of Ten, but questions remain about how well suited these standards are to the circumstances of developing countries.

Many standards, such as those embodied in the Basel Capital Accord, tend to assume conditions that are not always present in developing countries— or even in some industrial countries. For example, without proper loanloss provisioning, standard measures of capital adequacy may be meaningless. Moreover, given the greater volatility of macroeconomic conditions and private capital flows in emerging markets, developing countries may require more stringent standards than do industrial countries. Some Latin American countries seem to have already taken this view and are setting more demanding capital ratios and risk weights for calculating capital adequacy than the Basel Accord calls for.

Despite these many initiatives, and despite all of the progress made, we cannot yet claim that the situation is under control. Where, then, do we

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go from here? The Fund, with its responsibility for surveillance of the macroeconomic and financial stability of its members and the soundness of the international monetary system as a whole, has a keen interest in seeing that the gaps are filled and that domestic banking and financial systems are strengthened. From our perspective, the principal emphasis should be on reinforcing internal bank governance and market discipline in banking practices. But there is also a clear need to improve external oversight, especially until internal governance and market discipline become more effective. And, of course, the macroeconomic environment has to be conducive to the stability of financial systems.

One promising approach is to look for standards and practices that have served particular groups of countries well, whether they are industrial or developing countries, and to consider how those standards and practices can be adapted and applied in other countries. Such an effort to seek out and agree on best practices and disseminate them to a wider group of countries is, indeed, the philosophy that lies behind the valuable work of the Basel Committee. This spirit has likewise animated the Fund's successful initiative to develop standards to guide members in the public dissemination of economic and financial data.

I believe that this approach offers considerable advantages. International guidelines would help national authorities make improvements in domestic regulation and supervision that they might not otherwise be able to carry out, whether for lack of information, for competitive reasons, or because of domestic opposition. Moreover, by reinforcing market discipline over banks' behavior and by facilitating supervision, such standards would provide strong incentives to improve internal bank governance, which, again, lies at the heart of most banking problems. Although these international banking guidelines would be voluntary, the prospect of a positive market reaction for countries that implement them should provide a strong incentive for reform.

Beyond developing international guidelines, we need to find ways to deal with other difficult issues, such as how to help countries take corrective action against problem banks early, while distortions are small; how to close down insolvent banks; how to design payment systems so as to limit contagion effects; and how to ensure that lender-of-last-resort facilities do not prolong the lives of unsound banks or lead to moral hazard. The Fund stands ready to help with these tasks in the following ways: by contributing its universal experience to the development of internationally agreedupon regulatory and supervisory standards, and making sure that such standards match the circumstances of developing countries; by helping disseminate those standards; by monitoring progress in their implementation or in the implementation of national policies aimed at the same objec-

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PROMOTING SAFE AND SOUND BANKING SYSTEMS

PART ONE • MICHEL CAMDESSUS

tives; and by helping to restructure banking and Financial systems. Needless to say, all of this will need to be done in close collaboration with other international, regional and national organizations involved in this work.

When the challenge is of such dimensions, we must all hang together or we shall surely hang separately.

The work that we have accomplished so far in Latin America, in close cooperation with the Inter-American Development Bank and the World Bank, is a source of encouragement. The following are only a few recent examples of initiatives in which our institutions have jointly participated: • In Venezuela, a coordinated effort by the Fund, the IDB and the World Bank to provide technical assistance has contributed to strengthening banking supervision following that country's financial crisis.

• In Costa Rica and Nicaragua, the IDB and the Fund have worked together on programs to modernize and restructure state-owned banks.

• In Argentina, the IMF, the World Bank and the IDB have cooperated with the authorities in privatizing a number of provincial banks.

• In Ecuador and Guyana, the Fund and the IDB have assisted with the drafting of modern banking legislation.

• In Nicaragua, the authorities' program of structural reform and macroeconomic stabilization, supported by the Fund through its Enhanced Structural Adjustment Facility (ESAF), has been greatly reinforced by an IDB technical assistance project to modernize the central bank and to develop core financial and economic statistics, for which the Fund serves as executing agent.

Having learned from this experience, we are more determined than ever to give these joint operations high priority, allowing us to pool our surveillance and financing resources with our sister organizations, while drawing on the expertise and technical capabilities of our colleagues in Basel and in the central banking community. Beyond a doubt, an enormous amount of work remains to be done, not just in Latin America but around the world. Let us therefore join forces and bring together our collective experience and insight into these problems to ensure that these efforts, so essential for domestic prosperity and global stability, go forward.

Michel Camdessus is Managing Director of the International Monetary Fund.

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Andrew D. Crockett

The tension between the need for national diversity in financial systems and the benefits of international convergence is a theme that runs throughout this book. We have heard much about how financial systems in Latin America are different from those in the industrial countries. But we should not forget that the financial systems in the industrial countries are likewise marked by great diversity—in the importance of banks relative to securities markets, in the range of activities that banks undertake, and in the structure of bank ownership. Partly because of these differences, and because of often deeper differences in the nature of government, regulatory and supervisory systems differ from country to country.

At the same time, of course, the globalization of financial markets constitutes a powerful force for convergence internationally. Investors will buy financial assets in foreign countries only when they are assured that the securities markets in those countries meet certain minimum standards.

Banks are allowed to set up foreign branches only if the host-country supervisors are satisfied that they are properly supervised at home, or if there is some other means of assurance that their foreign guests will be well behaved.

What have been the main causes of financial fragility in Latin America? There has been no one predominant cause. Rather, several elements have been important, and the relative importance of each differs from country to country. The lack of a single cause points to an important conclusion: that no single remedy is likely to apply to all countries.

Without claiming that they are exhaustive, I would identify three elements that have led to weak financial systems in Latin America. The first is an unusual degree of macroeconomic volatility. A volatile economic environment inevitably makes it hard for banks to assess credit risk. A company's credit history under conditions of extreme inflation may not be a good guide to its performance in a more stable environment. Inflation can mask inefficiency, both in the companies that borrow arid in the banks that lend to them.

Second, an uncompetitive environment for banks has made them inefficient. Excessive state interference in the banking business has been an important factor, not only in the form of large state-owned banks domi-

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Separate but Converging: International Financial Standards and National Financial Systems

PART ONE • ANDREW D. CROCKETT

nating the banking system, but also in more subtle forms of political meddling in lending decisions.

An oligopolistic banking structure often stifles competition. The chapter by Liliana Rojas-Suarez and Steven R. Weisbrod offers an interesting analysis of the danger of excessive economic concentration in Latin America. Such concentration is not always easy to deal with, particularly in small countries. The result all too often in Latin America has been banks that are grossly overstaffed or with overly extensive branch networks.

Lack of competition has allowed bad banking practices to take root in many countries. Lending to connected enterprises is pervasive in Latin America, with the attendant dangers of compromising objective risk assessment and increasing the temptation to engage in fraud. Excessive mismatches between the maturities of assets and of liabilities, and between the currencies in which they are denominated, have also proved a problem. Here one needs to look carefully behind the appearances. A bank's books may look balanced, but this balance may have been achieved at the expense of shifting risk to the bank's borrowers. For example, banks may attempt to offset maturity mismatches by charging their long-term borrowers variable interest rates. But if these borrowers face difficulties in servicing their loans when short-term interest rates rise sharply, this risk may simply rebound back on the banks as a credit risk.

Inadequate diversification has also been an important failing. Too often in Latin America, bank lending is too concentrated sectorally or geographically.

The third element that has led to weak financial systems is that mechanisms of prudential oversight have often lagged behind financial liberalization. The move to freer financial markets almost inevitably increases banks' risks and makes them more complex. Yet all too often the official supervisory system has not been strengthened sufficiently to cope with these risks. In some cases, supervisory guidelines have remained lax or easy to evade. When supervision is not carried out on a consolidated basis, for instance, banks can transfer problems offshore or to other members of their conglomerate group. The responsible authorities often lack the resources to monitor banks adequately, or lack the power to enforce the rules.

Yet market-based control mechanisms have not been given the chance to work either, because disclosure has been insufficient or inaccurate. It cannot be said often enough that officially enforced rules and regulations can only be part of any oversight mechanism. Any regulation inevitably prompts attempts to avoid or evade it. This is all the more true when the structure of financial markets is changing rapidly and may at times outgrow specific regulatory provisions.

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This list of causes could be extended—an inadequate legal framework, for instance, is often a central failing—but let me now turn to what needs to be done. High on every Latin American policymaker's agenda is the problem of heightened volatility. It goes without saying that stable and sustainable macroeconomic policies can do a lot to reduce volatility, and Latin America has made significant progress in this respect in recent years.

It is important, however, not to declare victory too soon. In setting their prudential norms, banks and their supervisors should design systems robust enough to cope with the volatility we have seen in Latin America over the last decade or so. A few good years should not be allowed to lull banks or their supervisors into complacency.

What can be done to help banking systems in the more volatile environments? One way is to make banks more international. Michael Gavin and Ricardo Hausmann emphasize in their chapter that financial institutions operating in volatile economies can get some help through international diversification. Restrictions that severely constrain the portfolios of home banks to the local market clearly work against the principle of diversifying banking risk. These restrictions should therefore be carefully reviewed.

This strategy, of course, brings with it certain new risks: for example, it introduces the difficulty of supervising the foreign activities of local banks.

The entry of foreign banks can also help. Because their portfolios are less concentrated in lending to firms in the host country, and because they usually have access to external sources of liquidity and foreign exchange, they can weather shocks to the local economy better than the domestic banks. Naturally, the authorities need to keep in mind certain transitional risks. For example, the entry of highly competitive foreign banks may well reduce the overall profitability of the banking system, making it more vulnerable to adverse shocks.

Are the international guidelines recently adopted by some of the industrial countries relevant for banks in Latin America? Many observers believe that banks in Latin America should hold higher levels of capital than those guidelines call for. It should be remembered that the 8 percent standard for capital-to-risk-weighted-asset ratios in the Basel Capital Accord was always intended as a minimum: it was understood that national regulations should supplement these ratios as circumstances warranted.

Many industrial countries with relatively strong banking systems do indeed require higher ratios of the banks they supervise, and higher ratios still for those banks perceived as riskier. Higher capital-to-asset ratios provide not only a greater safety margin but also discourage excessive risk taking, since the bank owners themselves have more to lose. As Pedro Pou notes in his comment, Argentina has recently adopted a capital standard of 11.5 percent.

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SEPARATE BUT CONVERGING

PART ONE • ANDREW D. CROCKETT

Whether certain groups of countries could and should reach formal agreements to aim for capital ratios above the Basel standard is an open and rather controversial question. A case could be made for such an agreement—it is easier to persuade domestic banks of the need for higher capital ratios if they know that banks in similarly situated neighboring countries are also being made subject to higher ratios. Ideally, one can imagine countries varying their minimum capital ratios according to the volatility of their economies. Yet there are formidable practical difficulties in calculating volatility and in ranking countries accordingly. An additional problem is how to define the transition from one regime to another once there are several standards.

Another possibility is that capital requirements could be differentiated even within given risk-weight categories of the Basel standard. I am intrigued (and Pedro Pou referred to it in his comment as well) by recent Argentine regulation on credit risk, which in effect uses the bank's own assessment of the relative riskiness of its different loans. It does this by imposing higher risk weights on those (presumably riskier) loans with higher interest rates.

Others argue for alternative (or perhaps supplementary) prudential ratios. It has been suggested that supervisors in Latin America should focus on liquidity ratios rather than capital ratios. Liquidity ratios can indeed be a useful supplement to capital ratios. From a theoretical perspective there is nothing sacrosanct about capital ratios—one can imagine alternative ways of achieving more or less the same thing. As a practical matter, however, capital ratios have become a central element in international banking regulation. The framework that was put in place about a decade ago has been deepened and refined. Capital ratios have thus come to constitute the core of international cooperation. No one doubts that all countries should live up to these ratios, in spirit as much as to the letter.

Liquidity ratios might be useful supplements, but they cannot substitute for adequate capital ratios.

The second cause of financial fragility in Latin America that I identified was the uncompetitive environment. The privatization of state-owned banks is one promising way to introduce competition and has indeed been pursued by many countries. Yet governments need to beware of several possible drawbacks. Much will depend on who the new private owners are: it is not helpful simply to exchange public sector inefficiencies for private sector incompetence or fraud. Those awarded banking licenses must be subject to careful screening, even if it slows down the pace of privatization.

Another important step would be more explicit accounting of the impact of government operations on the banking system. Such quasi-

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fiscal operations typically serve to circumvent legislative and political constraints on fiscal policy, and they are often a major drag on the banking system. It would be much better if government subsidies to, or revenues from, the banking system were explicitly included in government budget statements.

Eliminating bad banking practices is clearly a major challenge both for the banks themselves and for their supervisors. Many of today's problems are an indirect legacy of earlier financial repression, which did not encourage the development of necessary skills. This should serve as a warning to those who argue for extensive re-regulation. If the authorities are too intrusive in their regulation, banks' acquisition of know-how can be inhibited.

The third problem leading to financial fragility is that implementation of mechanisms of prudential oversight has often lagged behind liberalization and internationalization. Bank supervision clearly needs to be strengthened before liberalization occurs. Supervisors need to be better trained to monitor banks as they try to cope with the new and expanded activities permitted under liberalization. They also need to be able to evaluate the risks involved as these new activities expand.

Banks operating in a highly regulated financial system, with controls on interest rates, credit expansion, and capital flows, typically earn considerable economic rents. Once quantitative restrictions on bank credit are lifted and interest rate controls are dismantled, one usually sees a significant rise in the ratio of bank lending to GNP. This is accompanied by a growing concentration of loans among higher-risk activities, including real estate and, sometimes, financial market speculation. It is not unnatural for banks, seeing the easy profits they used to make on their traditional business eroded, to be tempted to take more risks to sustain their profits.

Even in many industrial countries, with well-established traditions of bank supervision, supervisors were not well equipped to cope with increased risk taking in the new, liberalized environment.

Reporting systems need to provide better information, on a consolidated basis, to include reporting of offshore exposures—often a significant lacuna. This requires deeper cross-border cooperation of supervisory authorities, which can happen only in an atmosphere of mutual trust: supervisors on both sides need assurances about the seriousness of their counterparts' efforts, about respect of confidentiality, and so on.

There is a limit to what even the best supervisors in the world can or should do to preserve the safety of banks. Supervisors are not there to substitute their own credit judgment for that of the banks, nor is it their job to design and implement bank management systems. It is the management of the bank that is primarily responsible for such decisions.

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SEPARATE BUT CONVERGING

PART ONE • ANDREW D. CROCKETT

This brings me to the final area where improvement is needed, that of accounting and disclosure. It is up to management to make good or bad decisions, but up to the financial markets to sanction those decisions. This requires the keeping of accurate financial accounts. Yet we all know of countries where the published records of banks' positions looked quite healthy even when they were on the brink of collapse. The main reason for such unwelcome surprises is the common pretense that bad loans are good.

Stricter asset classification is therefore urgently needed. Provisioning practices need to be reformed to reduce the scope for delay in recognizing bad loans and to encourage banks to make adequate provision against loan losses. To this end, more emphasis needs to be given to evaluating borrowers' current creditworthiness. Banks should not be allowed to keep loans current simply by extending new loans. The high volatility of asset prices in emerging market economies also makes it especially important to take due account of market values and to value realistically the collateral underlying bank loans. A number of Latin American countries have recently tightened their rules in this area. This is to be very much welcomed, even if it leads, as it is expected to in the case of Mexico, to a sharp rise in the amount of past-due loans reported.

It is also important to ensure that public disclosure of basic information about bank performance, bank income, and bank balance sheets becomes more harmonized internationally. There are at present two main competing standards: the Generally Accepted Accounting Principles used in the United States, and the International Accounting Standard, which is used in many other countries and which may be gaining wider international acceptance. More work is required on this question, but if banks could be induced to report on broadly comparable bases it would clearly help the financial markets and the rating agencies and make for more effective market discipline.

None of this is easy. After all, financial accounting systems are often intimately linked to a country's traditions and laws, not to speak of its state of development. Yet international financial markets do require information that is broadly comparable, and this in itself is an important spur to better practice. It is thus also a powerful force for convergence.

I began by referring to a rather general tension between national diversity and international convergence, which lies behind the specific question of what can be done for the financial system in Latin America. How can we reconcile differing national needs with the pressure for international convergence? Maintaining a tolerance for diversity is important in any regulatory system, not only because countries are different, but also because financial systems have to be allowed to evolve over time in line with changes in their circumstances.

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I will summarize by offering three conclusions. First, the market itself can help in putting different countries on the same footing without forcing them into a straitjacket. For this to happen, proper accounting as well as full and accurate disclosure are essential. Effective competition between different financial institutions is also important. And an effective market infrastructure needs to be in place to reduce the risks of market manipulation, minimize counterparty risk, and so on. We are only in the early stages of making market discipline as effective as it can be for financial systems. Much work remains to be done on market infrastructure.

My second conclusion is that international agreements on regulation can help by covering certain agreed-upon common ground. The Basel Accord is perhaps the outstanding example of an effective international financial agreement. Typically, such agreements are not rigid international treaties, but rather guidelines that all members seek to live up to. They work through peer group pressure. They provide external support for those seeking to impose more effective supervision at home. But there is no supranational enforcement, nor do such agreements provide detailed blueprints. Indeed, they are deliberately not all-inclusive, because accounting systems, legal frameworks and national traditions differ. Even so, reaching such agreements can be a difficult and drawn-out process—indeed, that was certainly true of the Basel Accord.

It will take time to clarify to what extent the guidelines developed for internationally active banks in the industrial countries should be adapted for developing countries. Clearly, nothing should be done that is inconsistent with the guidelines of the Basel Committee, although transition periods may be needed for some countries. It is possible that certain things taken for granted among the Group of Ten need to be spelled out more explicitly for other countries. It is also quite possible that some countries will require tougher guidelines. A good deal of work is being done on these issues—notably by the Basel Committee—with the major developing countries. This work is very important.

My third conclusion is that building robust financial markets is critically dependent on a strong domestic commitment—by governments and by the broader business community as much as by the financial institutions themselves—to further reform and eliminate abuses. Better financial markets cannot be imposed from abroad. All those involved—governments, central banks, other supervisory agencies, and market participants themselves—have to realize that building stronger financial systems will require concerted and sustained efforts lasting over a number of years.

Andrew D. Crockett is General Manager of the Bank for International Settlements, Basel, Switzerland.

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SEPARATE BUT CONVERGING

Lawrence H. Summers

The strengthening of financial systems in emerging market economies is a particularly appropriate and timely topic for Latin America, but not because the region is unique in suffering financial system failures in recent years. In fact, Latin America has plenty of company in that regard. Rather, it is appropriate because the international community is now putting together a coordinated plan of action to strengthen financial systems in emerging markets, and because institutions such as the Inter-American Development Bank have been playing a critically important role in this exercise.

In the wake of the Mexican financial crisis, the Group of Seven nations outlined a series of proposals to improve the international capacity to manage and, where possible, prevent macrofinancial crises. The proposed measures included stronger disclosure standards, improved country surveillance by the IMF, expansion of the resources available to the IMF in emergencies, and measures to facilitate market-based solutions to financial crises that involved sovereign nations. These initiatives are now well under way. The IMF bulletin board is up on the Internet. Surveillance procedures have been changed. Negotiations toward a New Arrangement to Borrow have made great progress. The Group of Ten's report on orderly workouts of financial crises has attracted much attention. But ultimately a well-functioning global capital market depends not just on the prevention and management of crises at the macrofinancial level, but also on the stability and strength of national capital markets. That is why, at the Lyons Summit, the G-7 leaders outlined the key elements of what they believe should be the next phase of an agenda of financial reform. The centerpiece is an effort to develop an international strategy to strengthen financial systems in general, and banking systems in particular, in emerging markets.

No one can doubt the international community's strong stake in achieving that objective. Over the past decade, banking crises have become an all-too-familiar feature of the financial landscape, with staggering costs both for national financial systems and for the broader economies of the countries involved. Spain, Finland and Sweden, not to mention the United States, Japan and France, have all either been through or are now in the process of completing cleanup efforts that cost a significant fraction of

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Strengthening Financial Systems in Emerging Markets: An Agenda for Action

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national output. The 3 percent of GDP that the savings and loan debacle is estimated to have cost the United States is certainly at the low end of estimates among the industrialized countries hit by banking crises. The cost of Spain's banking crisis may have been as high as 15 percent of that country's GDP. And as IDE President Enrique Iglesias has noted, such sums may well prove small in relation to the costs of some of the crises that Latin America and certain transition economies have witnessed. .

These costs alone illustrate the strong stake that governments have in strengthening domestic financial systems. But I believe that the international community has a powerful stake as well. Our common interest goes beyond the natural desire to limit the risk to our own financial institutions and citizens who hold stakes in foreign banks that are poorly supervised.

The international community's interest is grounded in the belief that strong financial systems in emerging economies will help spread prosperity. Financial intermediaries, after all, perform a task that is central to the proper functioning of the entire world economy: that of linking the savings of workers in industrialized countries with the huge opportunities for investment available in so many developing countries. Yet in a world of mobile capital, financial disruptions beginning in one economy are much more likely than before to spill across borders, increasing the risk of contagion effects, or what an economist might call reputational externalities. Troubled banking systems often drive macroeconomic policy far off course by creating huge unanticipated fiscal obligations and by driving monetary policy into imprudent actions, thereby creating the conditions for macroeconomic distress. The official international community has an obvious and strong interest in minimizing the potential for weak financial regimes to trigger financial collapse, since it is so often drawn in to absorb some part of the costs.

For these reasons I believe it is appropriate to think of strengthening financial systems in emerging markets as a challenge not just for those countries, but for the whole international community. On the general principle, too rarely practiced in government, that it is useful to explore what is behind a problem before rushing to a solution, let us reflect briefly on the factors that seem most important in contributing to banking crises. I see banking crises as reflecting the interplay of four factors, with the weight of each factor varying according to the circumstances.

The first factor is some form of macroeconomic distress, of which banking systems can be both victim and cause. A macroeconomic shock, such as a surge of capital outflows that results in depreciation of the currency and lower asset prices, can hurt banks with weak balance sheets, precipitating a broader crisis. Conversely, the monetary and fiscal costs of bailing out failed banks can impair macroeconomic stability. The prospec-

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STRENGTHENING FINANCIAL SYSTEMS IN EMERGING MARKETS

PART ONE • LAWRENCE H. SUMMERS

tive impact of strong stabilization measures on a weak banking system can hinder their implementation and deter countries from taking the steps necessary to head off a financial crisis.

A second crucial factor, and the one that has attracted perhaps the greatest attention from my colleagues in the economics profession, is moral hazard. Excessively generous guarantees or state-sponsored safety nets, whether explicit or implicit, can create dangerous incentives for risk taking. Bankers and shareholders allowed to operate with a heads-I-win, tailsyou-lose mentality not only will be prepared to take great risks themselves, but will pressure other banks to do so by bidding up the cost of funds.

Those unwilling to exploit the deposit insurance system will find themselves unable to compete with those who are. The presence of moral hazard obviously has had a great deal to do with the expansion of unsound banks in many countries.

A third element, one that has received less attention in some academic circles than it probably deserves, is the opportunities that banking by its nature affords for looting of shareholder and depositor wealth and for self-dealing. Consider the simple example of a bank that accepts deposits, lends at a high rate of interest, records profits, and pays dividends to its shareholders on a large scale. The capital ratios, measures of profitability, and other conventional measures of the financial strength of such a bank may look sound for a time, even though the managers may be systematically looting the institution. Weak systems of bank supervision and examination will allow problems to go undetected, magnifying the potential for abuse by bad managers or by those criminal enterprises attracted to banking simply by its potential for illicit gain. Indeed, I am struck by the degree of criminality that seems to be uncovered in every serious and pervasive financial crisis. We should all take to heart Morris Goldsteins admonition that it is as important for supervisors to look at the "good" loans on a bank's books as it is to look at those already recognized as bad.

Fourth, banks that are not run as banks, or that are not owned by bankers, often turn out to be less than fully viable. Governments that run state-owned banks as instruments of fiscal or industrial policy, or for political purposes, are asking for trouble. When industrial companies are allowed to own banks and direct their lending, particularly to themselves or their customers, the consequences can be equally messy. A successful approach to bank regulation has to recognize the possibility and assess the likelihood of each of these sources of financial weakness. It has to be pragmatic and acknowledge that, in an imperfect world of profit-seeking people, the objective cannot be to eliminate these problems, but must be rather to reduce their incidence, limit their potential for damage, and contain the fallout when things do fall apart.

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Any gathering of finance ministers and central bank governors is certain to draw the attention and interest of the press, which tends to define the "news" coming out of the meeting in terms of what is said in the published communique^ how much money was committed to be spent, or, better yet from the journalists' point of view, the degree of public criticism of each others policies. But I have come to believe that the most important thing that happens at official meetings is none of these. It is instead the building of a common understanding about the roots of problems, a consensus that provides a common framework for action in each of our countries. So it should not be surprising if I say that a successful strategy to strengthen national financial systems must start with an effort to shape a consensus on the key elements of a strong, well-supervised banking system and a well-regulated capital market. Building on the extensive work already done, and recognizing that neither the United States nor the Group of Ten has any monopoly on wisdom in this area, one can identify several important elements in the strategies that have already been successful at the national level.

First, strong supervisory regimes are essential. This means tough requirements for entry into the banking industry; prudential norms for capital, equity and currency exposure; limits on connected lending and direct lending; strict rules governing income recognition, loan classification and loan-loss provisioning; reporting and disclosure requirements; a rule-based regime for remedial action against banks; and consolidated supervision and a framework for dealing with insolvent institutions.

Second, these rules and standards have to be enforced by a thorough system of bank examination backed by an independent bank supervisory authority with the ability to enforce compliance. Adopting a banking regime that looks good on paper is not sufficient to head off the next crisis. Elegant risk-weighted capital ratios are not enough. Bank examination has to be on-site, detailed, regular and complete, focusing on credit quality and internal controls, if it is to result in an accurate picture of the bank's condition. Only such an approach to examination is likely to succeed in creating a culture of credit that is conducive to financial stability.

Third, supervisors need a framework in place to deal with problem banks and situations, and with systemic threats. Early warning systems, procedures for prompt corrective action, and clearly delineated authority to intervene in failing institutions can establish a more stable banking environment. A deposit insurance system is surely part of the equation, but it is crucial that the safety net be extended judiciously and carefully to create a proper balance of incentives for bank owners, managers and depositors that minimizes moral hazard.

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STRENGTHENING FINANCIAL SYSTEMS IN EMERGING MARKETS

PART ONE • LAWRENCE H. SUMMERS

Finally, the supervisory regime has to be complemented by strong credit infrastructure. Among other things, this means a functioning bankruptcy system and a well-developed legal regime.

This list is hardly comprehensive. I have focused on those aspects that relate to the regulation of banks. Privatization, the attraction of external capital, and the development of well-functioning securities markets obviously have crucial roles as well. The kinds of national strategies I have described are those that appear to be appropriate today, based on our current understanding. Arguments stressing the need for careful, thorough and appropriate supervisory regimes are often invoked to suggest that financial liberalization be delayed until such regimes are in place in order to promote stability. I think, however, that this argument is often taken much too far. Among the Group of Ten countries there is very little evidence that those regimes with more open capital markets, or that are more willing to accept foreign competition, have somehow experienced more or more severe financial crises than those that have maintained more restrictive regimes. Where crises have followed financial liberalization, a strong case can be made that the difficulty stemmed much more from flaws in the design of the liberalization strategy than from too rapid a pace. Indeed, by attracting foreign capital, and by developing greater access to liquidity, liberalization can often have important stabilizing benefits.

The architecture that I envision coming out of the Lyons Summit initiative has three parts: guidelines and principles developed by the international organizations of banking and securities regulators, enhanced surveillance of national financial systems by the IMF, and technical assistance and lending to the financial sector by the multilateral development banks.

The international organizations of banking and securities regulators have already gone a long way toward identifying the core principles, practices and objectives that underlie sound supervisory regimes for banking and securities, and sound legal and operational infrastructures for financial markets. The challenge now is to define more specifically how this model may need to be modified and refined to fit the circumstances of emerging markets. The credibility and relevance of this effort will depend critically on involving the authorities of these emerging financial markets themselves in developing the new guidelines. Although responsibility for designing the guidelines and principles of sound regulatory systems will necessarily fall on the international organizations of supervisors and regulators, I believe that the international financial institutions can play a useful role in helping countries put that framework in place.

Given that macroeconomic stability remains the IMF's central preoccupation, it is essential that the Fund take an active role in addressing the vulnerabilities of financial systems that can contribute to macroeconomic

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instability. The IMF's involvement can take, and increasingly is taking, several forms. Its surveillance can be a useful vehicle for encouraging countries to adopt the guidelines developed by the supervisory community and assessing progress toward that objective. Where prevention fails, and where banking problems loom large as a source of macroeconomic strain, the IMF's involvement can be deepened, and its adjustment programs can be designed to address financial system weaknesses more directly.

The World Bank and the regional development banks have an equally important role to play, as recent events in Mexico and Argentina demonstrate. For example, they can help develop the institutional capacity for financial regulation through technical assistance and training of supervisors and examiners in cooperation with other international bodies and national authorities. The IDE's initiative in this area is worthy of note. Also important is the development of healthy financial systems through financial sector lending programs directed at helping countries implement systems based on principles such as those I have described. And inevitably in an imperfect world, occasions will arise where active engagement in the resolution of serious banking problems and the restructuring of failed financial institutions will be necessary.

None of these is a totally new initiative by any stretch. Work in these areas has been under way for a very long time. But just as the development of the interstate highway system in the United States was a highly beneficial innovation, but one that called for new forms of regulation and enforcement for its benefits to be fully realized, so too the new global capital market, with its tremendous capacity to mobilize more capital more quickly than ever before, is a positive force whose energy and potential will be best realized with appropriate government action. I think we will have the best opportunity to sustain capital flows of $200 billion a year into emerging markets, and to realize the maximum benefit of those flows, if we continue to meet the challenge set by U.S. Treasury Secretary Robert Rubin: that of developing regulatory institutions that are every bit as modern as the markets they serve.

Lawrence H. Summers is Deputy Secretary of the U.S. Department of the Treasury.

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STRENGTHENING FINANCIAL SYSTEMS IN EMERGING MARKETS

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Supervision and Regulation

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PART TWO

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Liliana Rojas-Sudrez and Steven R. Weisbrod

The commonly accepted justification for regulating the safety and soundness of banks in Latin America is similar to the justification in the industrial world. Banks operate within a public safety net: they have access to central bank funds in an emergency, and they are often covered by publicly provided deposit insurance. Both these facilities permit banks to transfer some of the risk in their asset portfolios from shareholders to taxpayers without compensating them for that increased risk. Hence the safety net creates incentives for banks to take on more risk. As a result, banks must be supervised and regulated to restrain their ability to shift risk to the public.

The need for bank regulation has long been recognized, and, in the industrial countries, the tools for regulating banks have undergone continuous improvement. Most notably, bank supervisors have developed sophisticated measures for evaluating the adequacy of bank capital. Banks with more risky commitments, including those off the balance sheet as well as on it, can now be more clearly identified and required to hold more capital than banks holding safer assets. In addition, over the last 10 years supervisors have become more aggressive in insisting that banks set aside adequate loan-loss reserves against nonperforming loans. Through pressures to maintain appropriate capital levels and adequate loan-loss reserves, regulators have been able to restrain the growth of risky banking institutions before their condition deteriorates and public assistance becomes necessary. Regulators have also developed sophisticated tools to measure bank liquidity that take into account a bank's ability to meet commitments to deliver funds to its customers on short notice.

The success of regulators in industrial countries in monitoring and constraining bank risk has led many commentators to advocate the adoption of similar rules for capital adequacy and similar standards of asset evaluation in Latin America, as well as in other developing countries. For example, the weaknesses of the Mexican banking system, so evident in the aftermath of the peso devaluation crisis of 1994-95, have been blamed in part on inadequate bank supervision. Specifically, Mexican bank supervisors tolerated an underprovision of reserves against credit losses, which in

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Toward an Effective Financial Regulatory and Supervisory Framework for Latin America: Dealing with the Transition

PART TWO • LILIANA ROJAS-SUAREZ/STEVEN R. WEISBROD

turn led to an overvaluation of bank capital relative to risk-weighted assets. It is well recognized that before capital adequacy standards can be effectively applied in Latin America, accounting standards must be improved and supervisory personnel must be better trained to determine whether banks are appropriately accounting for nonperforming loans.

While we fully agree with the principle that, under ideal conditions, the regulatory and supervisory framework for financial institutions should converge across countries in the long run, this chapter deals with a most pressing issue for policymakers in Latin America: how to handle the transition period when the preconditions needed for effective implementation of industrial country standards are not yet in place.1 Specifically, we raise more fundamental questions about how banks in Latin America ought to be supervised now in order to minimize the probability of a financial crisis before implementation of industrial country standards can work effectively.

We consider whether the prevailing structure of wealth ownership in the region alters both the priorities of bank supervisors and the effectiveness of industrial country supervisory ratios in assessing bank risk in Latin America. In particular, we question the short-run applicability of capitalto-risk-weighted-asset standards as a means of shifting the cost of risk from the public back to bank shareholders. We argue that the concentration of wealth in Latin America and the accompanying illiquidity of equity markets permit investors who control banks to subvert the intent of capital requirements, even when the bank itself is subject to rigorous accounting standards.2 Investors in developing countries holding a majority interest in a bank can offset their equity position in that bank with a liability position to the same bank or to a bank owned by a related party—in effect, they can borrow from the bank (or a related bank) the funds necessary to acquire ownership in the bank. In contrast, in industrial countries, where markets are large and wealth is dispersed, it is much more difficult to finance the acquisition of a majority stake in a bank using loans from related parties. Since the quality of bank capital is thus low, in many Latin American countries the public safety net is severely underpriced, creating incentives for bank risk taking greater than those present in industrial countries with better quality of bank capital. The empirical evidence presented in this chapter suggests that well-functioning equity markets are necessary for the enforcement of capital standards. In other words, good markets are complementary to good supervision.

1 For a comprehensive discussion on core principles for bank supervision, see Basel Committee on Banking Supervision (1997). Because they are general principles, transitional issues are not analyzed in this chapter.

2 For separate arguments on the difficulties of translating industrial countries' capital adequacy standards to developing countries, see Kane (1995).

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Consolidated supervision, in which supervision extends beyond the balance sheet of the bank itself to those of related companies and activities, is an effective tool in industrial countries to prevent these kinds of conflicts of interest. However, it cannot mitigate these problems in Latin America unless it is extended to the nonfinancial as well as the financial interests of bank owners.

The high concentration of wealth and the interconnection of balance sheets of large wealth holders implies that, in the event of a domestic financial crisis, the failure of one major investor weakens the balance sheets of all major investors. This causes a decline in asset values at all banks and a rapid deterioration in their capital position, even for banks that previously reported very high capital-to-risk-weighted-asset ratios. This means that, in Latin America, the probability that a shock resulting in the failure of one or a few banks will develop into a systemic banking crisis is greater than in industrial countries. Because supervisors are aware of this problem, they have in many cases shifted their attention from capital-to-asset ratios to liquidity ratios. Many countries have encouraged banks to hold high levels of liquid assets in relation to total assets by imposing liquidity requirements.

Two problems arise in executing such a policy. First, supervisors must determine whether domestic currency liquid assets are really liquid when banks need an asset with a stable value, such as hard currency reserves.

Second, they must consider the incentives for banks to evade liquidity requirements in markets where the cost of holding liquid assets is very high.

Although these problems make both meaningful capital standards and liquidity standards difficult to enforce in Latin America in the short run, bank regulators operating in today's financial systems are not completely without signals to advise them of the relative riskiness of banks in their markets. Although the market for bank equity is less developed in Latin America than in the industrial countries, the market for bank liabilities, such as interbank borrowings and deposits, is more attuned to differences in risk across institutions than is the case in industrial economies.

Hence, regulators can use these liability markets to assess the riskiness of banks.

A number of policy implications follow from this analysis. These policy recommendations can be divided into those that can be successfully implemented in the short run and those that will take more time to have an impact on the operation of the market. In the first group, we emphasize three policy prescriptions. First, Latin American supervisors should focus on improving those markets that already work in Latin America, namely, the markets for bank liabilities. For example, supervisors could encourage public offerings of certificates of deposit to facilitate comparing interest

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DEALING WITH THE TRANSITION

PART TWO • LILIANA ROJAS-SUAREZ/STEVEN R. WEISBROD

rates across banks. Full disclosure of key market rates should also be encouraged. Second, public safety nets for bank liabilities ought to be severely limited so that risky banks face a high price for funds raised in the liability markets. Third, macroeconomic policies, such as operating procedures for monetary policy, must play a much more important role in restraining bank risk in Latin America than in the industrial countries. In particular, accommodative monetary policies aimed at smoothing interest rate fluctuations should be avoided.

The second group of policies is aimed at mitigating the effects of wealth concentration, and it is for this reason that it will take some time to fully implement them. These policies include reforming accounting standards for banks to make those standards equivalent to those in industrial countries; instituting consolidated supervision of the balance sheets of all the business activities of major shareholders of banks; and requiring disclosure of these findings to the public. Priority must be placed on identifying the sources and quality of bank capital before capital-to-risk-weightedasset requirements can be effective. However, no matter how good the rules, it will be difficult to improve the quality of bank equity markets without expanding both the potential investor base and the potential number of equity issuers in the market. This, almost by definition, requires opening the country to unrestricted foreign direct investment, by both financial and nonfmancial firms.

This chapter is organized as follows. The next section provides an overview of the major ratios used by supervisors in industrial countries to evaluate banks and assesses the conditions under which these tools are effective. The section that follows develops an accounting framework to analyze the market for bank capital in an economy where ownership of industrial and financial companies is concentrated and held in common by a small group of individuals. This framework suggests that where wealth is concentrated, banks can increase their capital at very low net cost to the group. This section also presents evidence that the behavior of bank capital in Latin America is consistent with the predictions derived from the framework. The next section describes how markets for liquid assets in Latin America differ from those in industrial countries and assesses the ability of bank regulators to control bank liquidity in several Latin American markets. The section after that considers the alternatives available to supervisors for extracting information about the quality of banks and restraining the growth of risky banks in Latin America. It is argued that while bank regulators work on creating the conditions under which the application of supervisory ratios can effectively monitor bank risk, they can use specific market-based measures, namely, liability costs, to evaluate bank risk. In Latin America, these measures may even provide better indicators

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of risk than in industrial countries, since holders of bank liabilities in the region have less confidence in the ability of supervisory systems to protect the value of their investment than do investors in industrial countries. The penultimate section complements the discussion in the previous section by advancing policy recommendations that can enhance the effectiveness of market-based supervisory tools. The final section offers some conclusions.

Common Supervisory Tools and Why They Work in Industrial Countries Regulators in industrial countries have at their disposal a variety of supervisory ratios to portray the quality of banks' balance sheet and off-balance sheet commitments. These ratios are meant to convey the strength and volatility of a bank's earnings, the ability of the bank to remain liquid in the face of a temporary loss of access to short-term funding markets, its ability to withstand sharp increases or declines in interest rates, and, above all, the quality of the bank's credit commitments, including letters of credit and derivatives as well as traditional loans. The summary statistic for bank risk, which is eventually intended to include a composite assessment of both credit and market risks, is the capital-to-risk-weighted-asset ratio. This ratio assesses the value of a bank's equity capital, which absorbs risks that would otherwise fall on the bank's liability holders or the public safety net, against that of its asset portfolio, after assigning the various assets different weights according to their perceived risk.

Bank supervisors use several key ratios to evaluate the quality of a bank. First, to permit supervisors to evaluate the quality of loan portfolios, banks must report the ratio of nonperforming loans to total loans. Usually the former are defined as loans that have interest payments overdue by 30 days or more. Banks must also report their ratios of loan-loss reserves (funds set aside against the possibility of default of questionable loans) to total loans and to nonperforming loans.

Second, so that supervisors can evaluate liquidity, banks must report their ratios of liabilities due immediately, such as large short-term certificates of deposit, to their assets that they can sell immediately, such as government securities for which there is a ready market. Liabilities due immediately are determined not by maturity alone, but also by the probability that investors will actually withdraw their funds on the maturity date. For example, a large portion of the demand deposit base of U.S. banks actually behaves as long-term funds: depositors are reluctant to move their transaction accounts to another bank, even in the face of a crisis, because doing so is expensive and the deposit insurance system is reliable.

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DEALING WITH THE TRANSITION

PART TWO • LILIANA ROJAS-SUAREZ/STEVEN R. WEISBROD

Third, regulators use several measures of earnings quality. Earnings volatility is measured by, among other things, analyzing the impact of interest rate changes on the bank's cash flow, which in turn is measured through duration analysis of bank receipts and payments.3 The earnings strength of a bank is measured by comparing its return on assets and return on equity with those of groups of similar banks, in a procedure known as peer group analysis. Of course, for bank earnings comparisons to be meaningful, supervisors must ensure that banks are making adequate provision for the various risks they face out of their cash flow. For example, banks that underfund their loan-loss reserves are also overstating their net income. If banks record interest as accruing on loans when that interest is not actually being paid, they will also overstate their income. Hence, it is typical for supervisors to limit the time period over which banks can record the accrual of unpaid interest. For example, in the United States it is limited to 90 days.

The capital-to-risk-weighted-asset ratio is quickly taking on the role of summary statistic for most of the risks enumerated above. The ratio can serve this function because, in theory, each of the above supervisory ratios implies an adjustment to the value of assets and liabilities that ultimately affects the size of the bank's capital account. For example, an increase in loan-loss reserves reduces the value of the net loan portfolio without changing the value of bank nonequity liabilities. Hence, an increase in loan-loss reserves must result in a decrease in the equity capital account, and thus in the capital-to-asset ratio.4 Market risks, such as the bank's net exposure to interest rate changes, are also being introduced as part of the capital requirement. Hence, if duration analysis indicates increased exposure, banks will find that their capital requirement has increased.

To make the system just described work, accounting and supervisory standards must accurately portray the character of a bank's commitments off the balance sheet as well as those on it. This is important because the public safety net creates incentives for banks to evade supervision by misstating the risks they face and overstating their capital accounts relative to their balance sheets. Hence, accounting rules for classification of assets must be clear, and supervisors must have the necessary skills to determine whether the rules are being appropriately applied. For example, bank loan 3

The duration of a fixed income instrument is measured as the weighted average of the time to receipt of individual payments in the instrument's future payment stream; the weights used are the present values of the future payments. Duration analysis evaluates the sensitivity of a bank's assets and liabilities to changes in interest rates.

4 If a bank increases its loan-loss reserves out of its net cash flow, it must either reduce dividends or reduce retained earnings. In the latter case, the impact of loan-loss provisioning on the capital account is negative. In the former, its effect on the capital account is less direct. Expected dividends decline, placing pressure on the bank to increase future payout ratios.

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documentation records must be reliable enough for the supervisor to determine whether proper policies regarding accrual of interest are being followed.

The increasing sophistication of supervisory systems covering complex risks has raised the question of whether outside supervisors can adequately analyze bank risk or whether they must increasingly depend on the internal procedures for risk control administered by the banks themselves. For example, in the United States there are serious proposals to let banks use their own internal models of risk assessment in determining capital requirements. The banking industry generally supports the approach toward capital standards followed by the December 1996 Amendment to the Basel Capital Accord. The amended Basel standard permits banks to use internal models, within restricted parameters, to evaluate market risk in relation to capital (for a further discussion of the amendment, see IMF, 1996). However, to avoid having to rely on quantitative input parameters set by regulators, a number of large banks have asked for greater flexibility in the use of their own risk assessment models (see Institute of International Finance, 1995). These proposals result from the recognition by many regulators that they cannot police all risks; instead they must depend on internal mechanisms to make it in bank employees' interest to ensure that risks are evaluated properly.5 In contrast, supervisors in most Latin American countries are still at the stage of trying to make their accounting and supervisory standards stringent enough to provide a somewhat accurate portrayal of the risks each bank faces. The most common failing is inadequate classification procedures for loan risk, resulting in underprovisioning against potential loan losses. However, there are other hidden, and therefore perhaps more dangerous, problems. For example, in many major markets the balance sheets that banks report are not detailed enough to allow supervisors to trace flows of funds in the interbank market. Asset classification procedures often lead to large, undifferentiated "other assets" categories. Capital account reconciliation statements are usually not provided, making it difficult to trace the sources of increases in bank capital from one reporting period to the next. In some cases, reporting periods are not even standardized across banks, making it difficult to calculate ratios that provide meaningful performance comparisons.

Thus, the question of internal incentive systems for risk management, now a major issue in the industrial world, is not yet the first priority for 'Support for market-based regulation is also found in the academic literature: see, for example, Goodhart (1996). In January 1996, New Zealand implemented a new market-based system of regulation for banks.

For a discussion of this system, see Nicholl (1996).

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DEALING WITH THE TRANSITION

PART TWO • LILIANA ROJAS-SUAREZ/STEVEN R. WEISBROD

Latin American policymakers. However, even if the legal and accounting problems in Latin America were corrected so that supervisory ratios could be accurately measured, incentive problems would remain, because the appropriate environment for applying those ratios so as to constrain bank risk taking still does not exist. In particular, even if the value of assets could be accurately assessed, concentration of wealth in the hands of a few investors and the consequent lack of development of a real market for equity considerably weaken bank capital-to-risk-weighted-asset ratios as a regulatory tool to constrain bank risk taking. In the following section, an accounting framework for bank capital is presented that shows how equity market conditions affect the quality of reported bank capital. It also provides some evidence to support the assertion that the capital reported by many banks in Latin America may not be a reliable constraint on their risk taking.

Equity Market Development and the Feasibility of Enforcing Capital Standards The purpose of a capital standard is to reduce the incentive for bank stockholders to take risks at the expense of the public safety net. This incentive originates in the fact that the cost of liabilities covered by the safety net does not fully reflect the risk of the balance sheet, because the government—and, therefore, the taxpayers—absorb some of the risk at a belowmarket price. As a result, uninsured equity investors can capture the upside from risk taking without fully paying for the downside. By increasing the proportion of equity funding to insured funding, and thus forcing equity holders to increase their own funds at risk relative to the total risks assumed by the bank, regulators reduce shareholders' net expected gain from risk taking.

This general proposition about shareholder behavior would seem to apply in both developing and industrial countries, once accounting standards in the former provide an accurate assessment of risk. However, this section attempts to demonstrate that the market and ownership structure for both financial and nonfinancial firms in Latin America limits the usefulness of capital requirements as an instrument to reduce bank risk, even when industrial country accounting standards are applied. Because wealth in Latin America is highly concentrated, the potential market for equity capital is small and hence concentrated and uncompetitive.6 Therefore it is 'Although there are no precise estimates of wealth concentration in Latin America, there is abundant evidence that income concentration is high. For example, whereas in industrial countries the richest decile of the population has, on average, an income level 17 times that of the poorest decile, in Latin America the comparable figure is 52 times (see Londono, 1996).

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difficult for regulators to determine whether shareholders' wealth is really at risk when they supply equity capital to a bank. Moreover, since wealth concentration creates incentives for investors to supply low-quality bank capital, the public safety net will be severely underpriced, creating greater incentives for bank risk taking than exist in industrial countries, where developed equity markets discourage investors from supplying low-quality capital to banks.

As an introduction to this issue, it is helpful to recount some of the concerns of regulators in industrial countries about the quality of bank capital. For example, regulators in the United States worry about "downstreaming" of debt issued at the bank holding company level as equity to the bank owned by the holding company.7 There are two reasons for this concern. First, debt liabilities pay a contractual interest rate, and hence the investor holding this debt can sue in bankruptcy court if payments are not made. A case might arise in which the bank holding company fails to make an interest payment on its debt because one of its nonbank subsidiaries is in financial difficulty. To meet the obligation, the holding company may attempt to increase dividend payments from the bank to the holding company, which would weaken the bank. Worse yet, the holding company might attempt to increase dividend payments by forcing the bank to take increased risk. Second, debt securities, unlike equities, have maturities. If, at maturity, the holding company cannot roll over its debt, it will have to sell the equity of the bank. If a buyer cannot be found, the bank will have to liquidate some of its assets, reducing its capital cushion.

The rest of this section is organized as follows. First, a simple accounting framework is developed to demonstrate how wealth concentration, coupled with an explicit or implicit safety net, acts to reduce the value of a capital-to-risk-weighted-asset ratio as a tool for controlling bank risk in developing countries. Next we describe the very different conditions in industrial country equity markets that make it possible for capital-to-asset ratios to be a reliable tool for managing risk in the presence of a public safety net. We then report evidence supporting these claims. We conclude by showing how the problems of bank quality in Latin America become exposed during crisis periods.

7

A bank holding company is a company that holds as assets the equity of a bank or of several banks as well as other financial companies whose business is closely related to banking. Such a company can "downstream" debt as equity to banks by issuing debt as a liability and using the proceeds to fund its holding of bank equity.

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PART TWO • LILIANA ROJAS-SUAREZ/STEVEN R. WEISBROD

A series of examples will demonstrate that "accounting" capital, even when evaluated by industrial country accounting standards, may not represent "real" capital when wealth and equity holdings are highly concentrated.

The first example describes a simple, hypothetical case in which individuals are permitted to use banks they own to make loans to themselves for the purpose of injecting capital back into the same bank. This case does not reflect the reality of present-day banking regulation, in which such self-lending is prohibited. Therefore, the remaining examples assume that regulators prohibit self-lending, but show that where wealth is concentrated, regulators cannot prohibit reciprocal loan schemes among a few individuals that have almost the same consequence as simple selflending.

Example 1: Bank Capitalization Through Self-Lending Figure 1 presents a series of simple balance sheets illustrating the difficulty of tracing and regulating the interrelationships among banks and nonbanks. Individual A owns an industrial company, Company A, whose equity value of 75 appears as an asset on his personal balance sheet (Figure la). This individual also holds cash assets equal to 25. Individual A owes no debt, and so the only offsetting item on the claims side of the ledger is his net worth of 100. Individual A decides to start a bank, Bank A. Assume that regulators require a minimum of 100 in capital to start a new bank, and the new bank must have assets of 25 in cash. Assume also that, once the bank begins taking deposits, it must hold a 25 percent reservesto-deposits ratio. To capitalize the bank, Individual A sets up a bank balance sheet with three accounting entries. The first is a bank loan of 75 from Bank A to Individual A, which appears as an asset item on Bank As balance sheet (Figure Ib). The second entry, also an asset, is 25 in cash, which Individual A has supplied from his personal balance sheet. The third entry, on the claims side, is labeled "capital" and is worth 100 (the sum of the two assets). With his loan from Bank A and his 25 in cash, Individual A has in effect bought stock in Bank A worth 100.

As a result of these transactions, Individual As personal balance sheet now consists of equity holdings in the bank and in the industrial company of 100 and 75, respectively. The claims side now consists of 100 in net worth and 75 borrowed from Bank A. Bank As assets are a loan to Individual A for 75 and 25 in cash. The bank can now accept 100 in deposits (Figure Ic), paying depositors an interest rate that does not fully reflect the risk of the bank's balance sheet, because depositors have some expectation

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Accounting Framework for Bank Capitalization

Figure 1 la

Individual A Company A : Equity j Net Worth 75 ! 100 Cash: 25: Company A Real Asset: Equity 75:75

Ib

Individual A Company A Equity Loan from Bank A 75 75 Bank A Capital Net Worth 100 100 Comp any A Real Asset Equity 75 75 Bank A Bank A Loan to Individual A Capital 75 100 Cash 25

le

Individual A Company A Equity Loan from Bank A 75 75 Bank A Capital Net Worth 100 100 Company A Real Asset Capital 175 75 Loan from Bank A 100 Bank A Bank A Loan to Individual A Capital 75 100 Bank A loan to Company A Deposit 100 100 Cash 25

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that the public safety net will protect them.8 The bank now lends 100 to Company A, allowing the company to more than double its assets.

Because the quality of bank capital in this example is extremely low, the underpricing of the public safety net is severe. Individual A, therefore, has clearly gained by establishing a bank: his company receives a cheap loan, whereas his risk exposure from holding equity in the bank is offset by a liability to the same bank.9 Company A can even receive a loan at a belowmarket interest rate from the bank as a result of the bank's low-cost liabilities. Individual A therefore obtains a capital gain on the project funded by the low-cost loan—if the project succeeds. If instead the project fails and Company A goes bankrupt, the equity capital in Bank A disappears, because the company defaults on its loan. Depositors, realizing the bank has no equity, stage a run on the bank, taking the 25 in cash but losing the remaining 75 of their deposits, for which they will expect compensation from the deposit insurance fund. At the same time, 8

For example, where commercial paper markets exist in Latin America, interest rates are substantially above those paid on bank deposits, whereas, in contrast, in the United States these rates are the same. It should be noted that liquidity characteristics as well as risk characteristics affect these relatíve rates. ' The conditions in the equity market are also likely to créate monopoly power in banks as well, which will also keep deposit rates below competí ti ve levéis.

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PART TWO • LILIANA ROJAS-SUAREZ/STEVEN R. WEISBROD

Individual A goes bankrupt, because his equity in the company as well as in the bank has lost its value.

To summarize, Individual A has established a bank to provide 100 in capital to his firm, at the risk of losing 25 of that 100, which is his cash investment. The remaining 75 in equity he places in the bank has no cost to him, since this asset is offset by a liability to the same bank. If the asset fails to perform, he offsets it with a failure to pay his liability. Individual A will be willing to risk his 25 in cash to establish a bank if the expected return on the cheap loan he can make to his company offsets the expected cost of losing the cash. Obviously, the lower the cost of bank liabilities— because of the underpricing of the safety net—and the more the company can borrow from the bank, the more likely the individual is to establish a bank. Notice that, in the absence of regulation or market forces that constrain the expansion of the bank, after the initial investment of cash in the bank, increasing capital is essentially costless, because for every dollar by which Individual A increases the bank's capital, he can offset the transaction with an equivalent loan from the bank. (Depositors, however, must be willing to put more cash into the bank to permit it to expand.) We next consider how a regulator might prevent related parties from supplying costless equity to banks they have established.

Example 2: Bank Capitalization Through Reciprocal Lending Bet-ween Banks One possibility is to prevent banks from lending money to the individuals that own them; that is, we relax the assumption in Example 1. However, two or more potential bank owners can get around this regulation by lending to each other to establish banks, as Figure 2 illustrates. Here, two individuals, A and B, each own an industrial company, also designated A and B. Each company has issued 75 in equity, which is owned by the respective individual and funded by net worth, as before (Figure 2a). Each individual also holds 25 in cash.

Since it is now illegal for a bank to lend funds to its major shareholders, the two individuals establish their banks by each borrowing from the other's bank. Individual A transfers 25 of his own cash to Bank A, which makes a loan of 75 to Individual B. The bank issues 100 in equity to Individual A, who buys the equity with 25 in cash and a loan of 75 from Bank B. Individual B buys 100 in equity in Bank B with 25 in cash and the loan of 75 from Bank A. Banks A and B now take deposits of 100 each and make loans of 100 to Companies A and B, respectively (Figure 2b).

Assume, as before, that Company A goes bankrupt. Individual A loses the equity in Company A, and equity in Bank A disappears as Company A

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DEALING WITH THE TRANSITION

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Individual A Company A Equity ' Net Worth 75 100 Cash 25 Company A Real Asset ' Equity 75 75

Individual B Company B Equity Net Worth 75 100 Bank A Capital 25 Company B Real Asset Equity 75 75

2b

Individual A Individual B Company A Equity Loan from Bank B Company B Equity Loan from Bank A 75 75 75 75 Bank A Equity Net Worth Bank A Capital Net Worth 100 100 100 100 Company A Real Asset Equity 175 75 Loan from Bank A 100 Bank A Loan to Individual B Capital 75 100 Loan to Company A Deposit 100 Cash 25

100

Company B Real Asset Equity 175 75 Loan from Bank B 100 Bank B Loan to Individual A Capital 75 100 Loan to Company B Deposit 100 Cash 25

100

defaults on its loan from Bank A. Depositors stage a run on Bank A, taking the cash. They also demand payment of Individual B's loan of 75, which he repays by turning over to them the equity in Bank B. But Individual A now has no income to pay his bank loan to Bank B, so equity in Bank B falls to 25, the value of the cash in the bank. Depositors in Bank A, therefore, have claims on cash in Bank A as well as three-quarters of the remaining equity in Bank B. Bank B depositors now become skeptical about the quality of their bank and stage a run, but since Company B is still solvent, they obtain the full value of their deposits.

Individual B retains control of his company, but he loses three-quarters of the value of his invested cash to depositors in former Bank A. He must therefore weigh the value of his gain through access to cheap credit

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Figure 2 2a

PART TWO • LILIANA ROJAS-SUAREZ/STEVEN R. WEISBROD

against his expected loss in cash before entering into a reciprocal loan contract between his bank and Individual As bank. This, of course, is the same calculation that A makes when he borrows money from his own bank.

Thus, reciprocal loans expose both A and B to the risk that the other's bank will go into default; this increased risk implies that, to go ahead with the scheme, they will need a higher expected rate of return than in the previous example. However, if both banks fail, the two individuals' risk positions are the same as if each bank had lent funds to its owner.

To make this case equivalent to the case in which each individual borrows from his own bank, the two individuals must find a way to protect their cash in their bank if the other bank should go bankrupt. One way to do this is to sell minority shares in the banks, asking the minority shareholders to put up the cash. This, of course, is only possible if disclosure requirements are weak and minority shareholders inattentive to the potential risk of the equity they purchase. Given the state of disclosure requirements in many Latin American countries, however, it may be possible to structure these kinds of deals.

Example 3: Bank Capitalization When Lending to Related Parties Is Prohibited Regulators might still try to foil the schemes of Individuals A and B by prohibiting ownership of industrial companies and banks by the same individual. We analyze this case by relaxing the assumption in Examples 1 and 2 that lending to related parties is permitted.10 This regulation, however, may be harder to enforce than the regulation prohibiting banks from lending to their owners, because, as is typical in some Latin American markets, wealth may be too concentrated to permit separation of ownership. Nevertheless, assuming that this regulation is enforceable, we now determine whether its existence changes the incentives to establish banks with reciprocal loans.

In this example, as before, and indicated in Figure 3, Banks A and B make loans to Individuals B and A, respectively, of 75. Each individual again contributes 25 in cash to buy equity in his bank equal to 100. Each bank again issues 100 in deposits, but it must lend these to companies unrelated to its owner. Because the banks still have access to low-cost liabilities from the stockholders' point of view, owing to the underpricing of deposit insurance, banks can earn exceptional profits directly from loans rather than through subsidized loans to related companies. Assume that Bank As loan 10 Even in the United States, a single individual can own both a bank and an industrial company, although common ownership of both by a holding company is prohibited.

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Figure 3 Individual A Company A Equity Loan from Bank B 75 75 Bank A Equity Net Worth 100 100 Company A Real Asset Equity 175 75 Bank A Loan to Individual B Capital 75 100 Loan to Unrelated Party Deposit 100 100 Cash 25 Individual B Company B Equity Loan from Bank A 75 75 Bank A Capital Net Worth 100 100 Company B Real Asset Equity 75 75 BankB Loan to Individual A Capital 75 100 Loan to Unrelated Party Deposit 100 100 Cash 25

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to an unrelated party goes into default. The capital of Bank A disappears, and the depositors stage a run on the bank, taking the 25 in cash and demanding repayment of Bank As loan to Individual B. Instead, Individual B turns over 75 of his equity in Bank B to depositors of Bank A. Since Bank A is bankrupt, Individual A ceases payment on his loan of 75 to Bank B, handing over worthless equity in Bank A to Bank B. Bank B s equity value has now fallen to 25, the value of the cash in the bank.

Again, Individual B potentially loses three-fourths of his cash to depositors in Bank A. This example shows that joint ownership of a bank and an industrial company is not necessary to make the establishment of a bank extremely profitable. The only necessary condition is concentration of wealth in an environment where an explicit or implicit safety net is present. The latter assumption is necessary because small, concentrated equity markets are necessary for transactions such as those described in the accounting framework to take place.11 We next show why such transactions are highly unlikely to occur in large industrial economies with dispersed wealth.

11 It might be argued that regulators could effectively prohibit the transactions presented in Figure 3 by prohibiting individuals from funding bank equity with loans from any source. This regulation, however, would be difficult to enforce, as individuals could create shell companies whose stock is held by an individual. That individual funds the shell company's stock with a bank loan. The shell company then holds the equity of the bank.

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PART TWO • LILIANA ROJAS-SUAREZ/STEVEN R. WEISBROD

Evidence from large industrial countries suggests that, as economies grow, two things happen that have an important consequence for the market for bank stock, which we have assumed up to now is illiquid. The first is that the size of nonfinancial enterprises increases. This requires the marshaling of larger pools of capital to supply these organizations with funds.12 The second is that wealth holding becomes more dispersed, implying that individual balance sheets grow at a slower rate than the economy as a whole.

The first factor implies that, as economies grow, the need for large banks increases, since large firms need a large pool of short-term funds.

(Firms also diversify their funding sources as they become large, causing, for example, an expansion of equity markets.) As a matter of prudence, banks must limit their exposure to single borrowers as a percentage of their capital.13 The second factor, coupled with the first, implies that outside investors will hold a larger proportion of bank stock as economies become larger.

These two factors change the dynamics of the accounting framework described above. First, it is no longer possible for a single wealth holder or a small group of wealth holders to mobilize enough cash to purchase a significant share of a large bank. This implies that outside shareholders must play a bigger role in the capitalization of large banks than they do in developing countries. Second, in developing markets large wealth holders can supply leveraged capital—that is, equity funded with loans—to a bank and still maintain the confidence of outside investors, such as depositors, because of the relative strength and size of their overall balance sheet relative to their investment in bank capital. In contrast, in large markets with dispersed wealth, an individual would have to borrow too much money relative to his or her net worth to make majority investment in a large bank believable. Also, it would be more risky to form reciprocal lending relationships as described above, because each party's exposure to the other party's bank would increase relative to his or her net worth as the leverage 12 Of course, many banks in Latin America are large relative to their economies. But these banks are much smaller than the large banks of major industrial countries that pool capital from sources worldwide. Moreover, in the recent trend of mergers and bank consolidations in several Latin American countries, foreign capital has often been present.

13 Bank funds can be mobilized to lend to a single large borrower through the loan syndication market rather than through an expansion of a single bank's balance sheet. However, a single bank often provides a credit line to a single borrower that, when called upon, becomes a syndicated loan. Credit line exposure to a single borrower represents a risk that must be diversified with a relatively large balance sheet. In addition, it takes a fairly large bank to assemble a large pool of lenders into a syndication group. These groups are typically managed by large wholesale banks. In addition, some analysts argue that there are operating economies of scale in banking. However, operating economies of scale imply deconcentration as markets expand, rather than an expansion in bank size.

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ratio of each investor increased. Hence, it is likely that part of the equity investment would have to be funded by third-party lenders whose expected return on investment does not include the benefits of reciprocal lending described above. Outside lenders would subject proposed loans to more severe credit tests than reciprocal lenders.

All of the above factors lead to a reduction in insider ownership relative to outsider ownership, which increases the incentive for insiders to manage the bank in their own interest rather than in the interest of all shareholders. For example, insiders can place themselves in positions of senior management and take high salaries out of the bank, reducing dividends to outsiders.14 However, in order for banks to attract the outside investors they need, institutions and bank behavior must change to provide assurance that the interests of those investors will be protected. It is now in the interest of the bank to provide disclosure concerning insider equity holding. Banks must demonstrate to outside investors that internal controls prevent managers from acting as privileged insiders by increasing their perquisites. The ultimate protector of outsider shareholder interests is the market for takeovers, in which multitudes of small shareholders can be mobilized to act as a single shareholder. The increase in market size, the dispersion of wealth, and the institution of minority shareholder protections reduce the possibility that equity can be injected into banks at only marginal risk to the investor. As a result, equity injections under these conditions represent a real transfer of risk from the general public to shareholders. This, in turn, reduces the underpricing of the safety net from the stockholders' point of view, and therefore reduces incentives for risk taking. Thus, capital standards become a viable tool for restraining bank risk in industrial countries.

Empirical Evidence on the Supply of Equity As discussed above, because the high concentration of wealth in Latin America relative to that in industrial countries permits bank owners in the region to transfer some of the risk of their investment activities to the general public, their cost of funding is cheap. As a result, bank owners in these markets can extract large profits. Risky investments can be made by lending either to related parties at below-market rates or to unrelated parties at market rates. Because bank owners can supply capital to their banks at very little real cost to themselves, they can meet the demands of regulators 14 The abuses associated with leveraged holdings of bank stocks are likely to decline as markets expand.

These abuses can occur in small markets because bank owners can strike reciprocal deals with offsetting loan payments to each other. In large markets, loans to buy bank stock will operate as arm's-length markets.

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for higher capital-to-risk-weighted-asset ratios. The complex connections among balance sheets of major wealth holders make it difficult for regulators to evaluate the true quality of bank capital.

The factors just described should make it possible for bank owners in Latin American countries to raise large amounts of capital relative to the capital base of their bank over a short period. Figure 4 presents evidence that this is indeed the case. The figure plots the growth rate of capital, net of reevaluation adjustments to bank assets and retained earnings, against real loan growth rates for Argentina, Colombia, Ecuador, Mexico and Peru, as well as for Japan and the United States.15 The data cover various years, depending on data availability. They indicate that growth of capital has been quite rapid—greater than 30 percent—in at least one year of the periods covered in all the Latin American countries in the sample. Growth rates were especially high in Ecuador and Colombia in 1995, in Peru and Argentina in 1994, and in Mexico in 1993. In contrast, annual growth rates of capital in Japan and the United States have been less than 10 percent.

An important possible explanation for such rapid growth of capital in Latin America is that bank capital starts from a very low base relative to its level in industrial countries.16 Thus, the data could indicate a stock adjustment problem rather than the quality of the market for bank stock.

Such an interpretation is supported by the fact that Mexican banks raised a lot of capital in 1993 and very little in 1994, and Peruvian banks raised a lot of capital in 1994 but very little in 1995. However, we have already pointed out that the extremely small capital base in most Latin American markets is, in fact, the reason why major wealth holders are able to control most banks in a given market.17 Therefore, stock adjustment problems and concentration of wealth are both characteristics of small markets. Moreover, the fact that within a given country the rate of growth of capital changes drastically from one year to the next is a further indication of the ability of shareholders to mobilize capital quickly and easily.

15 Retained earnings are available only for Mexico. In the other markets we used total net earnings, which assumes that all earnings are retained. No adjustment for asset prices was available for Peru since this item is not accounted for in the capital account. For Argentina the data are for the 20 largest commercial banks. Our measure of capital should approximate a real growth rate of capital, since bank earnings should include a premium for inflation to keep the real value of the balance sheet constant.

Prudent banks should retain the inflation premium in the capital account to keep the real value of capital constant. Hence, capital obtained from outside should represent increases in real capital.

16 Capital growth rates as measured in Figure 4 cannot be the result of accounting overstatement of bank earnings, since we have calculated growth rates net of retained earnings. However, they may be overstated because of lack of provisioning for bad credit that would exceed net earnings. But if capital were needed for provisioning, it would still have to be raised from sources other than earnings, which again raises the question of whether capital is raised in a true market or not.

17 Of course, not all bankers in Latin America are motivated by the forces described in our framework.

Some may actually prefer to issue equity in international markets precisely to avoid any appearance of conflict of interest.

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Figure 4 Loan Growth and Net Equity Growth in Selected Banking Systems (In percent)

Note: Net Equity = Equity - Surplus - Retained and Current Earnings.

Sources: Argentina: Banco Central de la Republica Argentina, Estados Contables de las Entidades Financieras, various issues; Colombia: Banco de la Republica; Ecuador: Banco Central del Ecuador; Japan: Nikkei Kinyu Shinbun, June 1, 1995; Mexico: Comisi6n Nacional Bancaria y de Valores, Boktin Estadistico de Banca Multiple, various issues; Peru: Superintendencia de Banca y Seguros, Informacidn Financiera Mensual, various issues; U.S.: Federal Reserve Bulletin, various issues.

Figure 4 also indicates that net equity grew more slowly than real loans in several markets for several time periods. It might be argued that this implies problems for banks in these markets in raising capital. However, as Figure 5 shows, for those countries and time periods in which net equity growth rates were slower than real loan growth rates, the net equity-to-loan ratio was substantially above 8 percent, which would meet the international standard set by the Bank for International Settlements (BIS) if loans were the only risky asset on the balance sheet.18 It should also be noted that, even after loan growth exceeded capital growth, equity-to-loan ratios remained above 8 percent.19 18 Figures 4 and 5 refer to equity-to-loan ratios, while the BIS standards refer to capital-to-asset ratios.

However, the arguments in this chapter are not affected if capital-to-asset-ratios are considered capitalto-loan ratios and capital-to-asset ratios for selected Latin American countries. These are not riskweighted ratios.

19 In Mexico, capital-to-risk-weighted asset ratios have been reported by the National Banking and Securities Commission since 1991. It is this ratio that is used for constructing the Mexican data in Figure 5.

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Figure 5 Equity to Loan Ratios vs. Loan Minus Capital Growth Rates in Selected Banking Systems (In percent)

1 The equity to loan ratio is as of the beginning of the year.

Note: Net equity = Equity - Surplus - Retained and Current Earnings.

Sources: Argentina: Banco Central de la Republica Argentina, Estados Contables de las Entidades Financieras, various issues; Colombia: Banco de la Republica; Ecuador: Banco Central del Ecuador; Mexico: Comisidn National Bancaria y de Valores, Boletfn Estadistico de Banco.

Mtiltiple, various issues; Peru: Superintendencia de Banca y Seguros, Informacidn Financiera Mensual, various issues.

Role of the Equity Account in Banking Crises in Latin America The accounting framework suggests that, when equity markets are concentrated, there is a lack of outside investors who can replenish bank capital in a crisis. Hence, regulators have to design programs to inject regulatory capital into the banking system during a crisis. In Chile in 1984, and in Mexico in 1995-96, programs were devised to exchange nonperforming bank loans for indexed bonds. This prevented banks from having to write down the value of bad loans and permitted them to maintain the appearance of high capital-to-asset ratios during the crisis. In contrast, in industrial countries where markets for bank stock either exist or can be developed, regulators can force bank stockholders to write down the value of their investment. Hence, as a result of market conditions, equity ratios often do not decline in Latin America during a crisis, whereas they do decline during a crisis in industrial countries.

The interconnections between banks through the financing of bank equity capital with loans from related banks can contribute to the lack of a market for bank assets in a crisis, since they facilitate the spread of credit problems from one bank to others. For example, if an individual has pur-

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chased bank stock with a loan from another bank, and the bank in which he or she owns the stock fails, that individual will then default on loan payments to the bank from which he or she borrowed the funds. Financial fragility is thus greater in Latin America than in industrial countries, because an adverse shock hitting a particular institution can quickly spread to other institutions through the interrelationship of balance sheets, soon generating a systemic crisis. Both these problems are mitigated in industrial economies, for two reasons. First, more reliable accounting standards and loan risk classification imply that loan-loss reserves will absorb much of the shock of the deterioration in credit quality. And second, the share of unleveraged equity in the major banks is likely to be a higher percentage of total equity, for the reasons described above.

In addition, banking crises in small markets are likely to be associated with general movements in the economy, creating high correlations between changes in the equity values of financial and nonfmancial firms.

In contrast, crises in large markets are more likely to be regional or limited to a relatively small segment of the economy, leading to much lower correlations between the equity values of financial and nonfmancial firms. For example, in Mexico the correlation of price indexes for financial and nonfinancial equities was over .99 from September 1994 through June 1996.

Thus, during the crisis the value of all shares fell together. In contrast, in the United States in 1987, during a period of severe stress in the banking system, the correlation between these two indexes was only .63.

These factors cause secondary markets for bank assets or for banks themselves to dry up much more quickly than in industrial countries. In industrial countries, assets can be sold at a discount from their face value, and, correspondingly, the capital value of the bank can be written down. A price can therefore be identified at which the bank is insolvent, and the bank can either be sold or dissolved. If it is dissolved, regulators can find markets for pieces of the former bank to reduce their liability to pay off insured depositors.20 For example, in the United States, banks and thrift institutions in Texas suffered a crisis severe enough to force most major institutions into insolvency. However, regulators were able to sell major Texas bank holding companies to outside investors at prices substantially higher than the net value of their financial assets (which was negative), because holders of outside capital were willing to place a positive value on the banks' underlying distribution network and customer connections. The market for thrift institutions was not nearly as strong, primarily because the thrifts had weak 20

For a discussion of how the lack of markets for bank assets or for banks themselves imposes severe constraints on the resolution of banking crises in Latin America, see Rojas-Suarez and Weisbrod (1996a).

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distribution systems and a customer base that was much more volatile than those of the banks. The thrift deposit base consisted mostly of time deposits, whose holders were highly interest rate sensitive; commercial bank depositors, on the other hand, used their accounts mainly for transactions purposes, which created a more loyal customer relationship. Even so, regulators could find buyers, albeit at substantial discounts, for much of the repossessed real estate owned by the thrifts.

Thus, in markets like the United States, when banks get into trouble, asset values are written down and capital declines. In 1987, a year when substantial losses were recognized in the Texas banking system and when several New York banks recognized substantial losses on their Latin American loan portfolios, capital at New York banks fell by 14 percent and that at other large U.S. banks by 6 percent. Capital in the entire U.S. banking system fell by 1.5 percent in that year. That same year, as a result of nonperforming loans, capital at Japanese city banks (which include most of the largest banks in Japan) fell by 1.5 percent.

In contrast, in nominal terms Mexican bank balance sheets and capital accounts expanded in 1995, with nominal capital increasing by 40 percent.21 Growth in assets and liabilities was slower than inflation, however, because the interest rates earned on loans and paid on deposits were below inflation; hence, the real value of loans and of deposits declined. In addition, the banking authorities swapped loans for bonds, reducing risky assets as a percentage of total assets. Thus, loan losses were partially absorbed by depositors and stockholders through inflation, and partially by the authorities. (The authorities did close a few small banks, forcing equity holders to lose nominal as well as real capital.) But for most banks, nominal capital was not written down as a result of the sale of assets.

The fact that real debt burdens were reduced through inflationary losses absorbed by depositors, rather than by writing down the value of equity, is consistent with the notion that regulators had to design government programs to recapitalize banks rather than sell banks or bank assets at prices that would have subjected the government to intolerable losses.

Hence, regulators had very limited capacity to use the capital account for its intended purpose: they could not force a writedown of assets and close banks, because in reality there was no domestic market for these assets.

The problem here is quite similar to the one described above. Because the balance sheets of major wealth holders are tied closely together, they all tend to decline at the same time. Therefore, there is little internal wealth independent of these interrelationships available to support the system. In 21

In the United States, declines in real and nominal capital were approximately equal because the inflation rate was low.

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contrast, in the United States, when the Texas banks and thrifts collapsed, outside wealth came into the market, reducing the cost to the government of a bailout.

In Argentina, capital accounts did not expand significantly in 1995 for the 20 largest private banks as a whole. However, arrangements for nondeposit funding to troubled banks, such as through interbank lending programs, were expanded so that these banks could meet deposit withdrawals without reducing the value of their loan portfolios. For the 20 largest banks as a whole, deposits fell by 4.4 percent, total liabilities increased by 4.4 percent, and total loans increased by 4.2 percent in 1995. Thus, the real value of Argentine balance sheets remained approximately constant, indicating that loan values were not written down substantially.22 As in the case of Mexico, this shows that markets were not readily available on which to dispose of nonperforming bank assets.23 Liquidity as a Constraint As discussed in the previous section, the concentration of ownership and wealth in many Latin American markets makes it difficult to find markets for the assets of failed banks or for the failed banks themselves. As a result, during a banking crisis asset prices can fall much more drastically in Latin America than in the typical industrial country. Hence, capital-to-asset ratios that appear healthy in normal times will not provide much protection against bank failures in a crisis. An alternative means of protecting the value of bank assets relative to bank liabilities is to require banks to hold liquid assets whose value does not deteriorate in a banking crisis. In this section we examine the feasibility of such a policy and analyze the evidence on how these policies have worked during banking crises. It will be seen that, as in the case of capital requirements, the feasibility of an effective liquidity requirement depends on whether it can be enforced. Again, this in turn depends on the strength of incentives and the quality of assets used for liquidity purposes.

Bank Demand for Liquidity Whether or not they are compelled to hold liquid assets under reserve requirements, banks demand such assets to meet temporary excessive deposit withdrawals and to meet other unexpected demands for funds, such 22

A few large private banks reported substantial decreases in the value of their loan accounts. In some cases these decreases were supported by injections of capital or by expansions in their liability accounts, indicating that loan writedowns did not account for the full loss in value of these assets.

23 However, as indicated below, some banks were able to find markets for their assets during this crisis.

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as unforeseen requests to extend the term of a loan. Holding liquid assets imposes a cost, measured as the difference between the interest rate the bank earns on its liquid assets and the rate it would have earned by investing the same resources in nonliquid assets. This does not necessarily imply that banks will be unwilling to hold more than a bare minimum of liquid assets, however, because bank customers may be willing to absorb the cost of these assets. For example, depositors might be willing to accept a lower interest rate on their deposits from banks that hold higher ratios of liquid assets to deposits, if they believe that their deposits will be more liquid as a result. Potential borrowers may be willing to pay higher fees on credit lines from banks that hold high ratios of liquid assets, because they can be more certain that the bank will provide a loan under their credit line when liquidity is especially tight.

Banks, however, have a wide variety of means of promising liquidity to their loan and deposit customers. Individual banks can contract with other banks for lines to borrow in the interbank market. Banks can make loans to customers whose balance sheets will remain liquid even under extremely tight credit conditions. Or banks can secure access to long-term floating rate funds to assure borrowers that credit will be available under a wide variety of circumstances. It can be argued that many of these tools are less reliable than the actual holding of liquid assets. For example, in periods of tight liquidity, there may be no bank in the market with excess funds to lend in the interbank market, interbank lines of credit notwithstanding. Similarly, it may be difficult to find borrowers whose balance sheets will remain liquid under extremely tight credit conditions.

If banks and their customers perceive these problems, banks will find it profitable to hold liquid assets. However, under conditions such as those in Latin America, such assets may be difficult to find. For example, banks that choose to hold domestic currency, or deposits at the central bank denominated in domestic currency, have a liquid asset that, by definition, will maintain its value in domestic currency terms. But if, during a crisis, their deposit customers should demand foreign reserve assets, banks and their customers may discover that domestic currency has become quite illiquid in terms of the foreign reserve asset. For example, in a financial crisis created by the devaluation of the domestic currency, the price of domestic currency can fall drastically relative to foreign reserve assets.

Thus, to ensure liquidity, bank customers in Latin America might demand that their banks hold foreign reserve assets. These assets, however, will probably be very expensive to hold. For example, domestic currency financial instruments often have a risk premium incorporated in their interest rate to compensate holders for the possibility of a devaluation. Thus, if a bank holds foreign reserve assets for liquidity purposes,

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this asset may pay an interest rate substantially below the bank's cost of deposits.

The bank may prefer to maintain credit lines with a foreign bank rather than hold liquid foreign assets, but of course this strategy may end up being more expensive if the bank eventually has to borrow large sums at very high interest rates. Holding liquidity in domestic currency will be cheaper in this regard as well. For example, a bank can maintain a domestic currency line of credit with its central bank that might be very cheap, depending on the discount policy of the central bank. But just as in the case of liquid assets, a credit line in domestic currency will be inferior as a source of liquidity to a line to a foreign bank denominated in foreign currency.

If, for some reason, banks and their customers underestimate the need for liquid assets on bank balance sheets, a reserve requirement policy might be justified. To determine when and in what form reserve requirements are a useful regulatory tool in Latin America, we turn to empirical evidence on bank behavior in Argentina and Mexico during the financial crisis of 1995, when Argentina applied a reserve requirement on bank deposits, whereas Mexico did not.

Empirical Evidence on the Demand for Liquidity The reserve requirement applied to bank deposits in Argentina prior to the 1995 financial crisis was effectively a U.S. dollar reserve requirement. Argentina maintained a one-to-one exchange rate with the U.S. dollar, and the central bank promised to maintain full dollar backing for the monetary base. Hence, reserve requirements on peso deposits were invested in U.S. dollar liquid assets by the central bank. Banks were free to issue foreign currency deposits, which were also subject to reserve requirements. However, banks held these reserves in the form of U.S. dollar deposits in U.S. banks or in short-term U.S. Treasury securities. Reserve requirements on both domestic and foreign currency bank deposits were 43 percent for transaction accounts and 3 percent for time deposits.

In contrast, Mexico did not apply reserve requirements to bank deposits, nor did it promise to maintain parity between the new peso and the U.S. dollar. Nevertheless, Mexican banks held liquid assets in the form of domestic currency government securities, which, of course, could only provide liquidity protection in domestic currency. These securities were made highly liquid as a result of central bank policy, which, beginning in March 1993, effectively permitted banks to use these securities to settle their payment obligations with the central bank (see Banco de Mexico, 1993). Banks with deficit positions in their accounts with the central bank

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could, at the end of the day, sell a government security to the central bank under a repurchase agreement, which was effectively a collateralized loan from the central bank to the bank in deficit. Although these repurchase agreements had a one-day maturity, banks were guaranteed the right to roll them over: when a bank repaid its loan, this created a deficit in its account with the central bank, which it could cover with another repurchase agreement. Since these securities could be used to settle payments, from the bank's point of view they were as good as cash.

Figure 6 shows that the ratio of banks' liquid assets to their total assets was greater in Mexico in 1994 than it was in Argentina, despite the fact that Mexico did not have a reserve requirement. This suggests that it was cheaper for Mexican banks than for Argentine banks to hold liquid assets—that is, the income forgone by holding liquid assets was less in Mexico than in Argentina. Given the earlier discussion, this should not be surprising. Banks in Mexico could hold domestic securities paying pesodenominated interest rates as liquid securities. The interest rate on these securities was probably close to the domestic wholesale deposit rate.24 In contrast, banks in Argentina had to hold foreign reserve assets, which paid lower interest rates than domestic deposits.

Of course, it might be argued that Mexican domestic securities were less liquid instruments than short-term U.S. assets, so that Mexican banks were not really more liquid than those in Argentina. However, within the context of the Mexican peso market, central bank policy was conducted to ensure the liquidity of the securities market, as indicated above. Thus, in judging liquidity needs, Mexican banks and their customers had to determine whether they were willing to suffer the potential costs of holding a new peso security that might become illiquid in the event of a crisis in the peso market.

One way to assess Mexican banks' attitudes with respect to the availability of local market liquidity is to determine whether banks were willing to expand their new peso loans when domestic liquidity was relatively cheap after the change in central bank policy in early 1993. Here banks differentiated themselves clearly. Some viewed the availability of liquidity as an opportunity to expand quickly. It is quite probable that banks that expanded loan portfolios rapidly extended risky loans to customers whose ability to withstand a depreciation crisis was relatively weak. In contrast, the largest banks in Mexico displayed a lack of willingness to expand loans rapidly.

This signified a concern, on the part of both these banks and their deposit customers, for the quality of peso loans in a peso crisis.

24

This conjecture is based on the fact that, beginning in 1993, interest rates for repurchase agreements on government securities were slightly below those paid on wholesale deposits.

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Figure 6 Liquidity to Assets Ratio in Argentina and Mexico, Year-end 1993 and 1994 (In percent)

Note: For Argentina, liquidity is defined as disponibilidades, and for Mexico, it includes disponibilidades, deudores por reporto, valores gubemamentales, and valores a recibirporreporto.

Assets do not include off-balance sheet items.

Sources: For Argentina, Banco Central de la Republica Argentina, Estados Contables de las Entidades Financieras, various issues. For Mexico, Comisidn Nacional Bancaria y de Valores, Boletin Estadistico de Banca Multiple, various issues.

Indeed, whereas the largest banks expanded their nominal loan portfolios at only a 6 percent annual rate in 1993 and at a 27 percent annual rate in 1994, other banks' loan portfolios grew at a 35 percent annual rate in 1993 and at a 41 percent annual rate in 1994. Also, depositors were willing to supply funds to the largest banks at an interest rate about 400 basis points (4 percentage points) below that paid by other banks, indicating that some depositors were quite concerned about how the loan portfolios of the smaller banks would fare in a new peso crisis.

After the depreciation crisis, it became quite clear that the loan portfolios of the smaller banks as a whole were less able than those of the largest banks to withstand the pressures created by the crisis. Thus, one important result of the easy domestic liquidity policy in Mexico was to encourage the expansion of risky banks relative to the system as a whole, a point we will return to in the next section.

Reserve Requirements as a Means of Financing Bank Runs In a financial crisis as deep as those experienced in some Latin American countries, liquidity requirements may play a more important role than

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capital requirements in protecting the value of deposits. After all, in 1995 many analysts claimed that Argentine banks financed deposit withdrawals by divesting cash assets. In contrast, the Mexican banking system experienced net nominal deposit withdrawals only after accounting for interest credited. Hence, there was no divestiture of cash assets in the Mexican market. Here we investigate whether reserve requirements in Argentina and the lack of such requirements in Mexico affected this outcome.

Among the 20 largest private banks in Argentina in 1995, those that experienced the largest declines in bank deposits were those with a low ratio of transaction accounts (demand deposits and savings accounts) to total liabilities (Figure 7).25 During the financial crisis, the Argentine authorities reduced reserve requirements to permit banks to finance deposit withdrawals from their stock of cash assets. Because reserve requirements in Argentina were substantially higher for transaction accounts than for time deposits, banks with low ratios of transaction accounts to total deposits had much smaller cash-to-total-assets ratios (about 5 percent) on average than did banks with high transaction account ratios (about 15 percent). As a result, the low-transaction-account banks, which experienced by far the most deposit withdrawals, could not finance these withdrawals by reducing cash assets. This, of course, left low-transaction-account banks with the problem of finding alternative ways to finance deposit and liability withdrawals.

Of the 10 banks with the lowest ratios of transaction deposits to total deposits, nine experienced deposit withdrawals during the crisis. Five of these were able to finance the withdrawals by reducing assets, sometimes at a loss to the capital account. Although this was not particularly good news for the shareholders of these organizations, it does indicate that there was a secondary market for some bank assets in Argentina. The remaining four banks, however, required substantial inflows of nondeposit liabilities or of capital to finance deposit outflows, indicating that their asset portfolios could not be marketed to fund deposit withdrawals. These banks are likely to have received nondeposit funding from other banks.

Thus, among the 20 largest private banks in Argentina, some banks were able to provide liquidity to their depositors while holding very low reserve requirements. This experience shows that, in markets where central bank exchange rate and operating procedures keep liquidity costs high, some banks will find ways to create their own liquidity, even if reserve requirements are low.26 23

The analysis is based on the 20 largest private banks for analytical convenience.

The argument of how bank incentives to hold liquidity assets can be improved by avoiding a monetary policy aimed at smoothing interest rate fluctuations is fully developed in Rojas-Suarez and Weisbrod (1996b).

26

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Figure 7 Twenty Largest Argentine Private Banks: Real Deposit Growth and Ratio of Transaction Deposits to Total Deposits, 1995 (In percent)

Source: Banco Central de la Republica Argentina, Estados Contables de las Entidades Financieras, various issues.

In Mexico, banks did not sell liquid assets to finance loan expansion or to finance deposit withdrawals. In fact, in contrast with Argentina, through September 1995 securities-to-deposits ratios rose dramatically at small banks that had previously operated with relatively little liquidity. These small banks sold loans from their portfolios to the authorities in exchange for securities, or issued subordinated debt to expand capital and invested the proceeds in bonds. A possible reason why depositors did not withdraw their funds, thereby forcing banks to sell securities, is that such transactions would have resulted in the exchange of one new peso investment (a deposit) for another (a bond).27 This, of course, was a consequence of the fact that the Mexican banking system promised liquidity only in terms of domestic currency, whereas the Argentine system promised liquidity in foreign currency. It should be noted that the lack of liquidity in foreign currency would have remained even if the Mexican banks had been subject to reserve requirements, as long as the central bank invested these reserves in domestic securities.

27 Since, as is well documented, the Mexican crisis took the public by surprise, massive capital flight did not precede the crisis, as happened during the 1982 crisis. After the devaluation of the peso in December 1994, depositors had few choices to protect the real value of their wealth. A flight to U.S. dollar assets would have been expensive. By and large, the only domestic alternative, given the lack of developed capital markets, was to shift from bank deposits, guaranteed by the government, to another government liability.

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In comparing the Argentine and Mexican experiences, it is clear that liquidity ratios were higher in Mexico, but the quality of liquidity was lower.

Mexican liquid assets did not maintain their value in terms of the U.S. dollar during the crisis, whereas Argentine liquid assets did. Therefore, depositors in Argentina had the option of withdrawing funds from the Argentine banking system and moving into U.S. dollar assets at a fixed price.

In contrast, had depositors in Mexico withdrawn their funds in favor of U.S. dollar assets, they could only have done so at a very high price in terms of pesos. The central bank was not in a position to accommodate liquidity demand, because this demand was for foreign currency assets.

Thus, as in the case of capital, it is the quality of the instrument that matters for investor confidence in the system.

Devising Supervisory Procedures for Latin American Banks The data presented thus far indicate that supervisory ratios constructed for banks in Latin America must be interpreted with care. The usefulness of capital-to-risk-weighted-asset ratios suffers from inadequate accounting procedures as well as from more fundamental problems concerning the structure of ownership of banks, which constrain the development of liquid markets for bank equity. From an industrial country perspective, the Latin American situation probably appears somewhat discouraging, because regulators in industrial countries depend heavily on equity investors to prevent poorly run banks from obtaining the equity necessary for expansion under the capital guidelines. Equity investors are both uninsured and sophisticated, unlike depositors, who are assumed to have little incentive or capacity to evaluate bank risk. Without the information these critical equity investors provide, Latin American supervisors seem to be at a clear disadvantage vis-a-vis their colleagues in industrial countries.

Somewhat surprisingly, however, deposit markets in Latin America have often played a role similar to that of equity markets in industrial countries, at least in terms of providing information about the quality of banks.

There are two possible reasons for this. The first is that risky banks offer high interest rates to attract funds from new, uninformed depositors, which they then use to expand their portfolios of risky loans or to roll over bad credits. Banks must pay new customers higher rates, even on insured deposits, because these customers have switching costs. The second is that sophisticated depositors attempt to obtain high yields from risky banks under the assumption that they can withdraw their funds before the bank collapses. Risky banks probably offer high rates for both these reasons.

However, from the supervisors' point of view, the major issue is whether deposit markets can help identify risky banks.

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Low-transaction banks High-transaction banks

(In percent) Median 5.60 6.61

Range 8.11 2.89

Source: Banco Central de la Republica Argentina, Estados Contables de las Entidades Financieras, various issues.

Market Assessment of Banks in Countries That Have Experienced a Recent Crisis: Argentina and Mexico In assessing how depositors and other liability holders value banks, it is important for regulators to understand how business differences across different classes of banks affect liability holders' perceptions of the risk of bank liabilities. For example, in Argentina, among the 20 large private banks discussed in the previous section, the median interest rate paid on bank deposits in 1994 was higher at the high-transaction-account banks than at the low-transaction-account banks. However, the range of interest rates paid by the low-transaction-account banks was much wider than that among the high-transaction-account banks, indicating that the perception of quality varied much more widely among the former group (Table 1).

After accounting for differences in liability costs related to business differences, it is possible to determine whether depositors received higher interest rates from riskier banks. Figure 8 plots the interest paid by lowtransaction-account banks in Argentina on liabilities during 1994, the year prior to the financial crisis, against those banks' growth in nondeposit liabilities in 1995. Those banks experiencing the greatest nondeposit liability growth in 1995—a sign of an illiquid asset portfolio in the face of deposit runs—were those that paid the highest interest rates on deposits in 1994. Moreover, as Figure 9 shows, among high-transaction-account banks in Argentina, those that lost the highest percentage of deposits in 1995 also had the highest interest expenses in 1994. Thus, it appears that liability holders in Argentina predicted fairly accurately how banks would perform during a crisis. The perception of depositors would probably have appeared even better if we could have identified the costs of identical instruments for each of the banks before the crisis.

In Mexico, clear distinctions do not exist between banks based on deposit mix. Nonetheless, investors received a wide range of interest rates on liabilities of different banks in 1993, almost two years before the crisis.

Because no bank in Mexico experienced a run equivalent to those experi-

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Table 1. Argentine Banks: Cost of Average Liabilities, 1994

PART TWO • LILIANA ROJAS-SUAREZ/STEVEN R. WEISBROD Figure 8 Argentine Low-Transaction Banks: Cost of Liabilities and Nondeposit Liability Growth, 1995 (In percent)

Source: Banco Central de la Republica Argentina, Estados Contables de las Entidades Financieras, various issues.

Figure 9 Argentine High-Transaction Banks: Deposit Growth and Interest Paid, 1994-95 (In percent)

Source: Banco Central de la Republica Argentina, Estados Contables de las Entidades Financieras, various issues.

enced by some low-transaction-account banks in Argentina, we cannot use deposit withdrawals to gauge depositors' assessments of bank risk during the crisis. Instead we examine whether liability holders accurately predicted the condition of banks in 1996 based on interest rates paid by individual banks as a percentage of average liabilities in 1993. We assume that

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Figure 10 Nonintervened Mexican Banks' Interest Paid on Average Liabilities, 1993 vs. 1996 (In percent)

Source: Comisi6n Nacional Bancaria y de Valores, Boletin Estadistico de Banco. Multiple, various issues.

interest rates paid by banks in 1996 reflect the true condition of a bank at that time, since there has been much publicity about bank loan quality and banks' need for government assistance. Thus, Figure 10 plots interest paid on liabilities, which is obtained from bank income statements in 1993 for 12 Mexican banks, against interest paid on liabilities in the first half of 1996.28 The ordering of bank risk is fairly similar. These predictions would be more accurate if we could compare interest paid on specific instruments in 1993 versus 1996, as some of the difference in relative interest rates between the two periods may be due to changes in the structure of the liability portfolio.

Tiering in Other Markets As Figure 11 shows, data from three other Latin American markets—Colombia, Ecuador and Peru—reveal evidence of interest rate tiering among banks. The charts in this figure plot interest paid on average liabilities against liability mix. In all three countries, banks with very similar liability mixes have widely varying liability costs. If the experiences of Argentina and Mexico are any guide, those banks paying high interest rates on liabili28

We exclude banks that had very small balance sheets in 1993 and those banks in which the government intervened, on the assumption that the market no longer evaluates the risk of these banks as stand-alone entities.

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Source: Banco de la Republica.

b. Ecuadorian Banks Cost of Liabilities and Demand Deposits to Total Deposits, March 1995

Source: Central Bank of Ecuador.

C. Peruvian Banks Cost of Liabilities and Transaction Deposits to Liabilities, 1995

Source: Superintendencia de Banca y Seguros, Informacidn Finanzas Quaquil, various issues.

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Figure 11 Liability Costs and Liability Mix for Banks in Selected Latin American Countries (In percent) a. Colombian Banks Cost of Liabilities and Demand Deposits to Total Deposits, 1994

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Policy Considerations Because of the concentration of financial and nonfinancial wealth prevailing in many Latin American countries, and because many banks in Latin America do not face a real market for bank stock, it is difficult for regulators to depend on capital standards to control bank risk, at least in the short run. This problem will remain even if accounting standards are improved so that asset values are more correctly stated relative to liabilities.

However, as experience in industrial countries demonstrates, regulators seeking to constrain the behavior of risky banks must depend on a pool of investors who evaluate bank risk from a market perspective. If investors did not extract a heavy price for providing equity to risky institutions, capital standards would have little impact on bank risk. This implies that market discipline is a necessary ingredient for successfully enforcing regulatory policies.

It will take time to develop liquid equity markets in Latin America.

Regulators in the region must therefore make do with the limited markets that are available for pricing bank risk, namely, the liability markets. Because liability markets provide powerful signals about the relative strength of banks, regulators' first priority must be to ensure that these markets are working as effectively as possible. Thus, policy prescriptions for improving bank supervision can be divided into two groups: those that can have an immediate effect on improving a country's capacity to assess bank soundness, and those that will yield results over time.

Policies With an Immediate Impact Deposit Markets To sharpen the signals about bank risk emanating from deposit markets, policymakers should encourage the public offering of certificates of deposit, so that all investors can compare the rates offered by various banks.

It would also be useful to encourage banks to announce their prime interest rates (those they offer to their most creditworthy borrowers) to establish a marketwide benchmark for pricing credit risk. Publishing interbank bid and offer rates would also improve the flow of information on bank quality. This information should be relatively inexpensive to gather and process.

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ties, holding liability mix constant, may create problems for bank supervisors in the event of a banking crisis.

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Regulators and central bank authorities must be very careful not to follow policies that encourage depositors in the belief that markets will always remain liquid. For example, bank access to central bank funding, both to settle payments and for routine borrowing, should be strictly limited. Some banks, specifically those with a very high cost of funds, should probably be cut off from central bank funding altogether until deposit markets are willing to provide cheaper funds.

The Argentine data indicate that the problem of runs on bank deposits seems less severe at high-transaction-account banks, but this can create its own dangers. Banks that feel confident that their depositors will not stage a run may be tempted to hold risky and illiquid portfolios. Fortunately, these risks seem to be priced more or less efficiently in the deposit market. They are probably more sharply priced when these banks fund themselves in the money market, through instruments such as large certificates of deposit and through interbank lending. Thus, an appropriate policy would be to strictly limit these banks' access to central bank funding as well, so that they are forced to meet shortages of cash by entering the interbank market. If rates paid in this market are public knowledge, transaction-oriented depositors will gain valuable information about their banks. It is also important to limit deposit insurance coverage to small depositors to further encourage the more efficient pricing of risk in large deposit markets.

Central Bank Operating Procedures and Bank Risk A strategy of controlling bank risk through information provided by the deposit market requires a specific set of policies. If deposits are short-term, as most are in Latin America, some depositors are likely to refuse to roll over their deposits in the event of a rapid deterioration in bank risk, as the Argentine experience demonstrates. This implies that regulators and central bank policymakers must be particularly concerned with the liquidity of bank assets. To prevent bankers from becoming overconfident about the ability of risky borrowers to remain liquid during tight credit periods, central bank operating procedures must be designed to keep liquidity scarce, even during relatively stable periods. This will give banks incentives to find alternative sources of liquidity, even if reserve requirements are low. Thus, central banks should avoid engaging in policies to smooth daily fluctuations in short-term interest rates.29 29

See Rojas-Suarez and Weisbrod (1996b) for a more detailed analysis of the interrelationships between central bank provision of liquidity and its impact on bank asset quality.

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Limiting Access to the Public Safety Net

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No matter how efficiently the deposit and other liability markets operate, they do not give regulators the same control over bank risk that effective equity markets provide. Where risk is assessed by the rate on deposits, the regulator lacks a means of prior constraint on risky behavior. One cannot ask a risky bank to raise more deposits, for example. Hence, it is crucial that regulators attempt to improve the market for bank stock in their country.

This implies consolidated supervision and perhaps requiring major stockholders of banks to publish their personal balance sheets. However, no matter what the rules are in this regard, equity markets are not likely to become transparent until a diverse group of investors and users of capital enter the market. The best way to achieve this goal is to open the banking market fully to foreign competition. Such competition is not likely to penetrate into the business and banking relationships of the local establishment, but it will provide an outside source of capital both for the pursuit of new wealth and as a possible market stabilizer in the event of a banking crisis.

One method to encourage diversity in the banking market might be to permit foreign firms to manage pension funds, which are expanding rapidly across the region. Since private capital markets are underdeveloped in most countries in the region, a major investment vehicle of these funds will inevitably be bank deposits. Foreigners will make their investments in banks with an eye toward return and safety rather than with an eye toward cementing a business relationship. In addition, these funds might become a source of financing for bank capital.

It should also be noted that, in the absence of strong equity markets, the role of reserves against possible loan losses takes on greater importance. Regulators should insist that banks adhere to conservative policies in provisioning for past-due loans and that such provisions be made out of the bank's income rather than from transfers from its capital account, which may not represent real capital. In other words, regulators should be very strict about bank dividend policy. Banks should not be allowed to pay dividends until the regulator is certain that the bank is not overstating income by continuing to accrue interest on past-due loans, and that provisioning for nonperforming loans is adequate.

Conclusions This chapter has examined the feasibility of applying bank supervisory techniques used in the industrial economies to the banking systems of Latin America. We considered whether capital-to-risk-weighted-asset standards, used so successfully to control bank risk in industrial countries, can be a

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Policies That Yield Results over Time

PART TWO • LILIANA ROJAS-SUAREZ/STEVEN R. WEISBROD

useful tool for controlling the risk of Latin American banks in the short run. It has often been argued that such standards cannot be successfully applied until appropriate accounting and supervisory standards are followed in the region. In addition, however, we have argued that capital requirements cannot be an effective tool for restraining bank risk until welldeveloped markets for equity exist. In the absence of such markets, equity investors do not necessarily act as residual risk bearers, which is a necessary condition for effective capital standards.

We argue that equity markets in Latin America do not function well because of the high concentration of wealth in the region, which keeps equity markets illiquid. As a result, investors who control banks can subvert the intent of capital requirements, even if the bank itself is subject to rigorous accounting standards. Investors in developing countries having majority interest in a bank can offset their equity positions in a bank with a liability position, either to their own bank or to a related party. The high concentration of wealth has two important consequences from the regulator's point of view. First, the interconnection of balance sheets implies that the probability that the failure of a few banks will develop into a systemic crisis is greater in Latin America than in industrial countries— that is, Latin American banking systems are more fragile than their industrial country counterparts. Second, because the quality of bank capital is low, available public safety nets (such as deposit insurance schemes) will be severely underpriced, creating greater incentives for bank risk taking than exists in industrial countries.

The evidence presented here supports these propositions. The fact that banks in many countries have been able to expand their capital base rapidly over short periods of time is consistent with the conclusion that bank owners can supply equity to their banks at relatively low cost. In addition, the fact that sources of new bank equity are not available in Latin America during banking crises signifies that equity markets are concentrated and not very liquid.

On a number of occasions, the lack of strong markets for bank stock has led supervisors to shift their attention from capital standards to liquidity requirements. Liquidity ratios can be a useful tool during a crisis because liquid assets are supposed to maintain their value during such periods. The evidence analyzed in this chapter, however, indicates that, as with capital requirements, the effectiveness of liquidity requirements depends on the quality of the assets used to satisfy them. Indeed, the experience in Latin America demonstrates that domestic currency-denominated liquid assets are likely in a crisis to become illiquid in terms of foreign reserve assets, which are the assets many investors want to hold at such times.

Thus, it might appear to be prudent policy to require that banks hold for-

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eign reserve assets to maintain liquidity in a crisis. Argentina, in fact, pursued such a policy by placing high reserve requirements on transaction deposits. The Argentine experience indicates that reserve requirements did not provide liquidity to the banks that experienced the greatest loss in deposits in 1995 because these banks held relatively few transaction (demand and savings) deposits. Many of these banks, however, were able to remain liquid because they held very liquid asset portfolios. Thus, our interpretation of the evidence is that many Argentine banks followed sound liquidity policies, not because they were subject to reserve requirements but because the operating procedures of the central bank, including its exchange rate policy, limited the supply of liquidity to banks. As a result, prudent banks realized that they had to maintain their own liquidity because they could not depend on the central bank to supply it.

The weaknesses of both capital standards and liquidity ratios in the context of today's Latin American markets raise the issue of how supervisors can identify and monitor risky banks in the short run. Fortunately, deposit and short-term liability markets work fairly well in identifying risky banks. In both Argentina and Mexico, liability markets signaled which banks would perform badly in the crisis.

The policy conclusions derived from this analysis can be divided into those that can have an immediate impact on bank soundness and those that will take time to yield results. Within the first group, appropriate policies include improving the efficiency of short-term liability markets—including disclosure of key market rates—to help identify risky banks and limit recourse to the public safety net, including lender-of-last-resort facilities and deposit insurance. They also include the avoidance of monetary policies aimed at smoothing fluctuations in short-term interest rates; instead, central bank operating procedures should aim at keeping the cost of liquidity high. The second group of policy measures includes those necessary to improve the performance of equity markets by improving accounting standards, increasing disclosure of consolidated balance sheets, and increasing foreign participation in the market.

Liliana Rojas-Sudrez is Principal Adviser, Office of the Chief Economist, InterAmerican Development Bank. Steven R. Weisbrod is Consultant to the Chief Economist, Inter-American Development Bank. The authors gratefully acknowledge excellent research assistance by Yoshiaki Hisamatsu and Marco Rodriguez.

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PART TWO • LILIANA ROJAS-SUAREZ/STEVEN R. WEISBROD

Basel Committee on Banking Supervision. 1997. Core Principles for Effective Banking Supervision, Switzerland (April).

Banco de Mexico. 1993. Informe Anual. Mexico City: Banco de Mexico.

Goodhart, Charles A. E. 1996. Some Regulatory Concerns. Paper prepared for a conference at the Banco de la Republica, Bogota, Colombia.

Institute of International Finance. 1995. Report of the Working Group on Capital Adequacy. Washington, B.C. (July).

International Monetary Fund. 1996. International Capital Markets: Developments, Prospects, and Policy Issues. World Economic and Financial Surveys (September). IMF, Washington, D.C. Kane, Edward J. 1995. Difficulties of Transfering Risk-based Capital Requirements to Developing Countries. Pacific-Basin Finance Journal 3.

Londono, Juan Luis. 1996. Poverty, Inequality, and Human Capital Development in Latin America, 1950-2025. Washington, D.C.: World Bank Latin American and Caribbean Studies Division.

Nicholl, Peter. 1996. Market Based Regulation. Paper presented at a conference on Preventing Banking Crises in Latin America, World Bank, Washington, D.C., April 15-16.

Rojas-Suarez, Liliana, and Steven R. Weisbrod. 1996a. Managing Banking Crises in Latin America: The Do's and Don'ts of Successful Bank Restructuring Programs. IDB Working Paper No. 319 (February), Washington, D.C. . 1996b. "Central Bank Provision of Liquidity: Its Impact on Bank Asset Quality." Paper presented at a conference on Strengthening Latin American Banking in a Global Environment, ADEBA, the Institute of International Finance, the Inter-American Development Bank and the World Bank, Washington, D.C., March 23.

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References

Charles A. E. Goodhart

The authors' main theme is that in any country with concentrated wealth holding and underdeveloped equity markets, standard indicators of depositor protection such as capital-to-asset ratios, even when measured accurately in an accounting sense, are likely to be economically overestimated relative to norms in industrial countries. In short, the quality of capital is lower. One reason is that the narrow base of concentrated wealth holding makes it easier for owners of bank equity to borrow from their own or associated banks to finance equity purchases. A second reason is that that same concentration is likely to lead to a higher correlation between changes in equity values in financial and nonfmancial companies, so that banks' equity base is likely to collapse at the same moment that their borrowers run into difficulties. Consequently, a high capital-to-asset ratio in an emerging market economy is a less secure guarantee to depositors or to the public safety net than the same ratio would be in the typical industrial country.

Although I find that general argument persuasive, I am slightly less impressed by the empirical evidence offered in support of it. The authors' comparison between the Latin American countries on the one hand and the United States and Japan on the other, in Figure 4 and in the discussion (for example on Texas), conflates and therefore confuses two intrinsically separable issues. The first is the sheer size of economies, and the second is the average income and wealth of the people of those economies. For example, aggregating over all the Latin American countries would smooth away the extreme values of the ratios in the figures and tables. If the authors want to keep the data on individual Latin American countries, more suitable comparators would be the smaller European countries, notably the Scandinavian countries, which are relatively rich but more comparable in population to the Latin American countries, and moreover have had their own banking crises.

I am also somewhat less persuaded of the authors' claim that relative interest rates can be used as a signal of bank quality. One reason is the pervasive influence of bank size on relative interest rates. A large bank with a portfolio of highly risky assets may be able to borrow more cheaply than a small bank with a portfolio of much better quality, because the larger bank is perceived as "too big to fail." Yet none of the empirical measures presented for the Argentine and Mexican banks have been adjusted for relative bank size. Consequently I cannot tell from these data what such interest rate differentials are actually measuring. What I do conclude is that the relationship in Argentina between the reserve ratios on transac-

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Comment

PART TWO • CHARLES A. E. GOODHART

tion accounts (43 percent) and these on time deposits (3 percent) is absurd—20 and 10 percent would have been much more sensible. I would also like to know what was happening to the Mexican bank in the authors' Figure 10 whose cost of borrowing approximately halved, from 26.5 percent to 14.5 percent, from 1993 to 1996.

Implicit in much of the chapter is a concern about connected lending, where a bank may lend too much and at too low interest rates to individuals or firms tied by business relationships with those who effectively control the bank. This is, indeed, a major and perhaps the primary cause of weakness in emerging market economies. Some banks, for example in Russia, have been founded virtually for the sole purpose of channeling deposit funds to enterprises run by the bank's founders. But one must remember that major culprits in this respect are also to be found among the ranks of government, at both the national and the state level (remember Banespa, the bank of Sao Paulo state in Brazil, which managed to overburden itself severely with bad debts), and not just, or even perhaps primarily, among the narrowly based private sector industrial groups. It is even harder for bank regulators to prevent government-sponsored lending that is not in the best interests of a commercial bank than for them to stand up to the well-placed rich industrialist.

The authors' proposed medium-term remedy for the problem of wealth concentration, and hence connected lending, is straight out of the Anglo-Saxon economic cookbook: strengthen capital markets, rely on takeovers to discipline corporate governance, and encourage foreign competition in banking as in other industries. But there is another model, the German-Japanese model, which actually encourages relationship banking as a means both of promoting growth and of overcoming the information problems that may occur in the arm's-length Anglo-Saxon model. The main Japanese banks were often, or even usually, at the heart of industrial groupings. How and why do some countries seem to be able to make such interconnected ownership relationships work well, whereas in others they contribute to the fragility and even the downfall of both borrower and lender?

This strikes me as a crucial issue, which is largely sidestepped by the authors, who seem to take the preeminent Anglo-Saxon model as an unquestioned paradigm.

Finally, a somewhat unusual proposal of the authors is that the central bank should not iron out short-term fluctuations in the cash base or in interest rates. The idea is to keep the commercial banks on their toes in arranging, developing and keeping in use a multiplicity of alternative sources of liquidity. Although this practice might be helpful in a crisis, I wonder whether it would work in the absence of controls on foreign exchange inflows. Without such controls, in circumstances where exchange rate main-

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tenance is not suspect, all that would happen would be offsetting interbank flows over the exchanges, which would, of course, dry up largely or completely during crisis periods.

Charles A. E. Goodhart is Norman Sosnow Professor of Banking and Finance at the London School of Economics and a former Chief Advisor to the Bank of England.

The authors reply: Professor Goodhart raised questions regarding two of the propositions in our chapter and the appropriateness of the empirical tests we used to support them. He first questioned our proposition that high annual growth rates of bank equity are unique to developing countries, with their small capital markets and concentrated wealth, and suggested that such high rates may be prevalent in small capital markets in both industrial and developing countries.

Figure 1 below, which presents an alternative version of Figure 4 in our chapter, attempts to respond to this question. It expands the sample of countries for which annual growth rates of real bank equity (defined as the growth rate of equity net of retained earnings, and, where data are available, net of asset reevaluations) are reported to include several small European countries (Belgium, Denmark, Finland, Spain, Sweden and Switzerland), as well as an additional developing country (Turkey). As the figure Figure 1 Loan Growth and Net Equity Growth in Selected Banking Systems (In percent)

* Six-month data annualized.

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PART TWO • THE AUTHORS REPLY

Figure 2 Nonintervened Mexican Banks: Interest Paid on Average Liabilities, 1993 vs. 1996 (In percent)

Note: The number above each data point represents the volume of assets of a given bank relative to the volume of assets of the largest bank for 1993.

shows, growth rates of bank equity in industrial countries, both large and small, are substantially less than those in all the developing countries, with the exception of Mexico in 1994 and Peru in 1995.1 Thus, these data bolster the chapter's contention that it is the particular features of financial systems in developing countries, such as wealth concentration and small market size, that lead to high growth rates of bank equity. We argue that both of these factors are necessary to permit bank owners to increase the supply of bank capital at very low marginal risk to their wealth.

The second proposition questioned by Professor Goodhart is that differences in interest rates paid on liabilities by Mexican banks between 1993 and 1996 reflected investors' perceptions of differences in risk. He suggested that these differences might instead reflect tiering of interest rates based on bank size, as investors view large banks as too big to fail.

To determine whether our empirical findings were the result of bank size, we have labeled each point in Figure 2 (a modified version of the chapter's Figure 10) to indicate each bank's share of total Mexican bank assets in 1993.

It is apparent that large and small banks are distributed randomly with respect to the interest rate paid on liabilities. Hence, we conclude that interest rate tiering was on the basis of risk rather than bank size.

1 In both these cases, however, the previous year saw a high rate of growth of net equity. Moreover, Mexico's 1994 decline in net equity growth reflects the deep banking crisis in that country at the end of that year.

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78

Augusta de la Torre

Rojas-Suarez and Weisbrod emphasize the point, with which I believe Latin American regulators are familiar, that the concentration of wealth in Latin American countries conspires with underdeveloped equity markets to undermine the quality of such measures of bank capital as the ratio of capital to risk-weighted assets. The inability to adequately measure and assess bank capital fosters the creation of fictitious capital in our economies, in particular through the offshore market. Many of the gimmicks and tricks through which fictitious capital is created are executed in these offshore facilities. Supervision could go a long way toward greater comprehensiveness by eliciting the cooperation of offshore banking centers, with reporting from them on a timely basis. Moreover, as the authors correctly state, consolidated supervision in countries where wealth is concentrated should also extend to the balance sheets of individuals, even though such supervision is difficult to implement.

We in Ecuador have found that business groups that own industrial companies and banks have actively used offshore jurisdictions to generate fictitious capital increases. Domestic deposits have been transformed into accounting capital (as opposed to real capital) by circulating them around the various Caribbean jurisdictions and others where similar practices prevail. A striking example is a bank in which the Ecuadoran authorities intervened not long ago. It was found that, from the end of 1994 until the beginning of 1996, nearly all the increase in capital at this bank (which incidentally largely accounts for Ecuador's outlier position with regard to net bank equity growth in the authors' Figure 4) had been mere accounting capital. The owners had created fictitious capital by transferring deposits to offshore centers and then using those deposits to lend to the bank's shareholders, who in turn had used those funds to increase the bank's capital. In effect there had been no new, fresh resources going to the bank.

One policy lesson from this kind of activity, which we learned quite painfully in Ecuador, is that one of the best warning signals of deteriorating bank quality is rapidly growing capital. Normally, real capital increases only slowly, through sweat and tears. A sudden surge in capital growth should therefore put a bank on one's short list of suspected malfeasors.

Another lesson we have taken to heart in Ecuador is that better and more extensive coordination is needed domestically to bring together institutionally the supervisors of capital markets and the supervisors of banking and credit markets. In the case described just above, it was discovered that efforts to develop the country's capital markets had created some hid-

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PART TWO • AUGUSTO DE LA TORRE

den cracks in the regulatory framework. It was through these cracks that the bank had been able to create fictitious accounting capital by recycling deposits.

Ecuador's experience also teaches that an effective way to limit future abuses of the banking system is to make a severe and public example of any bank in which fictitious capital creation has led to insolvency and intervention. The capacity to single out a flagrantly misbehaving bank for extraordinary punishment varies from country to country, depending on the quality of the judicial system. But there is no better deterrent than harsh punishment for the bankers who engage in this type of illegal activity. And illegal it surely is—in the majority of countries of Latin America, I believe, banking laws prohibit the use of depositors' money to lend either directly or indirectly to buyers of stock in the bank itself. Clearly this prohibition can be, and often is, bypassed, and the skills for such circumvention are never in short supply. But when a culprit is found, the punishment should be heavy.

And, just as importantly, the bank regulators and the monetary and other authorities should take pains to publicize in great detail what the offending bank did and how it was punished. This will not only send a message to other bankers who might be contemplating similar behavior, but will also raise public consciousness and increase market discipline.

Another resource that one should take advantage of in such cases, as we have done in Ecuador, is the external auditors of the banks. In the case described above, the Ecuadoran authorities revoked the license of the external auditor that had failed to blow the whistle on the bank's fictitious capital increases. As a result of that action, we are quite sure that external auditors in Ecuador will henceforth be much more meticulous in their analysis of bank balance sheets, and more skeptical of sudden increases in capital.

A further lesson concerns access to the liquidity facilities of the central bank. Normally, access by any bank is based on its compliance with capital requirements. But the balance sheets of the Ecuadoran bank described above had been passing that test with flying colors, and consequently the bank had gained access to central bank liquidity, which was granted using the bank's loan portfolio as collateral. Only after the authorities intervened was it discovered that the bank's compliance was a sham.

The lesson is that central banks should impose additional criteria for access to their liquidity facilities, beyond compliance with regulatory capital standards. The authors' suggestion of using the liabilities markets as a source of additional criteria is, I think, very useful.

The authors also make the point that liquidity ratios can be complementary to the other criteria to protect asset value in time of crisis. They suggest that countries encourage banks to hold liquid and safe assets in

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foreign currency, which do not lose value in time of distress. I have mixed feelings about this recommendation. Perhaps any such liquid assets held by banks as a supervisory requirement should be accompanied, in the macroeconomic sense, by increased reserves in the central bank. The reason is that the more liquid banks are, the easier it is to engineer speculative attacks on the currency market. If banks are taking long dollar positions with their liquid assets, not only do they have a vested interest in encouraging such attacks, because they can count on capital gains, but they may acquire unduly speculative attitudes themselves.

In Ecuador, banks are obliged to maintain minimum liquidity ratios, with that liquidity consisting of central bank paper and other public paper.

Through repo operations the central bank acts as a market maker for such paper. In addition, our regulations set tight limits on open positions, long or short, in foreign currency. On the other hand, the central bank sets its reserve targets in terms of a minimum proportion of M2 or some other monetary aggregate, or some indicator of the capacity for speculative attack. Thus, if and when a financial crisis comes, as banks draw down their liquid assets—a move that normally is also accompanied by an attack on the currency—there is sufficient strength in reserve to withstand the attack without an exchange rate crisis, and therefore without loss of the value of those assets.

Augusta de la Torre is Governor of the Central Bank of Ecuador.

Comment Eduardo Fernandez Garcia

As Rojas-Suarez and Weisbrod note, the usefulness of financial indicators to assess the condition of financial institutions depends largely on their being calculated from precise, reliable and truthful information. The authors therefore recommend that the banking authorities in Latin American countries harmonize their accounting principles with international standards, so that bank disclosure statements will contain the information necessary for bank supervision to be effective. Indeed, the usefulness of financial ratios not only within domestic financial systems but also for purposes of international comparison depends on accurate information being available. We in Mexico therefore consider it important to study the feasibility of homogenizing the accounting principles used in Latin America with internationally accepted norms, and in particular with the norms used in those countries with which we maintain close relations.

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PART TWO • EDUARDO FERNANDEZ GARCIA

For that reason, beginning in 1997 new accounting principles consistent with international practice will be applicable to credit institutions in Mexico. Also, to facilitate consolidated supervision of financial groups, similar accounting principles have been issued for other financial entities such as brokerage houses and nonbank intermediaries. The new principles include certain accommodations to the conditions under which the Mexican financial system currently operates, such as guidelines for adjusting accounting measures for inflationary conditions.

The authors argue that, even with the adoption of accounting principles consistent with international standards, measures of financial capitalization are of limited usefulness in Latin American countries, mainly because, in their view, excessive income concentration in the region has prevented capital markets from developing sufficiently. They show that healthy capital markets are essential for the proper functioning of a prudential regulatory framework based on capital requirements. The authors also argue that concentration of equity ownership gives rise to self- and cross-lending, which weakens the applicability of capital requirements. Such conditions allow institutions to assume greater risk without jeopardizing their own resources, thereby evading existing regulation. The problem translates into low quality of bank capital, illiquid capital markets, and increased systemic risk—problems that are ready to boil to the surface in the event of a domestic crisis.

Income concentration and cross-shareholdings among large financial and industrial groups do indeed reduce the quality of injected capital and hinder the task of the supervisors. Yet these problems are not so daunting that they cannot be tackled through appropriate regulation and improved supervision. It must be acknowledged, however, that financial liberalization in many Latin American countries has not been accompanied by a parallel strengthening of supervisory bodies. This discrepancy has, in fact, opened the doors to unsound practices such as those the authors mention. Nevertheless, even under conditions of excessive income concentration and weak capital markets, more solid supervision can do much to eradicate such conduct. For this reason the financial authorities of many Latin American countries are undertaking important modernizations of their supervisory processes. In Mexico these reforms have been accelerated since 1994, with the support of the Inter-American Development Bank and the World Bank.

We endorse the authors' main recommendations regarding the need for financial authorities in Latin America to promote the development of capital markets. This would foster the atomization of ownership of commercial and financial institutions, promoting a more active role for equity markets in administering and monitoring them. Such actions will be en-

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hanced by prudential measures relating to the corporate structure of financial institutions, aimed at redefining the responsibilities of directors, protecting minority shareholders' interests, and establishing clear and applicable norms for the adjudication of conflicts of interest. While these structural changes are being implemented, regulators should be making progress toward strengthening our countries' debt markets, which, as the authors observe, constitute a valuable tool for evaluating the risks of financial institutions as well as differentiating one from another.

On the matter of deposit insurance, we agree with the authors that such systems should grant only a limited government guarantee, to protect the interests of less sophisticated investors, and should avoid generating incentives for controlling groups to take excessive risk. However, in countries that have recently faced unstable financial markets, depositor protection must be reduced gradually.

It is worth pointing out that although capitalization indexes do not yet constitute the powerful tool that they are in industrialized countries, given our countries' prevailing concentration of incomes, they nonetheless remain a necessary element in the regulatory framework of our financial sectors. To increase their usefulness, they need to be complemented with additional capitalization measures that assess exposure to market risks. In this vein, the Mexican authorities have recently issued new capitalization rules for commercial banks and brokerage houses, which evaluate not only the credit risks associated with bank operations, but also the market risks that derive from activities both on and off the balance sheet. In addition, the calculation of net capital has been modified to bring the definition of basic and complementary capital applicable in Mexico closer to the Basel Committee's proposed definition, already commonly applied in the industrial countries.

I will close with some remarks regarding the authors' comments specifically regarding Mexico. First, the authors maintain that an important share of the cost of the recent banking crisis in Mexico was borne by depositors through negative real interest rates paid on their deposits. Our calculations, however, indicate that these rates were highly positive during 1995.

Second, the authors argue that in time of economic crisis the financial and the real sectors in Latin American countries are equally affected, because of the strong link between the two, and that this renders shareholders (who are the same in both sectors) unable to spare the necessary resources to recapitalize failing institutions. This, however, is not always the case: in Mexico, the industrial conglomerates that own some of the main financial groups are also heavily engaged in export activities, which were much favored by the peso devaluation. Their returns were thus not as highly correlated as may have been the case elsewhere, and this helped in the recapitalization of bank groups. This pattern of ownership goes a long

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PART TWO • EDUARDO FERNANDEZ GARCIA

way toward explaining the increase in capital levels observed in the Mexican banking sector during 1995.

Another factor in the increase in bank capitalization has been the opening of our economy, which has favored the growth in foreign investment in the financial sector. A number of foreign investors have brought in fresh capital through the acquisition of equity in domestic financial groups.

The authors suggest that the strategy followed by the Mexican authorities impeded the liquidation of troubled institutions, thereby raising the fiscal cost of managing the crisis. Our view is that, given the magnitude of the crisis and the presence of a deposit insurance scheme that guaranteed all bank liabilities (except subordinated debt), had the authorities allowed bankruptcies and liquidations to occur indiscriminately, the result would have been a severe systemic crisis, imposing a much higher fiscal cost. Therefore, the authorities acted in two ways. First, they intervened in those institutions whose solvency could not be guaranteed by their shareholders; these are in the process of being sold or liquidated. Second, the remaining institutions have participated in programs that encourage existing owners or new shareholders to recapitalize them. It is worth stressing that financial intermediaries have explicitly committed themselves to seeking sources outside of the Mexican financial system. In this way, the establishment of adequate regulation has brought about the recapitalization of domestic banks. Our experience shows that the implementation of appropriate supervisory rules and mechanisms can mitigate some of the structural problems faced by the financial sectors of Latin American countries.

Eduardo Fernandez Garcia is President of the National Banking and Securities Commission, Mexico.

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84

William A. Ryback

Capital adequacy requirements presuppose that certain fundamental principles of measuring capital are already in place. Yet as we all know, this is far from the case in Latin America at present. Although much has been accomplished in the last few years, much remains to be done. First, attention needs to be given to the question of how close each country's standard must be to those set out in the Basel Capital Accord. Most countries in the region claim to have adopted risk-based capital adequacy requirements similar to the Basel standards. Yet in fact countries have adopted systems that differ in many material respects from the Basel standards, and differ from country to country as well.

During the debates leading up to the issuance of the Basel accord, there was much discussion about how rigid the standards should be. Some countries argued strongly for a liberal accord, with rather loose standards and considerable leeway for national discretion. But in the end the argument for a relatively strict approach, with only limited scope for national discretion, won the day. Those countries that favored a more liberal regime were those that had the furthest to go to achieve both the structure and the level of capital that the accord mandates. They are also the ones that have taken the longest to resolve the existing problems in their banking systems. Therefore, the argument could be made that more needs to be done to harmonize the different interpretations of the Basel accord.

It is likely that the stated capital ratios of many Latin American banks do not reflect their true financial positions. Accounting practices differ, with some countries permitting liberal reporting treatment of nonperforming loans and renegotiated debt. Common problems are inadequate loan-loss reserves (the result of underreporting of problem assets), inflation adjustments that may mask the true value of certain assets, and flexible accounting treatment for investments in other companies and for related revaluation reserves. The overall flexibility permitted in some countries in adhering to national standards allows banks within the same country to differ on how they apply the same home-country accounting standards.

This leads us to my second point, namely, that any measurement system that seeks to compare capital adequacy across national borders needs a common system of accounting standards and common standards for valuation of assets. This was the fundamental starting point for the discussions

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Panel Discussion: Adopting Capital Adequacy Requirements

PART TWO • WILLIAM A. RYBACK

on capital adequacy standards in Basel. The Group of Ten countries already had in place a set of relatively harmonious accounting practices and systems for identifying problem assets. More work needs to be done in this area by the Group of Ten and will be undertaken shortly. But even more work needs to be done to harmonize valuation standards in Latin America. Meaningful comparisons between banks in the hemisphere with respect to their adequacy of capital cannot be made unless and until this is done.

My third observation is that consolidated balance sheets are a necessary ingredient in applying common capital adequacy standards. Here the news is good. Many countries have recently begun to require consolidated balance sheets of their financial institutions. Others have not taken this step but are moving in that direction. Although balance sheet consolidation is thus becoming the norm, supervisors in the region nonetheless need to ensure that it is full and complete, that is, extending to offshore assets.

They also need to ensure that judgments about the true value of these assets are made in accordance with internationally accepted standards. Mere consolidation of balance sheets without verification of their true value is not particularly meaningful.

A critical mass of bank supervisors in Latin America want to move aggressively in these areas. Members of the Association of Latin American and Caribbean Bank Supervisors have already begun to debate many of these issues. To be sure, no absolute consensus has yet been reached. Some supervisors have acknowledged that the political will in their countries to reach agreement on these subjects lags behind the will of the supervisors themselves to get the job done. But progress is being made. The same association, for example, recently issued a paper on supervising practices for offshore offices. The recommendations made in that paper, however, rely on best-efforts implementation. These recommendations, which are in my view very reasonable, should be accepted as minimum standards and endorsed as such, and their implementation should be monitored.

Interest in reforming bank supervision has grown dramatically over the last few years in Argentina, Brazil, Chile, Colombia and Mexico, among other Latin American countries. Much remains to be done to implement harmonious and reasonable capital adequacy standards. But both the desire and the intellectual capacity appear to be present. I believe that with some further effort, and with the endorsement of the finance ministers of the governments involved, much further progress can be made.

William A. Ryback is Associate Director of International Supervision of the Board of Governors of the U.S. Federal Reserve System.

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86

Pedro Pou

This commentary is organized along five themes, starting with a review of the reasons why countries regulate banks and an explanation of how Argentina's approach may differ slightly from that of other countries. The second section poses the question of whether capital requirements are useful—and answers it with a firm yes. The third section comments briefly on the international approach to capital requirements, and the fourth asks whether that approach is useful for Latin America and for Argentina. The final section offers some comments on the use of capital requirements for market risks.

Reasons for Bank Regulation Many commentators appear to start from the premise that regulation is required because banks have access to the central bank's lender-of-lastresort facilities, or because a general safety net is present in the form of a public or publicly sponsored deposit insurance system. The moral hazard created by these arrangements, so this reasoning goes, justifies the complex web of bank regulations that most countries adopt.

For me, however, this amounts to putting the cart before the horse.

Here I agree with the theme of a recent book on bank regulation that the fundamental reason for regulation stems not from public intervention but from information asymmetries.1 In particular, we cannot expect depositors to be fully informed, or to monitor and control bank owners and bank staff perfectly. It is well known that the incentives of different claimholders on any organization will be in conflict; equity holders, for example, will want to take more risky actions than depositors would like. Depositor protection then becomes a first and fundamental reason for public intervention.

A second question is then whether depositor protection justifies a broad safety net in the form of deposit insurance. In Argentina in the past and in many other countries today, the moral hazard of a general safety net, combined with the ineffectiveness of mechanisms to control banks, has resulted in huge losses to taxpayers. Moreover, even in some countries where general deposit insurance exists, depositors have suffered substantial real losses due to large devaluations of the currency, which were in part provoked by the monetary consequences of banking problems in com1 See Mathias Dewatripont and Jean Tirole, 1994, The Prudential Regulation of Banks. Cambridge, Mass.: MIT Press.

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bination with the safety net itself. Hence, for some countries, even a general safety net for bank claims does not provide full insurance in the true sense of the word.

For these reasons Argentina has decided to maintain only a very limited safety net. A fully funded, private limited deposit insurance scheme exists but receives no public financing. Liquidity assistance to banks is available through repurchase operations, and this facility has recently been expanded significantly by a $5 billion repo program with a set of international banks. Central bank rediscount operations are strictly limited by Argentina's Convertibility Law. As was demonstrated in 1995, we will not rescue insolvent banks and we are prepared to allow depositors to suffer losses, even in nominal terms.

This relatively tough policy, combined with a comprehensive regulatory regime, has refashioned incentives in the banking sector to such an extent that, even though Argentina faced possibly its severest financial shock ever in 1995, with 18 percent of deposits leaving the system, the actual dollar loss to depositors was very small indeed. Moreover, the lender-oflast-resort operations undertaken by the central bank over the first five months of that year resulted in no cost whatsoever to the taxpayer.

Even with such a limited safety net in place, we believe that a strong banking regulatory framework is justified for several reasons. One is the need, mentioned above, to protect less informed claimholders. A second reason is the presence of externalities that banks generate both toward other banks and toward the remainder of the economy. Unlike companies in other industries, banks affect each other in a variety of ways: directly through outstanding contracts and liabilities, and indirectly through contagion effects, which are perhaps another result of imperfect information. An individual profit-maximizing bank will not internalize the costs that its actions impose on the rest of the banking industry; hence it will in general choose to take riskier actions than society as a whole would prefer. Beyond the effects of banks upon each other, the banking sector as a whole has a greater effect on the functioning of the broader economy than does any other single sector. A well-functioning banking sector is thus a crucial component of national economic performance. But individual banks will not internalize the results of their own decisions on national welfare. Once again, regulation to safeguard the sound operation of banks may be justified.

Are Capital Requirements Useful?

Bank capital requirements, by ensuring that the owners of bank equity have substantial resources of their own at risk, reduce conflicts in incen-

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tives. Naturally, however, problems remain. To the extent that bank owners can engage in "regulatory arbitrage" to avoid putting their own resources at risk, the value of regulations on capital is reduced. My sense is that, although we are surely in a second-best, and perhaps even in a third- or fourth-best world, where some regulatory arbitrage does still occur, capital requirements are at least partly effective and do serve a valuable purpose in reducing incentive problems.

International Approach to Bank Regulation The 1988 Basel Accord, agreed to by bank supervisors from the Group of Ten industrial countries, established a minimum ratio of capital requirements to assets at risk, taking into account counterparty risks. This was an extremely important agreement in that it was the first to establish a level playing field for banking institutions in different countries. It was especially important for the signatories themselves, given their degree of financial market integration and the amount of cross-border activity in which their banks engaged. Three points are worth noting, however. First, the accord was between the Group of Ten countries only and hence was not designed with Latin America in mind. Second, a lot has happened since the accord was concluded in 1988. Third, the accord sets only a minimum requirement, and even some of the G-10 countries themselves set capital requirements that are significantly higher for some banks than the 8 percent standard.

Determining whether the Basel Accord is relevant to Latin America requires posing some simple questions. First, is a level playing field for banks important in Latin America? Arguably the answer at present is no.

Intraregional banking relations, although growing, remain much less developed than between, for example, the United States and the European countries. This is not to suggest that Latin American countries should put aside any such aims altogether. However, it is probably fair to say that the objective of establishing an appropriate capital cushion for banks in each Latin American country individually is currently more important than establishing a common ratio across all countries of the region.

Second, should countries in the region adopt the minimum 8 percent requirement agreed to by the G-10 countries? Here again, the answer may be no: there are arguments to suggest that Latin American countries may require stricter ratios. Superficially, the reasons are fairly obvious. We must assume that, given the greater volatility of relative prices, and hence of counterparty risks, Latin American banks require a larger capital cushion than do banks in the G-10 countries. At a more theoretical level, however, this argument by itself may not be quite correct. To the extent that bank

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PART TWO • PEDRO POU

owners internalize the effects of higher volatility in their own decisions, higher requirements will be redundant. However, it is probably also true that, because of this higher volatility, the conflicts in incentives between different bank claimholders may be stronger in Latin America, and therefore a larger capital cushion may be required to help solve the fundamental incentive problem.

A third question is more technical. Are the broad risk classes adopted in the Basel Accord to measure assets at risk relevant to Latin America? A common methodology certainly has its merits, but my experience suggests that the Basel asset classes may be too broad. Asset classes appropriate for Latin America may need to be slightly more complex, as our risks may vary more.

One solution, admittedly imperfect, would be to include an additional factor in the calculation of assets at risk, namely, the interest rate charged on a loan. Loans that attract higher interest rates are likely to be more risky. Hence an additional factor that rises with the interest rate charged may be one way of improving the accuracy of the Basel risk weights. This, in fact, is the approach taken in Argentina: a basic ratio of capital to assets at risk is set at 11.5 percent, but those assets at risk are greater than they would be according to Basel criteria because of an additional, interest ratesensitive factor.

In short, capital adequacy requirements along the lines of those in the Basel Accord for counterparty risk are highly relevant to Latin America, and a common methodology has considerable merit. However, adaptation is required, and 8 percent should certainly not be considered a figure set in stone.

Capital Requirements for Market Risks Both Mexico and Argentina have recently issued regulations in the area of capital requirements for market risks, following the January 1996 amendment to the Basel Accord; both these regulations became effective on September 1, 1996. Here, perhaps even more than in the case of counterparty risks, adaptation is required. The so-called standardized approach of the Basel Amendment, a version of which is now in force in Europe, establishes risk weights that are fixed, both across countries and across time, for the calculation of capital requirements for assets with liquid markets.

Here again, Latin America's greater economic volatility implies that the values of the risk weights in the Basel Amendment and in the European Capital Adequacy Directive may have little relevance in the region. Latin America will surely need to set higher requirements for each dollar of liquid assets held on banks' balance sheets.

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However, two more interesting questions are, first, whether Latin American countries should have fixed risk weights over time, and second, whether Latin America should have the same risk weights across countries. Again I am afraid that the answer is probably no to both questions, because volatility tends to vary more in Latin America, both over time and across countries, than among the G-10. All is not lost, however. One solution to these problems is that proposed in a recent paper from the Research Department of the Central Bank of Argentina: Latin America should adopt a methodology for the calculation of time-varying risk weights similar to the Basel methodology, but not exactly the same risk weights.

The methodology adopted in the Argentine regulations fixes statistical tolerance values but then uses actual volatilities for the calculation of the relevant risk weights. In this sense Argentina's approach lies somewhere between the standardized methodology of the Basel approach and the so-called internal models approach.

Latin America might therefore agree on the statistical tolerance values and other fixed factors, so that the differences in the risk weights would stem only from differences in the volatility of assets in each country. This would be one way of establishing a level playing field while also ensuring a good fit of the regulations to the countries of the region.

Conclusions There are sound and fundamental reasons why regulations on capital are required, and such regulations serve a very useful and valid purpose. Even though we are clearly in a third- or fourth-best world, my experience suggests that capital requirements help resolve inevitable and fundamental incentive problems. The international approach provides an excellent starting point for thinking about appropriate regulations for Latin America, but only a starting point. In general, stricter regulations are required for the region, and adaptation of the international approach should be the norm. In the future, a level playing field will become as important in Latin America as it is now in the G-10 countries, but today it is probably more important for each country to ensure that it has a safe and sound system of regulation in place than to worry about whether its regulatory system is competitive with those of its neighbors. However, different requirements do not imply different methodologies, and especially in the area of capital requirements for market risks, a reasonably common methodology is both feasible and desirable.

Pedro Pou is President of the Central Bank of Argentina.

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PANEL DISCUSSION

Charles H. Dallara

Only a year or so ago, many attendees at this conference came together for another meeting on banking in Latin America, also sponsored by the InterAmerican Development Bank and the Group of Thirty. It is an encouraging sign of the times that this second conference focuses not on solving banking crises in Latin America, but rather on building and maintaining safe and sound financial systems in the region. Although we have all been through difficult times in recent years, today we can say that there is not a single systemic banking crisis in any Latin American country.

As many countries in the region move in concert from a high-inflation to a low-inflation environment, challenges emerge for the banking community. This reminds me of an experience I had as a young boy, when a small lake where I used to go fishing was drained. Overnight what had been a lovely, tranquil pond was transformed into a mud flat full of ugly tree stumps and even uglier creatures crawling around in the muck. In the same way, when countries reduce inflation, problems in the banking system that chronic inflation may have formerly concealed become all too visible. Many banks in Latin America today are struggling with this new, low-inflation environment, and not all may survive the transition.

But there is reason to be encouraged by the progress that many of them are making in strengthening the efficiency and competitiveness of their operations.

The president of the Inter-American Development Bank and the organizers of this conference deserve congratulations for their insistence over the years that this institution assume leadership in addressing financial sector issues throughout the region. Nothing in the structure of these economies is quite so fundamental to their long-term health. In a few recent cases we have seen how a weak banking system can transform a financial crisis into a sustained economic decline.

At the Institute of International Finance we approach these issues from the perspective of practitioners—providers of financial services— rather than from the perspective of regulators. The institute s membership, formerly concentrated among the leading banks of the Group of Ten countries, now increasingly includes the leading banks of emerging markets all over the world. In the last few months alone such leading banks as Banco Galicia, Banco Frances, and Banco Itau have opted for membership. The institute's responsibility, therefore, is to represent not just the concerns and interests of banks in London, Tokyo, Zurich or New York, but also those of the leading banks of Latin America and other emerging markets.

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From this perspective, our views on capital adequacy are not radically different from those voiced by William Ryback in the previous comment. We certainly share the view that, within the limits of national flexibility established by the Bank for International Settlements (BIS) in its guidelines some years ago, the capital requirements proposed by the Basel Committee are appropriate ones for the banks of Latin America to work toward and to build around. Some of the excellent chapters prepared for this book raise questions about the utility of capital requirements as a basis for safety and soundness in an environment where transparency is possibly inadequate, and where equity relationships are not as widespread as they might be.

Latin America is certainly not alone in having deficiencies in its accounting systems and in transparency, or in the problem of inappropriate relationships between some bank owners and borrowers. Anyone who has recently looked at the banking system in Japan can attest that that country has endured a similarly difficult struggle. The problems in the Japanese banking system are not simply a function of the real estate crisis there.

They relate to problems of asset valuation, accounting practices, and transparency. We at the institute work with many banks from Central Europe and Asia, and I can attest to their strenuous efforts to address many of the same problems we grapple with here.

I do not take these problems, however, as evidence that capital requirements can or should be put aside and replaced by other standards.

Certainly, liquidity measurements can be useful complementary tools for regulators and bankers. But basic capital requirements are essential. Capital must be sufficient and appropriate, and that means not having too little capital, but also not having too much: banks with excess capital can face misguided incentives just as do banks with inadequate capital. The challenge for bankers and regulators is to establish and implement a framework for determining what is an appropriate amount of capital and ensuring that it is in place.

We see this challenge being addressed throughout Latin America today. One also sees encouraging signs of growing collaboration between the regulatory agencies and the banking community. A distinctive feature of regulatory policy in the industrial countries as it has evolved recently is that it has not been forged through confrontation, in which regulators issue unwelcome edicts from above. The officials of the BIS and the central banks of the industrial world deserve credit for their practical and collaborative approach in establishing new capital and other regulatory requirements for their own leading banks and for those of the developing world as well. The process is only beginning, however. We encourage regulatory, central banking and other supervisory officials in Latin America to embrace that process as the BIS

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PANEL DISCUSSION

PART TWO • CHARLES H. DALLARA

itself has done. To some extent it is inevitable that they will embrace it sooner or later, as leading central banks from Latin America join the BIS and become part of its decisionmaking process.

Although the Institute of International Finance strongly favors a collaborative approach in establishing regulatory requirements, this is not to say that any central bank or any supervisor should cede final decisionmaking authority. But they can learn how to work with the grain of the market and with the reality of banking in each country. They can learn to take advantage of improved risk management systems in the banks themselves. Regulatory efforts can then produce a viable set of regulatory standards that banks will actually follow. We see this happening in the discussions, now taking place within the BIS, of new requirements for capital against market risks. Again, these guidelines are not being sent down from the mountaintop on stone tablets; they will be decided only after extensive consultation, collaboration and input from the world banking community.

As the particulars of capital requirements for market risk are eventually applied to Latin America, we encourage both the regulators and the regulated banks to work closely together in fleshing out the details.

Other weaknesses in the banking system must be addressed at the same time that capital requirements are being strengthened. Without proper accounting standards, transparency, and the establishment of proper arm'slength relationships between owners and borrowers, the credibility of the region's financial systems in global banking circles will remain less than optimal. Improvement in all these areas is the goal toward which many of Latin America's leading banks today are moving.

The forces of competition are gearing up throughout the region as well. One encouraging sign of this is that leading banks in several Latin American countries are now establishing operations in neighboring countries. It has long been remarkable that, even as recently as the early 1990s, the larger banks in Brazil were not a major presence in Argentina, and vice versa. But that is changing, and for the better. This phenomenon is part of a growing economic dynamism in the region, which we believe heralds a much more hopeful economic and financial future. The disappointments and disruptions of 1994 and 1995 should not detract from the underlying progress that has been made in establishing stronger economies and banking systems throughout Latin America. We at the institute think that stronger capital requirements can be an important part of building that new dynamism.

Charles Dallara is Managing Director of the Institute of International Finance and a former Assistant Secretary for International Affairs in the U.S. Treasury.

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94

Approaches to Financial Market Structures

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PART THREE

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George G. Kaufman and Randall S. Kroszner

The structure of a nation's financial markets and institutions is widely considered to be of greater policy importance than structures in other sectors for a number of reasons. Financial institutions, and banks in particular, encourage, collect and transfer the savings necessary to finance economic growth. In addition, banks and other financial institutions are integral to the monitoring of private enterprises and, in some countries, to the system of corporate governance, and thereby affect the productivity of resources. Numerous studies have provided evidence that the degree of development and efficiency of the banking system are key contributors to overall economic growth (King and Levine, 1993; Jayaratne and Strahan, 1996; Levine, 1996). Financial institutions also play a fundamental role in transmitting the government's (or the central bank's) monetary and credit policies to the rest of the economy, both through their deposit and lending activities and through their role in the payments system.

Because banks have a unique financial structure and a central place in the economy, however, liquidity and solvency problems at banking and financial institutions are widely believed to be more likely than similar problems in nonfinancial enterprises to spread quickly throughout the financial sector, and from there to other sectors and the economy as a whole. To maintain stability and lessen the potential for such adverse spillovers, virtually all governments have placed a regulatory safety net under banks, either implicitly or explicitly. Such regulation, however, has not solved the problem of financial system fragility, and may even have exacerbated it. A recent survey, for example, found that 131 of the 181 member countries of the International Monetary Fund had reported serious banking problems or bank failures in recent years (Lindgren, Garcia and Saal, 1996). The cost of resolving many of these episodes has been substantial. The estimated cost to governments alone of resolving bank failures has ranged from 2.5 percent of GDP in the United States to between 10 and 20 percent in Argentina (in the episode of the late 1930s), Bulgaria, Mexico, Spain and Venezuela; between 20 and 40 percent in Israel and Uruguay; and more than 40 percent in Argentina (in the early 1980s) and Chile (Rojas-Suarez and Weisbrod, 1996; Lindgren, Garcia and Saal, 1996; Caprio and Klingebiel, 1996).

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How Should Financial Institutions and Markets Be Structured? Options for Financial System Design

PART THREE • GEORGE G. KAUFMAN/RANDALL S. KROSZNER

Both high performance and stability thus are viewed as particularly important in the financial sector. This chapter analyzes the impact that alternative organizational structures of financial institutions have on achieving these goals. The first section describes the broad objectives of efficiency and stability in the design of financial systems and considers the challenges posed by the special structure of banks and of the financial system as a whole. The next section evaluates the effectiveness of different organizational forms of banks in achieving these objectives. In the third section, we analyze the consequences, both economic and political, of the interaction between alternative safety net regulations and alternative banking structures for efficiency and stability. The final section presents recommendations. Because the structure of financial institutions evolves dynamically with the overall economic and legal system, we conclude not with a "one size fits all" prescription for all countries, but rather by proposing a framework for understanding the effects of alternative structures in countries with different economic, regulatory and political characteristics.

Objectives of the Financial System and the Special Structure of Banks The design of financial institutions cannot be considered apart from the context in which they will operate. What will work best in a given country depends on a rich variety of factors, including the development of domestic financial markets, the system of corporate law and governance, the system of contract enforcement and bankruptcy, the regulatory setting, and the susceptibility of the economy to domestic and international economic shocks. Financial structures are dynamic and evolve over time, both shaping these factors and being shaped by them. The best way to approach financial system design is to understand the objectives of the economy as a whole and to explore how different combinations of elements of financial systems can best achieve those goals.

The primary role of the financial sector is to bring together savers and borrowers—suppliers and demanders of capital—so that scarce capital can be allocated to its most productive uses, thereby maximizing the risk-adjusted returns to savers. Financial markets may transfer funds directly between savers and borrowers through, for example, the stock and bond-markets. Financial intermediaries such as banks, however, can make the flow of funds more efficient by interposing themselves between savers and borrowers and transforming one type of security into another: for example, a demand deposit into a long-term mortgage loan. To avoid the inefficiency of each individual saver having to analyze and decide which projects to invest in, savers can pool their resources and delegate that task

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to financial intermediaries, which specialize in analyzing expected returns from various projects (Diamond, 1984). These intermediaries typically enjoy economies of scale and scope in investment analysis, information processing, and risk diversification.

In the financial sector as in any other, the more efficient its structural organization, the greater is its contribution to overall welfare. Free competition is traditionally viewed as the most effective means of achieving efficiency.1 Competition among financial institutions and between banking and capital markets should provide the incentives for financial entrepreneurs to organize those institutions and markets as efficiently as possible.

In most countries, however, the financial sector, particularly banking, is heavily regulated. Regulation rather than competition often determines the products and services that banks may offer, the types of assets and liabilities they may hold, the legal structure of banking corporations, the extent of control of nonfinancial firms by banks and vice versa, and, in some countries, even the number and location of bank offices.

One of the rationales most commonly given for not allowing unregulated competition in financial services is a concern for stability, both of the financial system and of the economy as a whole. In an undistorted system, private owners of firms have appropriate incentives to choose the financial structure that permits them to achieve the privately optimal amount of stability. Owners and managers decide how much risk of loss they will tolerate for a given expected level of return. Optimal stability in any industry, including the financial industry, does not imply the complete absence of failures or closures. Any healthy and dynamic competitive industry will have firms entering and leaving. Competition ensures efficiency precisely through a winnowing process that eliminates firms that have poor management or experience bad luck.

Stability in the financial sector, however, is widely perceived to be of distinct public concern beyond its importance for individual firm owners.

That concern arises from a fear that owners will not take into account the possibility that the failure of their institution might cause failures elsewhere, and lead to a systemwide financial panic or meltdown, which in turn might cause a broader macroeconomic decline. Bank owners may not take the cost to society of such a catastrophe into account in pricing risk and in determining the appropriate amount of their own capital to invest.

The socially optimal ratio of owners' capital to total bank assets thus may be greater than the privately optimal ratio. Since, however, the benefits of 1 An exception arises when strong economies of scale in production lead to natural monopoly, but scale economies in banking appear to be very weak beyond a relatively small size (see Humphrey, 1992; Saunders and Walter, 1994).

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OPTIONS FOR FINANCIAL SYSTEM DESIGN

PART THREE • GEORGE G. KAUFMAN/RANDALL S. KROSZNER

system wide stability accrue to all economic agents, and not just the banks, it may not be appropriate to have only the bank shareholders bear its cost.

This potential negative externality provides the justification for government intervention.

Financial institutions, and particularly banks, are viewed as more fragile than other firms, mainly because of two features of their structure.

First, they tend to be more highly leveraged than nonfinancial firms; that is, they have a relatively low capital-to-asset ratio. This structure gives banks a smaller cushion against losses and insolvency than most nonfinancial firms have. Second, banks typically hold a low ratio of liquid assets to liquid liabilities: many of their assets are loans to businesses and individuals that are difficult to sell quickly without loss, whereas a large portion of their deposit liabilities consists of demand and other short-term deposits.

Banks thus have a much greater mismatch, in terms of both liquidity and duration, between their assets and their liabilities than do most nonfinancial firms. This mismatch makes banks particularly sensitive to abrupt, large withdrawals of funds (bank runs) that cannot be met in full and on time by the banks' cash holdings and thus may require the hurried sale of illiquid earning assets. As they are forced to liquidate these assets, banks may suffer fire-sale losses that exceed their small capital base, driving them into economic insolvency. The duration mismatch also exposes banks to interest rate risk, so that abrupt changes in interest rates can cause realized and unrealized losses that can quickly exceed their capital.

Besides the possible problem of the fragility of individual banks, the banking system as a whole is also seen as particularly fragile. The close interconnection among banks through interbank deposits and lending means that losses at any one bank may produce losses at other banks. Losses and insolvency can thus cascade throughout the banking system. Moreover, if depositors are unable to distinguish the financially healthy banks from the unhealthy ones, trouble at one or a few institutions can spread quickly throughout the system, as depositors withdraw funds indiscriminately from all banks regardless of their financial fundamentals. In the absence of offsetting actions by the central bank, a run from deposits into currency will drain reserves from the banking system, worsen fire-sale losses, increase bank failures, and cause a severe contraction of money and credit and macroeconomic instability.2 The loss of the banks' information and monitoring services may make it difficult to reestablish lending relationships in the wake of widespread bank failures, thereby slowing recovery (Bernanke, 1983).

2

When a bank run occurs in a small, open economy, depositors may flee from the domestic currency entirely, exchanging their deposits for foreign currency deposits abroad. Unless the central bank allows the domestic currency to be devalued, bank reserves also will be reduced, with similar results.

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Concerns about the fragility of banks and the banking system in the absence of a government safety net, however, may be overstated for three reasons. First, bank failures become potentially contagious only if losses at one bank exceed its capital by enough to produce losses at creditor banks that exceed their capital, forcing the latter into insolvency, and so on down the chain. If losses associated with individual insolvencies could be minimized, the likelihood of contagion or systemic risk would be greatly reduced. As we discuss below, when delays have occurred in responding to problems at banks, thereby allowing the banks to become deeply insolvent, the delays have been primarily due to regulatory, not market, failure (Benston and Kaufman, 1995a; Garcia, 1996; Kane, 1989; Kaufman, 1995; Krosznerand Strahan, 1996).

Second, before the establishment of the Federal Reserve System as a lender of last resort in the United States, the failure rate of U.S. banks was actually lower than that of nonfinancial firms. When banks did fail, depositors and other bank creditors suffered smaller losses than did the creditors of failed nonfinancial firms (Kaufman, 1996a). In addition, U.S. banks held higher capital-to-asset ratios before the introduction of safety net regulations than they have since. Recent international experience suggests that banks substitute government deposit insurance or public capital for private capital (Peltzman, 1970; Garcia, 1996; Kroszner and Strahan, 1996).

Again, the safety net may have had the unintended consequence of making banks more rather than less fragile.

Third, allowing banks to fail and depositors to lose money need not cause macroeconomic instability. Baer and Klingebiel (1995) examine in detail five historical episodes of such failures in developing and industrial countries and find little or no evidence of an adverse macroeconomic impact from imposing losses on depositors at insolvent institutions when this was done as part of a comprehensive government program in which only economically solvent and well-capitalized institutions were permitted to remain in operation.

Alternative Banking Structures: Meeting the Objectives How well do various alternative structures for banking systems achieve the broad objectives of stability and efficiency? In this section we examine this question by focusing on how different structures fulfill certain more specific goals that contribute toward these broader objectives.

The set of possible bank structures forms a continuum from so-called narrow banks to broad or universal banks (Cowen and Kroszner, 1990 and 1994; Kroszner, 1996a; Kroszner and Rajan, 1994 and 1996). The activities of narrow or "fail-safe" banks are strictly circumscribed: such banks are

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OPTIONS FOR FINANCIAL SYSTEM DESIGN

Larger losses are possible as permissible activities widen and assets become more volatile, but diversification can promote stability.

Broad

More potential, without privately chosen or mandated firewalls.

Banks are susceptible to credit control under implicit industrial policy.

Less potential, if bank is not part of a financial conglomerate.

Banks are susceptible to credit control through regulatory definition of "safe" assets.

Important role for banks, particularly in managing financially distressed companies.

No relationship to structure, except for 100 percent reserve banks, which offer the central bank total monetary control.

Avoidance of conflicts of interest Avoidance of political manipulation Corporate control

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Monetary control

Banks are more likely to try to stifle competition from new institutions and markets. Greater potential for "too big to fail" syndrome.

Less likely, if bank is not part of a financial conglomerate.

Avoidance of regulatory capture

Weak role for banks.

Higher concentration likely.

Less concentration likely, but greater segmentation of markets.

Few failures and low losses overall, but the effect of structure depends on the ability to monitor: if rules are credible and monitoring is largely independent of the riskiness of assets, there is no relationship between structure and stability. If risky assets are more difficult to monitor, losses may be greater for broader banks, which may require more sophisticated supervisors.

Less likely, particularly scope economies.

More likely to be realized.

Restrictions on bank portfolios lead to fewer bank failures and lower losses to depositors, but may not provide greater overall financial stability.

Narrow

Competition

Economies of scale and scope

With effective intervention and closure rules, when bank net worth is positive

Stability Without effective intervention and closure rules

Objective

Banking structure

Table 1. Relationship of Banking Structure to Financial System Objectives

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usually constrained to invest only in short-term, highly liquid assets with no or very low credit risk. The deposits of such a bank may be regarded as collateralized by its assets (Benston et al., 1989). In most versions, narrow banks are prohibited from making commercial and industrial loans, mortgage loans, or other "risky" loans. Instead these loans are made by finance companies or other institutions that do not take demand deposits, although in some proposals both types of institutions may be controlled by the same holding company. Narrow banks would accept demand deposits, participate in the payments system (e.g., by processing checks), and hold highgrade, short-term instruments, but would not be directly involved in any other aspect of financial services.3 At the other end of the spectrum, universal banks are financial supermarkets that offer a wide range of financial services: they accept both demand and time deposits, and may lend to all types of borrowers for any purpose, underwrite and trade securities, and provide insurance, brokerage and trust services. Universal banks may also own and operate nonfinancial firms and in turn be owned by such firms. Under this structure there would be little distinction between banking and commerce.

Banking structures in most countries lie somewhere between these two extremes. No country, for example, restricts banks to only high-quality, short-term assets. Among the industrial countries, the United States operates one of the narrowest banking regimes, and those of Germany and Switzerland are among the broadest.4 Each banking structure has its advantages and disadvantages in terms of meeting the objectives of efficiency and stability (Steinherr, 1996). Each of these broad goals has numerous components, which we now consider in turn. The relationship between the structure of banking and the different financial sector objectives is summarized in Table 1.

Stability and Fragility In principle, narrow banking regimes are designed to minimize the sources of the perceived fragility of banks and the banking system discussed above.

First, with the requirement that bank assets be highly liquid, the problem of liquidity mismatch and the attendant concerns of fire-sale losses largely disappear. Second, with banks restricted to holding only debt of high credit quality and short duration, the potential losses associated with credit and 3

Narrow banks, however, should not be confused with specialized banks, such as savings and loan associations in the United States, that also face asset and liability restrictions but may assume substantial credit or interest rate risk.

4 Summaries of the banking structures of major countries appear in Bisignano (1994) and Organization for Economic Cooperation and Development (1993).

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OPTIONS FOR FINANCIAL SYSTEM DESIGN

PART THREE • GEORGE G. KAUFMAN/RANDALL S. KROSZNER

interest rate risk are largely eliminated. Thus, a high degree of leverage poses little problem, since the low risk of bank assets generates little need for a large solvency cushion. Finally, given the asset and liability restrictions, depositors have little reason to shift funds from bank to bank, and banks themselves have little reason to borrow from or lend to each other.

With the potential for loss thus limited, problems at one institution are unlikely to cause problems at others.

In practice, however, a narrow banking regime may not enhance financial stability. Because narrow banks, by definition, cannot accommodate all demands for traditional banking services, provision of the unmet needs will be shifted to other institutions, which may be independent firms or affiliates of the narrow banks through common ownership (e.g., holding companies). These entities may be at least as risky as traditional banks, and their insolvency could involve similar negative externality problems.

In addition, given their asset restrictions, narrow banks are likely to be able to pay only very low interest rates on deposits. Other intermediaries will have an incentive to issue deposit-like liabilities offering higher returns. Should these instruments become widely accepted, few funds would remain in the narrow banks. Safely backed deposits then might constitute a very small part of the overall financial system. Risk would not be eliminated but simply shifted elsewhere. If there is a concern about the stability of issuers of close substitutes for deposits, a complex regulatory framework may be required to monitor these nonbank competitors of the narrow banks, even though supervision of the narrow banks themselves would be relatively straightforward.

The fact that universal banks are allowed to hold much riskier assets and to become involved in much riskier activities does not imply that they are necessarily less stable than narrow banks. The overall risk of an institution is determined not by the riskiness of its individual activities, but by the covariances, or statistical interrelationships, among those risks. Allowing banks to enter a broader range of activities can facilitate their diversification and so may lower their overall risk. On the other hand, universal banks are more closely interconnected than narrow banks with the rest of the financial system and with individual firms, so concerns about contagion may be greater.

Historical evidence from the United States suggests that banks involved in securities activities did lower their overall risk through diversification. Before the Glass-Steagall Act of 1933 separated commercial banks from investment banks and forbade the former from underwriting private securities, some banks engaged in a broad range of securities activities, yet had lower variance in their cash flows, lower likelihood of failure, and higher capital ratios than did banks that chose not to enter the securities

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arena (White, 1986). More recently, simulations of the variance of cash flows and probability of failure for combinations of commercial and investment banks, as well as insurance companies and other financial firms, have yielded less clear-cut results (Boyd, Graham, and Hewitt, 1993; Saunders and Walter, 1994; Benston and Kaufman, 1995b). Current international experience also provides a mixed picture. Germany and Switzerland, which have long had universal banking regimes, have had very little banking instability. Yet Spain, which has also granted broad scope to banks' activities, has experienced serious banking problems. The United States, which for decades has had one of the narrowest banking regimes, has experienced serious banking problems. As we discuss in detail below, instability and depositor losses may have more to do with a country's safety net regulations and bank resolution and other prudential intervention policies and procedures than with the structure of the banks themselves.

Economies of Scope Narrow banks are denied the opportunity to take advantage of scope economies in providing a variety of financial services simultaneously. One of the few studies of the costs to U.S. banks of separating deposit taking from lending estimated that, in the United States, any efficiency losses from narrow banking are quite small (Pulley and Humphrey, 1993). Yet the fact that no bank in the United States or elsewhere has voluntarily chosen to structure itself in this way clearly indicates that bankers perceive value in providing these services jointly. Even if the costs to the banks themselves are low, there could be efficiency losses to the financial system. This could occur if borrowers enjoy cost savings from dealing with credible commercial banks or other financial institutions that make loans and monitor them continuously, rather than issuing bonds in the public markets (Billett, Flannery and Garfinkel, 1995; James, 1987;LummerandMcConnell, 1989; Preece and Mullineaux, 1994).

Universal banks, on the other hand, have the greatest opportunity to realize economies of scope. They may be efficient at providing a basket of financial services, allowing customers the convenience of "one-stop shopping." The close relationships that these banks develop with borrowing firms may minimize monitoring costs both for themselves and for the firms, making financial intermediation more efficient and reducing credit constraints on the firms. Economists, however, have not been able to find strong evidence of the existence of such scope economies in universal banks (Saunders and Walter, 1994).

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PART THREE • GEORGE G. KAUFMAN/RANDALL S. KROSZNER

Restricting the activities of commercial banks and fragmenting the financial system generally results in less concentration in the financial sector.

Although this may come at the cost of scale and scope efficiencies, as discussed above, it may bring the benefit of a lower likelihood of regulatory "capture:" large banks that dominate their industry can often manipulate regulation to serve their own rather than the public interest (Kroszner, 1996a, 1997a and 1997b). Some argue that the German financial system is one of the most protected and least competitive of any major industrial nation. German universal banks not only dominate banking but, through their relationship with the Bundesbank (Germany's central bank) and the other financial regulators, also appear to have hobbled the growth of the market for commercial paper (short-term, publicly issued corporate debt) as well as the broader equity and debt markets.

A possible silver lining in the cloud of the Glass-Steagall Act is that a rich set of alternative financial services providers and contractual innovations—from leveraged buyouts to venture capital firms and organized debt and equity markets—have been able to flourish in the United States, competing with the banks not only in the marketplace but also in the regulatory arena (Kroszner, 1996a). In countries with broad banks, financial institutions and markets not controlled by banks tend to be less developed (Prowse, 1996). As Table 2 illustrates, German firms in 1985 obtained 88 percent of their external funding from banks and only 6 percent through bond issues. In contrast, U.S. firms received only 36 percent of their external funding from banks but more than half from bond issues. Although regulatory capture is by no means a necessary side effect of universal banking, there does appear to be a high correlation. Special attention thus should be paid to the connection between government and the banks in a universal banking regime.

By protecting banks from competition, regulators may create or help to enforce a banking cartel that generates a stream of economic rents, or excess profits, for the cartel members. To avoid losing these excess profits, banks may choose a lower risk profile, for example by maintaining a higher capital ratio or making safer loans, than they would in a competitive environment (Keeley, 1990). Protective regulation thus could lead banks to be more stable, and this may account in part for the stability of universal banking regimes in Germany and Switzerland. Such stability, however, comes at the cost of monopoly profits and inefficiency in the financial system. In addition, regulatory capture by large and politically powerful broad banks may increase the likelihood of a "too big to fail" syndrome emerging, in which the imminent collapse of a major bank is perceived as

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Competition, Concentration and Regulatory Capture

OPTIONS FOR FINANCIAL SYSTEM DESIGN

107

Credit source Securities Intermediated debt Total From banks

United States

Japan

Germany

55

9

6

45 36

91 na

94 88

Note: Credit market debt excludes trade debt. Securities include commercial paper, other short-term bills, and long-term bonds. Intermediated debt consists of loans from financial intermediaries.

Source: Prowse (1996), p. 6.

threatening broader disruption and forces the government to bail out the bank's depositors and possibly even its shareholders.

Political Manipulation Just as banks may capture the regulatory system and use it to their own benefit, so too politicians and government officials may manipulate financial regulation for their own political ends. An example is the capital standards set out in the Basel Capital Accord. These standards assign values to classes of bank assets according to their riskiness; these values are then used as weights in calculating bank capital-to-asset ratios. Because the Accord defines the central government debt of major industrial countries as riskless, banks can reduce the amount of equity capital they must maintain by holding more government debt. This clearly provides a strong incentive for commercial banks to hold such debt, which in turn lowers the cost to governments of issuing it.

Narrow banks may be subject to a similar form of manipulation, in that regulators or legislators determine which assets are "safe" and thus eligible for these banks to hold. The temptation may be strong to define safety according to political and social rather than strictly prudential criteria. Narrow banks thus could become instruments for government credit allocation. Broader banks may also be subject to such manipulation. The government may encourage, explicitly subsidize, or mandate broad banks to allocate credit to targeted firms or sectors or to provide services at below-market prices to targeted groups.

Conflicts of Interest The more narrowly restricted a bank's set of activities, the fewer the opportunities for conflicts of interest in the bank's services to its customers. Such

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Table 2. Composition of Companies' Credit Market Debt, 1985 (Percent of total)

PART THREE • GEORGE G. KAUFMAN/RANDALL S. KROSZNER

conflicts may arise even for narrow banks, however, when they are part of a larger financial conglomerate. A narrow banking regime thus does not necessarily minimize potential conflicts.

The diverse activities of universal banks, on the other hand, present many potential conflicts of interest. Suppose, for example, a borrowing firm suffers an adverse shock to its earnings that makes repayment of its bank loans doubtful. Its bank may then have an incentive to underwrite a public stock or bond issue for the firm, but without adequately disclosing the firm's troubles to the public, so that the firm can use the proceeds to repay the loan. Although such conflicts are possible in theory, historical data from the United States suggest that commercial banks did not succumb to them when they were permitted to engage more fully in securities underwriting (Benston, 1990; Kroszner and Rajan, 1994).

Competition generally leads universal banks to adopt safeguards and structures to minimize the conflicts that may arise when the same entity can both lend to firms and sell the securities of those firms to the public.

Before such activities were regulated in the United States, for example, competitive pressures led banks voluntarily to set up separately incorporated and capitalized subsidiaries with distinct boards of directors for securities underwriting (Kroszner and Rajan, 1996). More recently, as the long-protected German financial system has begun to be opened to competition, Deutsche Bank (the country's largest commercial bank) has moved its investment banking operations out of Frankfurt and into its Morgan Grenfell subsidiary in London.

Another potential conflict of interest under a universal banking regime is the tying of products or services. A bank may require as a condition of a loan, for example, that the borrower purchase another service from it or an affiliated company that the borrower might otherwise not wish to buy, or might not wish to buy at the price offered. This ability to force tiein sales generally can arise only when the bank has some degree of monopoly power in at least one of the product or service markets. Moreover, if a narrow bank is affiliated with a larger holding company, the potential for forced tie-in sales may not be greatly different than in universal banks.

Corporate Control and Management of Financial Distress Because they usually cannot take equity stakes in other firms or become directly involved in firm management, narrow banks—even those that are free to make business loans—may not be able to play a large role in corporate control or in the management of companies experiencing financial distress. In the United States, it is not only the prohibition against bank equity ownership (except in special situations) but also the courts' inter-

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pretation of the bankruptcy statutes that affects banks' governance role.

Under the legal doctrine of "equitable subordination," banks that become actively involved in the management of a firm trying to avoid bankruptcy lose the priority of their loans to that firm should bankruptcy occur—their claims are downgraded to the level of equity holders.

In contrast, large banks in Japan that are at the center of large business groups may own equity in nonfinancial firms and become actively involved in assisting firms threatened with bankruptcy. They often replace existing management with their own officers, write new business plans, take a larger equity stake, and negotiate with the firm's other creditors on its behalf (Hoshi, Kashyap and Scharfstein, 1990; Sheard, 1994). In Germany, directors of universal banks typically sit on the "supervisory" boards of the firms in which they have stakes and take part in management on an ongoing basis, becoming especially active when the firm is in financial distress. On the other hand, more recent experience in both countries suggests that these arrangements have worked less well in practice than in theory.

When the contract enforcement system, including the bankruptcy laws, is unstable or very costly and slow to use, a universal bank has more flexibility than a narrow bank to ensure repayment. Since a universal bank may own equity and take an active role in management, it is better able to develop an ongoing relationship with the enterprise. Repeat dealing then may be able to substitute at least partially for third-party contract enforcement (Klein and Leffler, 1981; Shapiro, 1983; Kroszner and Stratmann, 1996). An uncertain or inefficient bankruptcy system can disrupt intermediation or, for that matter, any lending process. The system of corporate law and bankruptcy thus affects the role of banks in corporate governance, and hence has an influence on the choice of bank structure.5 Monetary Control The organizational structure of banking may also affect the degree of monetary control enjoyed by the central bank. Monetary policy generally involves adjusting the money supply by changing the quantity of reserves in the banking system, the required cash reserve ratio, or the rate charged by the central bank for discount loans. In a fractional reserve system, however, banks exercise an independent influence on the supply of money and credit through their choice of what level of cash reserves, if any, to hold in excess of the required minimum. Changes in excess reserves are mirrored directly in the amount of a bank's total assets that it invests in earning 5

For an analysis of which corporate governance system banks should adopt for themselves, addressing the question of "who monitors the monitors," see Kroszner (1996b).

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OPTIONS FOR FINANCIAL SYSTEM DESIGN

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assets rather than in cash. This ability of banks to change their quantity of excess reserves weakens, or at least complicates, the central bank's control over monetary policy.

One way to eliminate the banking system's independent influence on monetary policy would be to prohibit banks from holding any noncash assets—that is, to require 100 percent reserves (Simons, 1948; Friedman, 1960). Every change in the quantity of reserves initiated by the central bank would then be reflected in an equal change in bank deposits and the money supply. Nor could the public affect the money supply by choosing to hold more currency and less bank deposits, or vice versa. The central bank thus would exercise complete monetary control.

One hundred percent reserve banking would represent an extreme form of narrow banking. Banks would simply become warehouses for holding and transferring cash. Such banks would have low costs, and risks would be restricted primarily to operating risk and fraud. Since they could earn little if any interest, banks would be likely to impose service charges and pay no interest on deposits in order to earn a competitive return. Such restrictions would lead to a high demand for deposit substitutes, encouraging, as in the scenario described above, an end run around the banks, leaving them with few deposits.6 To increase the viability of narrow banks, most such regimes allow them to invest in relatively riskless earning assets. Then, however, the banks are no longer 100 percent reserve banks, because their cash reserves become smaller than their assets. All of the central bank's monetary control problems due to fractional reserve banking return. Once banks are permitted to invest in any type of earning assets, other than cash or reserves at the central bank, the loss of total control by the central bank is independent of how narrowly the banks' range of activities is restricted.

Interaction of the Banking Structure and the Safety Net All countries have, in effect, placed either an explicit or an implicit safety net under their banks and, in some instances, under their entire financial system. The elements of the safety net vary from country to country but generally include explicit or implicit deposit insurance and a lender-oflast-resort role for the central bank. In some countries they also include 6

An alternative, more radical variation on 100 percent reserve banking would be pure mutual fund banking, in which the deposit contract would be an equity claim, not a debt claim, on the bank's portfolio. The value of such contracts would then vary with the performance of the underlying portfolio, rather than remain constant. These would effectively be 100 percent capital banks. For more on the viability and stability of mutual fund banks and their consequences for monetary control, see Cowen and Kroszner( 1990).

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central bank guarantee of all payments system settlements among banks. In this section we analyze how the moral hazard created by deposit insurance can be reduced and the implications for alternative banking structures.

In principle, safety net measures could increase the stability of financial systems; in practice, however, it has proved difficult to design a safety net that does not undermine both efficiency and stability. Improperly designed safety nets may encourage behavior by both the insured banks and their regulators that, over time, is likely to prove far costlier than the benefits they may generate. As has been clearly demonstrated in almost all countries in recent years, poorly designed and implemented deposit insurance schemes, for example, have greatly reduced the discipline exerted on banks by depositors and thereby encouraged banks to engage in moral hazard behavior, both through assuming greater exposure to credit and interest rate risk in their asset and liability portfolios and through maintaining lower capital ratios. Insured depositors have little incentive to punish risky, distressed, or insolvent institutions with withdrawals, or to reward safe and sound institutions with deposits. Rojas-Suarez and Weisbrod (1996), for example, found that risky banks in Mexico expanded much faster during the years preceding that country's devaluation crisis (1991-94) than did the safer banks. This pattern suggests that depositors were willing to place funds in the weaker but insured banks that later failed. Mexico's experience in this regard mirrors that in other countries, including the United States in the 1980s.

By short-circuiting market discipline, deposit insurance also allows bank regulators to delay the imposition of sanctions on troubled banks and to permit even economically insolvent institutions to continue to operate, in the hope that the problems will resolve themselves with time. When they do not, the costs of such regulatory forbearance can be very large (Barth and Brumbaugh, 1994; Kane and Yu, 1994; Kaufman, 1995; Kroszner and Strahan, 1996).

Without deposit insurance, insolvent banks could not stay in business long. Banks in which depositors have little confidence, or that receive poor marks from independent private rating agencies, would have to offer higher interest rates to retain deposits. Otherwise, withdrawals by informed depositors might force troubled banks to sell assets quickly and perhaps experience fire-sale losses. Banks that could no longer satisfy depositors' demands in full and on time would suspend operations or close, either voluntarily or at the order of their regulators. In addition, without the strong "heads I win, tails you lose" character of the safety net, bank owners might have chosen a different initial risk profile for the bank. As noted above, prior to the introduction of lender-of-last-resort policies in the United States, bank failure and loss rates were lower than those for nonfinancial firms.

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The moral hazard problems associated with the safety net are not unique but exist in many market contexts, so it is valuable to understand how the market deals with such problems when left to itself. Tension exists, for example, between equity holders and debtholders in any firm, but particularly in one experiencing financial distress (Jensen and Meckling, 1976). The two groups of claimants have different payoff functions. Equity holders participate fully in the gains of risky gambles that succeed, but debtholders receive only predetermined interest and principal payments.

With limited liability, shareholders are not liable for losses greater than their equity stake. Because losses are first charged against capital, a negative shock to the firm's earnings or assets reduces the market value of the equity holders' investment. This shock then increases the equity holders' incentive to increase the firm's risk profile, since they now have little to lose yet will still reap the greater part of any gains. In contrast, debtholders simply want to protect the value of the debt and will therefore be averse to increases in risk. The equity holders in effect seek to play "heads I win, tails you lose" with the debtholders' money, paralleling the moral hazard problem of insured banks gambling with taxpayers' money.

Private markets address this problem through debt covenants, which tend to prevent rather than provide forbearance for excessive risk taking (Kroszner and Strahan, 1996). Debt covenants are explicit provisions in debt contracts that restrict the borrower's ability to take additional risks.

Banks themselves often include such provisions in their loan agreements with firms. These covenants are triggered as soon as earnings or capital fall below, or leverage rises above, a prespecified level. Some covenants allow the debtholders to seize control of the firm when the firm experiences financial distress. Covenants thus prevent a distressed firm from continuing to operate as it had before and attempt to prevent it from increasing its risk exposure.

When there is explicit or implicit government deposit insurance, regulatory discipline should be structured to mimic the way in which the market deals with moral hazard (Benston and Kaufman, 1988; Kroszner and Strahan, 1996). Rather than permit regulatory forbearance, governments should require that regulators follow clearly defined practices to restrict the risk-taking activities of banks experiencing financial distress, and to resolve bank problems through recapitalization, takeover, or liquidation before the bank is permitted to become deeply insolvent. In a manner that parallels private debt covenants, intervention by the regulators could be conditioned on capital ratios or other performance and solvency measures falling below some threshold. Such regulatory discipline would prevent depositor (and taxpayer) losses at individual institutions from mushrooming and possibly causing systemwide problems.

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A deposit insurance system with an effective and credible set of rules for intervention and, if this is unsuccessful in preventing further deterioration, bank closure before the bank's capital is fully depleted, can mitigate its moral hazard problems. Because these rules would lower the losses to the deposit insurance agency, deposit insurance premia could then be reduced. It may be desirable to scale the premium for each insured institution according to the agency's difficulties in monitoring its economic condition. Difficulty in monitoring serves as an indicator of the risk a particular bank represents to the insurance fund by not being able to resolve the institutions in a timely manner before losses become large.

The same intervention and closure rules could be equally effective for all banking structures, narrow or broad. Only the level of the capital ratio that triggers intervention would need to vary with the regime, depending on the ability to mark assets and liabilities (both on- and off-balance sheet) to market, the ability of the regulators to monitor banks and the frequency of that monitoring, and the probability of abrupt, large changes in net worth. The more difficult monitoring is, and the higher the probability of sudden, large changes, the higher would need to be the threshold capital ratio, particularly for resolution. To the extent that these rules are effective, and banks are resolved before their capital is depleted, losses would be limited to bank shareholders. Since there would be no losses to depositors, deposit insurance would be redundant. In effect, all of the bank's deposits would be collateralized by assets of at least equal market value, regardless of the types of assets permitted.

To some extent, private markets already impose such discipline by requiring higher capital ratios for broader than for narrower banks to provide a greater cushion against insolvency. The broader the bank and the more difficult it is to monitor, the higher should be the critical capital ratios for intervention and closure. Restrictions on a bank's activities should increase as its capital or other performance measures decline. In effect, the system would force a broad bank to become narrower as its capital declines; in other words, the bank's permitted structure would depend upon the level of capital it maintains.

An effective and credible set of intervention and closure rules would allow the stability of the banking system to be largely independent of its structure. These rules would thus reduce the likelihood of special treatment for banks deemed "too big to fail." To be effective, the closure rule must be explicit and applied consistently. If banks are owned by nonbanks, they (or any activities subject to the rule) would need to be organized as separately capitalized subsidiaries. If, vice versa, banks are allowed to own nonbanks, the nonbanks would need to be subject to the same capital rules or subject to market-determined capitalization as separate bank subsidiaries.

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Two additional key aspects about the intervention and closure rules should be noted. First, the probability of a bank's capital declining below the critical capital ratio, and even imposing losses on depositors and other creditors, depends less on the riskiness of the bank's assets than on the regulatory agency's ability to monitor the current market value of those assets and on the agency's willingness to intervene. Second, any capital that remains in a bank after it is resolved by the agency is returned to the initial shareholders. There should be no expropriation of private capital. If shareholders believe that regulators may deplete existing capital more than necessary in a resolution, they may have an incentive to recapitalize solvent institutions before their capital threatens to fall below the critical threshold. Concerns about arbitrary expropriation, however, would lead to little willingness to invest in banks at all.

The values of the capital ratios that should trigger intervention and closure may be expected to differ from country to country, depending, among other things, on the degree of macroeconomic instability, the liquidity of financial markets, and the sophistication of bankers and regulatory agencies. Estimating the appropriate values is difficult, but indirect estimates may be obtained from observing the capital ratios maintained by firms (such as finance companies) that compete with the banks in the same country but are neither explicitly nor implicitly insured. The capital ratios of such firms are driven by the marketplace and can, as a first approximation, be used for insured banks.7 The Federal Deposit Insurance Corporation Improvement Act of 1991 in the United States provides an example of how such intervention and closure rules might be structured.

Finally, such rules can be credible and effective only in a banking system in which the capital of individual banks, including any state-owned or state-operated banks, is already equal to or above the critical closure ratio. Otherwise the rule is violated at the start. If not all banks are solvent, a country can still introduce a closure rule, but with a specified transition period during which the critical capital ratio is progressively increased from a negative to a positive value. Such a program, however, requires a concurrent program for recapitalizing or otherwise resolving the insolvent banks (Kaufman, 1997).

7

Other aspects of deposit insurance schemes that are based on effective regulatory closure, including the appropriate insurance coverage and regulatory sanctions designed to prevent banks from sinking abruptiy to the closure threshold, are discussed in Benston and Kaufman (1988) and Kaufman (1995 and 1996b).

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This chapter has analyzed the consequences of alternative financial structures for the twin objectives of financial efficiency and stability. The alternative structures examined range from narrow to broad or universal banks.

Each presents advantages and disadvantages for the efficiency and stability of the financial system.

Which structure will prove more beneficial for a particular country or region depends upon the context in which it will operate. The state of development and competitiveness of domestic financial markets, the system of corporate law and governance, the system of contract enforcement and bankruptcy, the sophistication of bankers and their regulators, the extent of political connections between these institutions and the government, and the susceptibility of the economy to domestic and international economic shocks are all crucial in determining what structure is most appropriate. Because financial structures are interlinked with these other factors and evolve simultaneously with them, structural reform should be tailored to the country's initial conditions with respect to these factors.

Countries with relatively narrow banks and relatively well developed securities markets may wish to introduce measures to broaden the powers of their banks, but not to the point of encouraging monopoly pricing or regulatory capture. Countries with weak bankruptcy laws and contract enforcement systems may also wish to encourage broad banks. On the other hand, countries where banks have been able to retard the development of financial markets and alternative financial institutions may wish to curtail the power of broad banks to impede the establishment and growth of competitors. No single structural reform, however, guarantees that the objectives will be attained, or that they will be maintained over time. Financial sector reforms should not lock in one particular structure, but should through time allow alternative forms to emerge as the underlying economic and political conditions change.

One of the most important factors that shapes and is shaped by the organization of financial institutions is the existing regulatory system, and in particular the presence or absence of an implicit or explicit safety net.

Since the banking system is heavily regulated in most countries, the regulatory system and the incentives it generates often affect financial efficiency and stability more than does the country's banking structure. As discussed above, safety net measures such as deposit insurance have in practice tended to reduce rather than promote stability and have tended not to enhance efficiency. Design of the safety net is thus of primary importance and greatly determines the choice of the appropriate financial structure.

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Concluding Remarks and Recommendations

PART THREE • GEORGE G. KAUFMAN/RANDALL S. KROSZNER

Because explicit or implicit deposit insurance is likely to generate moral hazard problems, regulatory discipline should imitate as closely as possible the ways in which the market deals with these problems. A structure of regulation that commits the regulators to a credible set of intervention and closure rules parallel to those found in private debt covenants would be an important step in this direction. With fewer distortions from the regulatory system, the structure of banks would be determined endogenously, by market forces; for example, private debt covenants rather than regulators would force broader banks to become narrower as their performance and capital decline. The more regulatory forces come to resemble market forces, the more will the characteristics of the country and its institutions and markets themselves determine the most efficient and stable form for financial structure to take.

George G. Kaufman is John J. Smith, Jr. Professor of Finance and Economics and Director of the Center for Financial and Policy Studies at Loyola University, Chicago. Randall S. Kroszner is Associate Professor of Business Economics at the Graduate School of Business, University of Chicago. Both authors are consultants to the Board of Governors of the Federal Reserve System.

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Baer, Herbert, and Daniela Klingebiel. 1995. Systemic Risk When Depositors Bear Losses. In George G. Kaufman, ed., Research in Financial Services, vol. 7, pp. 195-302. Greenwich, CT: JAI Press.

Earth, James R., and R. Dan Brumbaugh, Jr. 1994. Moral-Hazard and Agency Problems: Understanding Depository Institution Failure Costs.

In George G. Kaufman, ed., Research in Financial Services, vol. 6, pp.

61-102. Greenwich, CT: JAI Press.

Benston, George. 1990. The Separation of Commercial and Investment Banking. New York: Oxford University Press.

Benston, George J., R. Dan Brumbaugh, Jr., Jack M. Guttentag, Richard J. Herring, George G. Kaufman, Robert E. Litan, and Kenneth E. Scott.

1989. Blueprint for Restructuring America's Financial Institutions.

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Benston, George, and George Kaufman. 1988. Risk and Solvency Regulation of Depositor Institutions: Past Policies and Current Options. New York: Salomon Brothers Center, Graduate School of Business, New York University. . 1995a. Is the Banking and Payments System Fragile? Journal of Financial Services Research 9: 209- 40. . 1995b. Commercial Banking and Securities Activities: A Survey or Risks and Returns. Washington, D.C.: American Bankers Association.

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Bisignano, Joseph R. 1994. The Ownership and Control Linkages Between Banking and Industry. In George G. Kaufman, ed., Research in Financial Services, vol. 6, pp. 1-60. Greenwich, CT: JAI Press.

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In Masahiko Aoki and Hugh Patrick, eds., The Japanese Main Bank System, pp. 188-230. New York: Oxford University Press.

Simons, Henry. 1948. Economic Policy for a Free Society. Chicago: University of Chicago Press.

Steinherr, Alfred. 1996. Performance of Universal Banks. In Anthony Saunders and Ingo Walter, eds., Universal Banking, pp. 2-30. Chicago: Irwin Professional Publishing.

Stigler, George. 1971. The Theory of Economic Regulation. Bell Journal of Economics and Management Science 2: 243-64.

White, Eugene. 1986. Before the Glass-Steagall Act: An Analysis of the Investment Banking Activities of National Banks. Explorations in Economic History 23: 33-55.

World Bank. 1989. World Development Report 1989: Financial Systems and Development. New York: Oxford University Press.

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Brian Quinn I found the chapter by Kaufman and Kroszner stimulating, promising, puzzling and disappointing, in that order. That may sound more critical than intended, so let me explain what I mean by each of those judgments.

First, it was stimulating to read a chapter that proceeds from first principles. Rather than jump to conclusions about particular policy issues, the chapter starts, correctly in my view, by analyzing the role of financial institutions in general, and of banks in particular. I wish more commentators would follow this approach; too often they make assumptions that may be appropriate for more developed market economies but do not necessarily hold for countries at an earlier stage of economic and financial development. Starting at the beginning helps avoid that problem.

The abundance of evidence gathered by the authors concerning many of the issues they raise was also most helpful. I expected nothing less from two distinguished academics, but it is nonetheless impressive to see each step in the analysis supported by references to academic research. And although I am sure they have firmly contrary views on many of the arguments that they report, they present those arguments and express their own opinions in moderate language and with admirable self-restraint.

I also found a good deal in the chapter with which I could agree. For example, the authors note that the design of financial institutions cannot be considered apart from a wide range of factors that vary from country to country, and that financial structures are dynamic and evolve over time, influencing and being influenced by all the other forces at work in a developing economy. That must surely be true, as it must also be correct to deduce that there is no unique model of financial structure that will ensure stability and efficiency in the financial system. It also needs saying, as Kaufman and Kroszner do, that banks as well as other nonfinancial firms must be allowed to fail if the financial sector is to be healthy and dynamic.

Refusal to accept this precept has led to dangerous and unrealizable expectations of what the public authorities can do, to say nothing of the additional inefficiencies that too often follow bank failures in the form of further legislation and regulation. The acknowledgment that bank failure must sometimes be allowed could help developing countries avoid some of the mistakes and the significant unnecessary costs that other, more developed countries have incurred.

What I found promising in the chapter lies in the statement that it would analyze the impact that the organizational structures of financial institutions have on achieving the goals of high performance and stability

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PART THREE • BRIAN QUINN

in the financial sector; and that the authors would, by exploring how different combinations of such institutional factors can best achieve these goals, offer a framework for understanding the effects of alternative structures in countries with different economic, regulatory, and political characteristics. This is pretty exciting stuff and I read on eagerly.

The chapter proceeds by analyzing the relative strengths and weaknesses of narrow banks and of broad or universal banks. This is done on the whole in a balanced and fair-minded way, although I do not agree with several of the conclusions reached. For example, to assert that the Basel Capital Accord has been used by politicians and government officials to manipulate the financial sector for political ends is, to my mind, puzzling and incorrect. In its original form, the Accord addressed only credit risk, but it has since been extended to incorporate market risk, with claims on government debt carrying well-defined capital charges. The increased holdings by U.S. and U.K. banks of claims on governments after the introduction of the original Accord is fairly easily explained by the economic cycle in both countries. I am confident that the same would hold true for other countries that adopted the Accord.

Nor, as a former regulator, do I accept it as demonstrated that "in almost all countries in recent years, poorly designed and implemented deposit insurance schemes...have...encouraged banks to engage in moral hazard behavior." I can think of several countries, such as Germany, where depositor protection schemes have been generous by any standard, but bank failures have not been common, as well as countries, including the United Kingdom, where deposit protection schemes have been quite limited, but bank failures or substantial bank losses due to bad lending have nevertheless taken place.

The authors conclude that public safety net arrangements generate instability and inefficiency in the financial system and can swamp the effect of different financial structures through their distortive effect on behavior. The solution they offer is a regulatory regime that mimics market forces as far as possible and so permits an optimal form of financial structure to emerge. This conclusion seems somewhat at odds with the authors' earlier, fairly moderate statements for several reasons. First, the regulatory regime they recommend strikes me as very close to what banking regulators in many countries already do. Second, the authors give little guidance as to what mix of regulation and deposit insurance might be most suitable.

(These are complementary and not alternative elements of the regulatory package.) Third, do the authors really wish to suggest that all that is needed for countries seeking a financial structure that delivers efficiency and stability is to get rid of the safety net, permit market forces to operate freely, and allow an optimal structure to emerge? Perhaps I have misunderstood.

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If not, I fear that the authors' preoccupation with the damage that safety nets may cause amounts to letting the tail wag the dog.

My sense of disappointment, therefore, derives from a sense that the chapter does not go nearly far enough in helping Latin American policymakers understand how to arrive at a financial structure that suits their particular situation. I do not find it at all plausible that each country, with its unique mix of corporate law, contract enforcement and bankruptcy law, susceptibility to economic shocks, and so on, merely has to sit back and let market forces produce an optimal financial structure.

The basis of the analysis for supporting such a conclusion also strikes me as rather narrow. The analysis deals only with banking structures and offers no guidance on whether and how capital markets should be encouraged or permitted in countries where savers are growing in number and sophistication. How, for example, do fledgling capital markets cope with large, volatile external capital flows? Is the Chilean model of compulsory national saving a helpful model to consider or not? It is certainly not the spontaneous creation of a free financial market at work. Do insurance companies have an important role to play in encouraging saving and investment? Should governments permit the formation of financial or mixedactivity conglomerates, and if so, at what stage of development and with what safeguards for depositors and investors? Even on the question of banking structures, no consideration is given to the role of nationalized banks, which is of considerable importance in many Latin American countries.

Nor are the arguments for and against bank holding companies examined.

I agree with the authors that building an efficient and stable financial system involves dealing simultaneously with a large number of different social, political and economic factors. But the problem might be reduced to more manageable proportions if one were to set out some of the current defining characteristics of Latin American countries in order to see where governments should direct their efforts. For example, my impression is that many Latin American countries are overbanked. Consolidation of banking systems is a difficult task better off managed rather than left to the market to resolve by means of bank failures, whose repercussions can be long-lasting and devastating for depositor confidence. Poor credit procedures seem a fairly common feature of Latin American banks.

This may be tackled more directly with a little help from their friends.

Asking and answering all the right questions calls for more knowledge of these economies than I can claim. But it is surely the way to proceed.

Brian Quinn is a former Executive Director of Supervision and Surveillance at the Bank of England, and former Chairman of the Supervisory Subcommittee of the European Monetary Institute.

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Richard Lang

I found only two minor points in the excellent chapter by Kaufman and Kroszner that I might question. The first is their reference to duration mismatches being a natural part of banking. This is certainly true with respect to maturity mismatches, but it need not be the case with respect to interest rate mismatches, if loans are made on a floating rate basis. The second is whether giving a zero risk weight to the obligations of industrial country governments constitutes manipulation of the system for political ends. It seems entirely appropriate that sound government paper should receive a very low credit risk weight. Government bonds do have some interest rate risk, but this is accounted for by having the market risk regime place a higher capital charge on long-dated bonds.

We in New Zealand have attempted to deal with some of the broader issues raised by the authors in a variety of ways. With regard to entry requirements for foreign banks, New Zealand sets a moderately high hurdle based primarily on the would-be entrant's reputation and standing. We welcome large, reputable international banks, and we set no limits on the level of foreign equity in subsidiaries.

Bank supervision is built around extensive public disclosure, with significant penalties for bank directors and managers who provide false or misleading information. We have relatively few rules on what a bank must do, or on what it may or may not do. As a result, banks in New Zealand tend to be broad-based institutions engaged in a variety of financial activities. There is no system of deposit insurance and no explicit government guarantee of deposits, and we do not undertake any detailed on-site inspections. Supervision is directed primarily at system stability. When a bank falls below its minimum capital requirement, we have a flexible but transparent process for dealing with it.

New Zealand's welcoming attitude to large, reputable international banks has resulted in the bulk of the banking system now being foreignowned. We do not see this as an undesirable situation. Large international banks bring the latest technology, and their presence ensures a high level of competitive efficiency. Also, the spread of ownership over a number of countries means that the domestic banking sector is less open to contagion if one bank fails. Unlike in most countries, there is no strong public constituency in New Zealand for local ownership and control of banks. However, because of the relatively high entry hurdle, it is quite difficult for small local nonbanks to acquire the status of a registered bank.

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New Zealand's public disclosure regime, in effect, requires banks to publish quarterly all of the same information that they must provide to the supervisor. This includes information covering overall financial condition, asset quality, market risk, risk management policies, and large exposures.

Every second quarter this information is subject to external audit. The information disclosed also must include details of the bank's credit rating and any changes to that rating. All of the bank's directors are required to attest both to the accuracy of the information and to their own satisfaction that the bank has an adequate system of internal controls. As I mentioned earlier, there are significant penalties for false or misleading declarations.

Once a bank has been registered, New Zealand sets few formal constraints on its activities other than a general requirement for prudent management and compliance with the disclosure regime. Beyond that, we require a minimum 8 percent capital ratio, in line with the standard Basel framework; we have limits on the level of exposure to connected parties; and we require banks to have some directors who are not also managers of the bank.

We do not place limits on large exposures or open foreign exchange positions, and we have no minimum liquidity ratios. However, banks' internal policies on all of these matters, as well as their actual peak and endof-quarter levels, must be publicly disclosed in their quarterly statements.

We do not restrict banks from taking equity interests in nonbanks.

We do not require banks to lend minimum amounts in specific regions or to minorities, nor do we impose any interest rate controls on banks. As we see it, public policy on income redistribution should be implemented directly and overtly, and not by imposing noncommercial activities on banks.

We believe that New Zealand's regime offers several advantages over what might be described as the standard supervisory framework. The first is that it is less costly and intrusive: it maximizes efficiency by not excessively and needlessly constraining bank activities or attempting to turn them into social welfare agencies. A second advantage is that the regime limits the moral hazard facing the supervisor by more clearly placing responsibility for prudent management where it belongs, namely, on the directors and management of the banks. A third is that it allows depositors to monitor the condition of banks and considerably lessens the perception that the government is underwriting their prudential soundness. Finally, New Zealand's regime utilizes market discipline as the principal means of promoting stability in the system.

Of course, no banking regime is ever perfect, and New Zealand's has certain features that some see as weaknesses. First, it relies fairly heavily on accurate public reporting by directors, managers, and auditors. However, whether or not costly on-site official inspections are superior is a matter

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PART THREE • RICHARD LANG

of opinion. Second, it relies on the skills of financial commentators and rating agencies to bring potential problems to the public's attention. Third, transparency can be a two-edged sword: problems quickly become public knowledge, so that a bank in difficulty has little time to work its way out.

Fourth, public information about the condition of foreign parent banks is, regrettably, often scarce and subject to delays. On balance, however, from our perspective the advantages of the present system well outweigh its disadvantages.

What happens when a bank falls below its minimum capital adequacy requirement? Because banks must publish detailed information each quarter, including information on capital ratios, any breach of the minimum requirements is inevitably made public within that time frame. As supervisor, the central bank has no power to allow a bank to delay disclosure. In fact, as soon as the bank determines that it may have breached its minimum capital requirement, it is required to report that fact to the central bank. It must then agree with the central bank on a plan for remedying the situation. The central bank has stated publicly that it will normally expect such a plan to include a moratorium on distributions to bank shareholders, as well as constraints on and, preferably, reductions in its exposure to connected parties. The plan must then be published no later than with the bank's next quarterly statement.

The essence of New Zealand's policy toward breaches of capital requirements is that, except during a very limited period, any forbearance granted must be transparent and publicly credible. The format and timing of any proposed recovery plan are not fixed, but obviously it has to be publicly credible or the bank will quickly fail. We believe that this approach encompasses appropriate discipline on all parties. There is no scope for delaying and hoping for the best, and regulators must publicly account for any forbearance.

To conclude, I endorse the authors' comment that the answer to the question of which structures are the most beneficial depends on the context in which those structures operate. None of us has the option of starting with a blank sheet of paper and designing the ideal system. Instead we must begin with existing structures, public attitudes, and vested interests.

There is no perfect answer. As we see it, however, New Zealand's approach imposes less costs, both directly and in terms of efficiency, and is arguably no less effective than most options put in practice by other countries.

Richard Lang is Deputy Governor of the Reserve Bank of New Zealand.

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Toyoo Gyohten

My observations are based on my experience as a former banking administrator and bank chairman in Japan. As anyone familiar with Japan's recent financial history can imagine, that experience is not entirely without regrets. The roots of the current problems in the Japanese banking system lie deep. When the Japanese economy was recovering from its wartime damage and trying to catch up with America and Europe, Japan's financial institutions, both public and private, were rebuilt with the urgent aim of mobilizing domestic savings and channeling those savings to the economy's productive sectors. In addition to 1,050 private banks, 50,000 post offices and farmers' cooperatives collected savings from every corner of the country. Many specialized government banks were established to channel those savings to particular industries. We saw it as essential for the success of this mobilization effort to protect the millions of small depositors scattered all across the country. We believed that unless depositors had confidence in the financial system, our national efforts would be in vain.

There were two alternative approaches to achieving depositor protection. The first was to protect depositors against bank failure through such mechanisms as government-run deposit insurance schemes. The second was to ensure that banks not fail in the first place. Japan chose the latter approach, to the exclusion of the former, and tried to achieve it through a combination of extensive protection and strict regulation of banks. In Japan's protected market of that era, bank efficiency was not considered a matter of exclusive importance. Deposit interest rates and shareholders' dividends were controlled, so that a stable lending margin and adequate reserves could be secured. The deployment of bank branch networks and the marketing and development of new financial instruments were also controlled, so that excessive competition would not increase banks' costs or risks. The financial industry was compartmentalized, so that each group and subsector would be secure on its own turf. Regulators acted not only as umpires but also as management consultants, interfering directly in banks' daily business.

On the whole, this system of protection and control worked well during the postwar period of economic recovery and development. Japan did not suffer a single bank failure throughout the entire postwar period until two years ago. Meanwhile, as the world knows, the Japanese economy made enormous strides with its chosen financial structure.

Since the 1970s, however, a changing financial environment has made it increasingly difficult to maintain the old system. In a globalized economy,

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PART THREE • TOYOO GYOHTEN

banks are faced with severe competition both at home and abroad, as customers express a growing demand for better and broader services.

It is here that my regrets begin. Instead of trying boldly and positively to adapt our financial system to the changing environment, we in Japan tried to preserve the old system. The cause of this inability to adapt was institutional inertia, as the vested interests of industry, combined with regulators' desire for preservation of their authority, tended to maintain the status quo. Restructuring was thus delayed for years. Then, in the early 1990s, Japan's boom came to an end: the stock and real estate markets collapsed. Falling asset values caused a sharp deterioration in bank balance sheets, and Japan's policy of no bank failures became unsustainable.

The interdependent relationship between regulators and banks, which resulted in a lack of transparency, seriously undermined the international credibility of the Japanese financial system.

Japan is now in the process of restructuring its system on three fronts.

First, regulatory reform is under way, including reform of the Ministry of Finance and the Bank of Japan. The aim is to increase transparency, reduce regulatory interference, and enhance the independence of bank supervision. Second, Japan is establishing a legal, institutional, and financial framework for resolving the problem of bad loans. Third, rules and mechanisms of intervention in and closure of failed banks are being established in order to preserve the stability of the system.

What lessons has Japan learned from this experience? I strongly endorse the view expressed by Kaufman and Kroszner that the question of which structures will prove most beneficial for a particular country at a particular period depends on the context in which they will operate. But the crucial issue is whether countries can be agile and courageous enough to adapt their financial structures to a changing context. This adaptation needs to be carried out collectively by regulators, the banks themselves, and their customers. Ultimately, however, responsibility rests principally on the shoulders of national policymakers.

I also agree that the most important requirements for a sound financial structure are efficiency and stability. But the meaning of those two words can vary widely, and efficiency and stability are not always easily compatible. I also agree that market forces will help enhance efficiency and stability. In fact, the ongoing convergence of world financial markets will certainly reinforce the influence of market forces on financial structures. But market forces are not a panacea, because the market does not represent the interests of all in society on an equitable basis. This is especially important to recognize in such areas as finance, which has certain public characteristics not shared by other industries.

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Although I broadly support the recommendations offered in the chapter, I must confess that there are two questions to which I still have no answer. First, to what extent do we need to protect the innocent and less well informed users of financial service? Should self-responsibility be the ultimate rule? Second, do bankers need to meet a higher standard of personal integrity than do managers of other firms, because of the partly public character of their job? And if so, is selection by the market the only available means—and an adequate means—of ensuring that only persons of strong character become bankers?

Toyoo Gyohten is Senior Advisor to The Bank of Tokyo-Mitsubishi, Ltd., Japan, and a former Vice Minister of Finance for International Affairs.

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Michael Gavin and Ricardo Hausmann

Globalization is a defining characteristic of our age, and nowhere more so than in financial markets, in many of which electronic communication has rendered the geographical location of market participants nearly irrelevant. Indeed, it has been suggested that the financial markets of industrial countries are approaching nearly complete integration, to the point that we may speak of the "end of geography" in financial relations (see O'Brien, 1992). Should this frighten us? Will it destabilize financial markets and the world economy? This chapter takes the view that globalization is not cause for fear. To the contrary, we argue that the internationalization of banking systems, and especially the growing presence in domestic financial markets of foreign banks with strong home country supervision, offers important benefits for countries worldwide, including in Latin America, and can promote both more efficient and more stable financial markets.

The internationalization of financial markets, made possible by the communications revolution and the gradual dismantling of official barriers to international financial transactions, is being driven by powerful economic and financial forces. The first stage of this process, the globalization of trade in financial assets, is largely complete in the sense that explicit barriers to such trade have for the most part vanished. A second, deeper form of internationalization is now under way—the growing participation of foreign banks in local financial intermediation and of domestic banks in foreign activities. This internationalization of banking gives local savers and borrowers the option of transacting with foreign financial institutions, forcing local financial institutions to compete with the best that the world has to offer. At the same time, internationalization provides expanded opportunities for domestic financial institutions to compete abroad. Internationally diversified financial intermediaries, whether domestically or foreign-owned, can also promote financial stability because they are less vulnerable to country-specific economic shocks. Depositors are attracted * This is an extensively revised version of the paper that was presented at the conference "Safe and Sound Financial Systems: What Works for Latin America," held at the Inter-American Development Bank in Washington, D.C in September 1996. The authors thank the discussants for their extremely useful comments, which have been incorporated to the best of the authors' ability in this revision.

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Make or Buy? Approaches to Financial Market Integration*

PART THREE • MICHAEL GAVIN/RICARDO HAUSMANN

to the safety provided by diversified institutions, and the resulting migration of deposits to such institutions provides a powerful force for internationalization.

Latin America has not been immune from these forces. Capital accounts have been liberalized, and international capital flows are now essentially unrestricted in most countries of the region. In recent years, internationalization of the banking system has also increased as international banks, both from the established industrial countries and from other countries of Latin America, have become increasingly important players in the domestic financial markets of the region. Particularly in the aftermath of financial crises, when safety becomes a more salient consideration for savers, we have seen Latin American depositors move toward foreign banks.

At the same time fiscal and prudential considerations associated with recent banking crises have made governments more receptive to foreign investments in the domestic banking system, providing an additional impetus to internationalization.

The governments of Latin America should embrace the internationalization of their financial markets, rather than attempt to resist it. Internationalization may pose some challenges for those charged with ensuring the soundness of domestic financial markets. But if carefully managed, internationalization can promote the stability as well as the efficiency of domestic financial markets, and can ease rather than intensify the regulatory burden of overseeing them.

Despite recent trends toward open capital accounts and increased capital flows, however, Latin America's integration with world financial markets remains shallow. This is revealed by the quite limited foreign investment in the region, which remains much below what would be required to equalize capital-labor ratios with those of the industrial economies, as would occur in a perfectly integrated world capital market. The shallowness of the region's financial integration is also revealed by the fact that banking crises have been national events, which would not be the case in a world where banks were highly diversified internationally, and thus not unduly exposed to national economic or financial shocks. This highlights the key fact that financial integration means much more than mere liberalization of capital account transactions.

The shallowness of Latin America's integration with world financial markets results, in part, from deficiencies in financial intermediation in the region's domestic banking systems. Efficient intermediation between savers and borrowers is required to make effective use of the international capital that is potentially available to investors in the region. These deficiencies exist in part because the fragile financial systems of Latin American economies render them highly vulnerable to economic shocks: know-

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ing that banks are dangerously exposed to national shocks, and that governments lack the fiscal capacity to make good on explicit or implicit deposit guarantees without resorting to inflation, depositors tend to head for the exits at the first sign of trouble. Their proneness to flee greatly amplifies the disruption associated with economic disturbances. This financial fragility, and the associated ineffectiveness of local financial intermediation, result, in turn, from a scarcity of certain key public goods that are necessary intermediate inputs for effective financial intermediation. These include macroeconomic and financial stability, an effective legal system for the adjudication of disputes over financial contracts, accounting and disclosure standards that permit a meaningful evaluation of a bank's financial condition, capital markets that facilitate broad ownership of financial institutions and provide mechanisms for owners to monitor and control the activities of bank managers, an efficient regulatory and supervisory structure, and reliable lender-of-last-resort and deposit insurance facilities.

Internationalization of the domestic financial system can help address these scarcities. It increases the system's resilience to domestic macroeconomic shocks because it implies the presence in the domestic market of internationally diversified banks, whose assets and funding are less sensitive to purely domestic disturbances. Although economic fluctuations are fairly highly correlated across the countries of Latin America, there are substantial gains to be had even from diversification across the region.

These gains would of course be magnified if diversification were extended to include countries outside the region. In addition, to the extent that these more diversified banks are related to parent institutions domiciled abroad, they may also be able to draw upon the financial strength of the parent in times of economic and financial stress. Thus, by making the domestic financial system less vulnerable to purely national shocks, globalization can result in a more robust financial system.

Internationalization of the domestic banking system can also help address the problems generated by weak market discipline and supervisory structures. Internationalization allows the introduction into the domestic market of banks not only from countries with strong financial supervisory and regulatory systems, but also that are subject at home to the market discipline associated with well-developed capital markets. Such banks bring with them accounting practices, disclosure standards and riskmanagement practices shaped by the requirements of the world's most demanding supervisors and private investors. They may also bring with them access to well-funded and well-managed lender-of-last-resort facilities, able to protect the institution and its depositors from destabilizing liquidity crises and potentially self-fulfilling runs. Foreign banks are in-

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APPROACHES TO FINANCIAL MARKET INTEGRATION

PART THREE • MICHAEL GAVIN/RICARDO HAUSMANN

creasingly forced to adopt in their local operations the same accounting, disclosure and prudential practices required in their home markets; these are enforced both by market discipline in the home country and by the principle of consolidated home country supervision of banks' global activities. Even if these practices were not required, banks would have an incentive to adopt them, since the transparency and financial soundness they create confer an advantage in the competition for bank deposits. This raises the important point: the adequacy of the regulatory and supervisory structure in a bank's home country is likely to be a source of comparative advantage, helping determine which of a country's banks succeed in the international market for financial services. Rather than creating a "race to the bottom" in regulatory and supervisory practices, the internationalization of banking markets may provide incentives for bankers to demand an upgrading in the quality of financial market regulation and supervision in their home countries.

In any event, the fact that banks from well-regulated home markets will be subject to strong market discipline and supervision by their authorities means that the internationalization of banking makes it possible for countries indirectly to import the scarce public goods required for effective financial intermediation. This eases the burden facing domestic financial market supervisors. No longer required to "make" all of the public services required for an efficient and stable financial system, countries now have the option, by permitting the entry of international banks from wellsupervised financial markets, to "buy" these services as well. The gains from this trade are to be found in a more efficient and stable banking system, less vulnerable to national economic shocks, and better able to channel domestic and foreign savings to high-productivity domestic investors.

The section that follows briefly reviews the nature and extent of Latin America's integration into the international financial system. We argue that integration is shallow in several important respects, and that the region has much to gain from deeper integration. This limited integration is partly caused by limitations of the domestic financial systems that hinder them from effectively intermediating a substantial portion of world capital flows.

The subsequent section argues that these limitations exist, in part, because the countries of Latin America lack comparative advantage in the provision of key public goods required for effective financial intermediation, and that internationalization of domestic financial markets can help overcome these deficiencies. We conclude by describing an approach to bringing about this internationalization.

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It may at first glance seem peculiar to take seriously the idea that Latin America enjoys insufficient access to world financial markets. Many of the world's most indebted economies are Latin American. The region suffered 10 painful years of recovery from the major international debt crisis of the early 1980s, and only recently completed the task of restructuring its external debts in the wake of that crisis. Recurrent Latin American debt crises seem to provide ample evidence that the region has, if anything, enjoyed too much international financial rope, without which its occasional macroeconomic hangings might have been less frequent. Moreover, in most countries the key policy challenge of the 1990s has been how to deal with excessive rather than insufficient inflows of international capital.1 But excessive by what standard? Capital flows to Latin America are actually small by relevant analytical and historical standards, and reflect a quite limited degree of integration with the world financial system, which is in turn reflected in the high cost of capital in the region. Limited financial integration with the world economy is also revealed in the fact that the region's banking crises have been national rather than international in scope.

National Banking Crises Reflect Shallow Financial Integration The essentially national character of most banking systems is perhaps most obvious during periods of economic and financial stress, when it is typical for many of a country's financial institutions to find themselves under pressure, while similar institutions in similar countries remain unaffected. This seems only normal, since macroeconomic and financial shocks are often country-specific, and it is natural to expect that such shocks will affect many banks in the economy.

However, in a highly integrated world financial market, international diversification of their business would permit financial institutions to limit their exposure to purely national disturbances, and one would not expect national shocks to result in national banking crises. To be sure, the local operations of a financial institution would be adversely affected by a shock to one country, but these results would generally be offset by more or less uncorrelated results in other parts of the world.

Although the theoretical benchmark of complete international diversification may be unattainable, the lack of diversification that we now observe leaves domestic financial systems highly and unnecessarily exposed 1

See Calvo, Leiderman and Reinhart (1996). Gavin, Hausmann and Leiderman (1995) review the Latin American context.

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How Integrated Is Latin America into World Financial Markets?

PART THREE • MICHAEL GAVIN/RICARDO HAUSMANN

to national economic and financial disturbances. This translates into deeper crises and greater macroeconomic volatility, as adverse shocks to the economy are amplified by financial stress associated with the shock.

International Capital Flows Reflect Imperfect Integration Latin America's traumatic financial history has taught many observers that a country's capacity or willingness to continue paying its international creditors comes into question when the country's foreign liabilities approach something like 50 percent of GDP, and when the country is required to transfer to foreign creditors the equivalent of around 6 percent of GDP. For example, in 1982, the year when the most recent regional debt crisis broke out, net factor payments to foreigners reached about 8.5 percent of GDP in Argentina and Chile, just over 7 percent in Mexico, 5 percent in Brazil, 4 percent in Peru, and 2 percent in Venezuela (Figure 1). In 1993, just before the 1994 Tequila crisis, net factor payments by Mexico to foreigners amounted to less than 4.5 percent of GDP. These levels of international liability, and the payments to foreign creditors that they require, are actually low by historical and some more recent standards. The most dramatic example is Puerto Rico today: decades of capital inflows have led to a large stock of foreign investment in the island, requiring net factor payments to foreign creditors of nearly 25 percent of GDP in 1982, rising to roughly a third of GDP in 1994 and 1995 (Hausmann, 1995). During the past several decades, international capital markets have moved huge amounts of capital into Puerto Rico, in the process contributing to higher levels of income and exports per capita than in any other Latin American economy, despite a very low rate of domestic saving. Foreign savers have, without any fuss, been paid the returns to this capital, while Puerto Rican workers have benefited from the higher labor productivity and wages that the larger capital stock has made possible.

A similar example is provided by Ireland, which was the recipient of enormous capital inflows during the late 1970s and early 1980s. These flows helped finance an impressive investment boom, which peaked in the late 1980s at over 30 percent of GDP. Partly as a consequence, Irish GDP per capita rose from 52 percent of the average for member countries of the Organization for Economic Cooperation and Development (OECD) in 1970 to 68 percent in 1993. Net factor payments to the holders of these large foreign investments peaked at nearly 15 percent of GDP in 1986, two to three times the levels associated with the debt crisis in Latin America.

Somewhat more remote but nevertheless revealing examples come from the international lending boom of the last century. During the last four decades of that century, net foreign investment inflows in Australia

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Figure 1 Net Factor Payments, Selected Economies, 1982 (Percent of GDP)

1

Data are for 1986.

Source: Hausmann (1995).

averaged about 5 percent of GDP, and during the 10-year period 1880-89 averaged 9 percent of GDP, without creating a crisis. Canada borrowed on a similar scale in the first decades of the 20th century.2 In both countries this foreign investment financed major investment booms that were important contributors to the countries' industrialization.

These examples are just what one would expect to see in a highly integrated international financial market, where capital is attracted from regions where it is relatively plentiful to regions where it is scarce, equalizing capital-labor ratios. But capital flows to Latin America have remained far short of what would be required to achieve this equalization. Latin American workers must, on average, make do with about a third the capital available to industrial country workers, and in many countries of the region the scarcity of capital is much more extreme (Figure 2).3 This scarcity of physical capital has as its financial counterpart the high cost and poor terms on which capital is made available to the vast majority of Latin American firms and households that do not enjoy direct 2

International lending to Argentina, India and South Africa was also very large in the late 19th and early 20th centuries. In Argentina, the lending boom ended in tears with the 1890 panic and the ensuing international debt crisis.

3 The data are from the Heston and Summers data base and refer to the nonresidential capital stock.

Some of the data, such as the very low capital-labor ratio recorded for Paraguay, are a little puzzling.

But the message of the data is not at all sensitive to such outliers, and a similar message emerges from calculations based on World Bank estimates of the capital stock.

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Figure 2 Capital Intensity and Productivity in Latin America, 1989-90 (Thousands of 1985 purchase parity power-adjusted dollars per worker)

access to international financial markets. For example, during 1995 and 1996, real lending interest rates were in the vicinity of at least 10 percent in almost every large Latin American economy, and were around 20 percent in Bolivia, Brazil, Ecuador, Peru and Uruguay. These rates do not, of course, provide a precise measure of the rate of return to physical capital in these economies, but they do convey a sense of the scarcity of capital in the region.

Not only is capital scarce and expensive in Latin America, but many financial products that would be taken for granted in most industrial economies barely exist there. Even relatively wealthy Latin Americans face much more limited access to long-term mortgage finance than do households of similar income in industrial economies. When such financing is available, lenders are typically only willing to finance a much smaller fraction of the purchase price. The range of available savings instruments is also much narrower than can be found in most industrial economies, and insurance contracts are less widely available. There are few, if any, explicit barriers to international trade in these financial products, yet they remain scarce. In this sense, too, Latin American financial markets and the products offered on them are predominantly local, not international.

In short, the enormous and persistent gap between the capital intensities of Latin America and those of the industrial economies, and the associated differences in the cost of capital, have not generated the large and sustained capital flows that one would expect to see in a fully integrated

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world financial market. The inflows that do take place often take shortterm, easily reversible forms that cannot prudently be intermediated to finance the long-term needs of the region's private borrowers.

All of these facts reflect a very limited integration with international financial markets. But the examples of Puerto Rico, Ireland, Australia and Canada indicate that there is no economic law limiting foreign investment to the relatively low levels generally observed in Latin America, and that the region's limited access to international capital may instead be due to institutional and policy shortcomings that can be remedied. If so, the implication is that, like these other economies, the region could seize the opportunity to jumpstart its development by tapping more effectively the vast pool of international savings.

Role of the Domestic Financial System What is holding back Latin America's integration into world financial markets? One important factor is sovereign risk, which, by reducing the certainty that financial contracts will be enforced, rules out some transactions that would otherwise be feasible within national borders. It seems likely, for example, that the substantial integration of Puerto Rico into the U.S. political and legal structure is an important reason for the enormous capital inflows into that economy.

Another important limitation lies in the weaknesses of domestic financial systems in countries of the region. The services of a local financial system are not required for international financing of governments or large industrial groups and corporations, which are essentially international players. Making that same international capital available to smaller businesses and consumers, on the other hand, requires the output of the domestic financial industry. If this intermediation is inefficient, international capital, however abundant, cannot be channeled to many high-productivity borrowers. In addition, if deficiencies in the domestic financial system raise the likelihood of economic and financial instability and crisis, potential domestic and international lenders will be reluctant to commit their savings to the country.

Thus, although increased capital mobility in the sense of an enhanced ability to access the world supply of savings is a key objective of financial integration, further liberalization of explicit barriers to capital mobility—where they still exist—is unlikely to achieve this end. The binding constraint on the region's access to international financial markets has little to do with these barriers, and much to do with more fundamental problems in the local intermediation of domestic and foreign financial resources.

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Figure 3 Bank Claims on Private Sector, Selected Latin American Economies, 1995 (Percent of GDP)

This state of affairs is not the inevitable result of Latin America's relatively low level of economic development, as can be seen from the interesting example provided by Panama. In that country, the domestic financial system mobilizes financial resources at a rate that is impressive even by industrial country standards, and enormous by the standards of Latin America.4 In Panama, bank lending to the private sector exceeds 80 percent of GDP, nearly twice the ratio mobilized by the next highest Latin American country, and well over twice the ratio observed in Argentina, Brazil, Colombia, Mexico, Peru or Venezuela (Figure 3). This does not reflect a relatively high level of development: Panama's GDP per capita is in fact lower than that of any of these countries except Peru. Accompanying Panama's high level of financial intermediation is a much richer array of credit instruments for firms and households. Banks finance consumer purchases and make long-term mortgage loans. In fact, at 25 percent of total bank lending, mortgage lending alone in Panama is roughly as large, as a share of GDP, as total credit to the private sector in much of Latin America.

Panama also appears to have significantly greater access to international financial markets than do most Latin American economies. That access is not unlimited: Panama did need to restructure its international debt along with much of the region in the 1980s. But indicators of the risk attached to Panamanian debts are substantially lower than in, for example,

4

Panama also has a large offshore banking sector. That sector is, however, segregated from the domestic financial system, and its operations are not included in the figures discussed here.

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Table 1. External Debt and Stripped Spreads on Brady Bonds in Argentina, Mexico and Panama (In percent)

Country Argentina Mexico Panama

External debt1 (% of GDP)

Stripped spread on par Brady bonds, August 1996

49.7 44.9 124.7

9.54 6.75 4.70

Source: World Bank, World Debt Tables; ING Barings.

1 As of 1995.

Mexico and Argentina, even though Panama's international debt is substantially higher as a share of its GDP than that of either country.

Despite an international debt-to-GDP ratio that is roughly twice that of either Argentina or Mexico, the stripped yield on Panamanian Brady bonds (the bonds created as part of the region's restructuring of its bank debt after the 1980s crisis) is substantially below the spreads recorded in Argentina and Mexico (Table 1). Although this difference narrowed as Argentina and Mexico recovered from the Tequila crisis, it remains significant.

The Panamanian experience suggests two lessons. First, Latin America's relatively shallow financial markets are not the inevitable consequence of its level of development. Although the greater depth of Panama's financial markets may be due to various factors, not all of which may be replicable in every country of the region, it does serve as a useful benchmark for the kind of financial development that it is possible to achieve, with the right policy and institutional framework, even in countries at relatively low levels of economic development. Second, Panama's experience supports the idea that a strong domestic financial system is associated with improved access to international financial markets.5 What Is Required for Effective Financial Intermediation?

Resolving Information and Incentive Problems One can imagine a number of market structures and institutional frameworks within which effective financial intermediation could take place, 5

As we discuss later, an important feature of the Panamanian monetary system is that it operates under a currency board. This makes it more difficult for the government to interfere in cross-border payments and may thus improve Panamanian borrowers' access to international financial markets.

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but in all such frameworks, certain important information and incentive problems that afflict debtor-creditor relations must be resolved. These problems arise because financial intermediation is the process of exchanging contractual claims on risky future income streams. Not only are the borrower's future capacity and willingness to repay uncertain at the time these contracts are made, but the borrower typically has an informational advantage over the creditor, and may also be in a position to take actions that undermine the financial interests of the creditor, to the borrower's own benefit. Lenders must therefore learn about their borrowers, find ways of limiting the problems of adverse selection and moral hazard that arise from these informational asymmetries, and make sure that borrowers have the right incentives to repay their debts.

Producing the requisite information and resolving incentive problems are the main business of the domestic financial sector (which may, of course, include participating institutions from any part of the world). Making good use of the international capital potentially available to a country requires that the domestic financial system work well; if it does, the funds channeled through it are likely to be productively employed, and as a consequence, the financial system is likely to enjoy greater access to international financial resources. If the sector performs poorly, the resources that it mobilizes will be inefficiently employed, and the country will find its access to international financial resources limited.

While coping with the information and incentive problems that stand between themselves and their debtors, banks create a second layer of information and incentive problems in their relations with their creditors, particularly their depositors, few of whom are in any position to evaluate the quality of the bank's portfolio.6 Almost everywhere, the highly imperfect solution to this problem has been for governments to provide some form of deposit insurance and create a lender-of-last-resort facility, and then attempt to limit the consequences of the moral hazard problem that these institutions create for banks by regulating the banks' activities and by seeking to ensure that last-resort lending is confined to solvent but temporarily illiquid banks. Markets also discipline banks: not only regulators but also bank shareholders and better-informed creditors require that bank managers present accurate accounts, using appropriate accounting methods, and that these accounts provide adequate disclosure.

6 We focus on banks because of their importance in Latin American financial markets, and because it is with banks that the most acute policy issues arise. Intermediated debt contracts administered by banks are dominant in Latin America precisely because of the information problems that make banking, and public policy toward banking, such a complex business.

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This approach to resolving information and incentive problems makes successful financial intermediation highly intensive in publicly provided services. National governments are faced with the need to charter banks, with the aim of excluding unfit institutions from the market, and to develop the regulatory and supervisory structure required to address the moral hazard problems created by the various forms of (imperfectly priced) insurance provided by the government. (In the United States, provision of these services is shared between the national and subnational governments: state governments also charter and regulate banks.) The lender of last resort requires substantial financial "muscle," or the ability to make resources available to the financial system in time of need, without creating the destabilizing expectation that the transfer will in the end be monetized and create a burst of inflation. Noninflationary last-resort lending cannot be taken for granted in Latin America, where there is little fiscal slack, and as a result adverse fiscal shocks have often generated inflation.7 The lender of last resort also requires some capacity to evaluate the soundness of the banks under its charge, so that it can at least attempt to distinguish fundamentally sound but illiquid institutions from those that are insolvent. Setting prudential norms and supervising compliance with them are complex tasks, involving the accumulation and evaluation of information on complicated transactions from institutions that may have an incentive to obfuscate their financial position. These tasks require a stable and skilled cadre of experts in the public sector.8 But in addition to these regulatory and supervisory structures, a number of other equally fundamental public goods must be provided. Accounting standards, like a common language, are a public good whose value as a means of communication depends upon their universal use. The financial system is also highly dependent upon effective adjudication and enforcement of private contracts—a solid legal infrastructure is the public good par excellence. This requires that the government provide some mundane, but in some countries neglected, services such as credible registration of property ownership. And it also requires a competent and independent 7

Gavin, Hausmann, Perotti and Talvi (1996) show that fiscal shocks in Latin America are often associated with a burst of inflation, unlike in the United States.

8 The difficulties are highlighted in Hovakimian and Kane (1996), who provide evidence that even in the United States, with its massive supervisory apparatus, regulators have been unsuccessful in preventing banks from shifting risk to taxpayers. As we argue below, there is good reason to believe that Latin American regulators are likely to have even more difficulty than their industrial country counterparts.

Although there may be ways that regulators could harness market forces more adequately than do current regulatory structures, thus economizing on the demands created for the public sector, effective supervision of financial markets is likely to remain a complex governmental problem.

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Why Are Financial Systems National?

These considerations are so fundamental that they have driven the creation of financial markets that are essentially national rather than international. We now largely take their existence for granted, despite the absence of any economic rationale for national delimitations on the activities of financial institutions. Bank charters are national (or subnational), and the associated "domestic" financial system is largely so, not because national borders provide a sensible geographic definition of a financial market, but because the activities of chartering, regulating, insuring and providing for the adjudication and enforcement of property rights require acts of government, including use of its enforcement powers, that can take place at the national (or subnational) level, but not at the international level.

The U.S. banking system, with its history of state-chartered and stateregulated institutions and strong restrictions on interstate banking activity, illustrates this point well. It makes little economic or business sense to define New Hampshire, Wyoming, Louisiana or any of the other states of the union as a financial market separate from those of other states, yet even today banks throughout the country face significant restrictions on their ability to do business outside their own state. This is because in early U.S. banking history it was the states, not the federal government, that took responsibility for providing the legal and regulatory infrastructure for banking activity. This power was used to promote the segmentation of local banking markets. This deliberate segmentation was in part a response to the fear of the relatively undeveloped western and southern states that deposits in national banks, which would most likely be headquartered in the northeastern states, would not be lent to their regions, thus starving them of capital. With the benefit of historical hindsight, it now seems clear that this concern was unfounded, and that the costs of a more fragmented, localized and vulnerable banking system outweighed any benefits that segmentation might have created.

The economic and business rationale for defining Argentina, Bolivia or Mexico as financial markets separate from the world financial system is little stronger than it is for Texas. The existence of a "domestic" financial market in these and other countries in the region is the result of political rather than economic or business considerations. There would be important economic gains from relaxing the political constraints and attempting to merge domestic markets more completely with international financial markets.

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judiciary with sufficient resources to achieve a rapid and fair resolution of contract disputes.

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Operating within the framework provided by domestic financial systems in the region, and outside it, there is of course substantial international financial activity. This activity creates an additional level of complexity and introduces new complications for the public sector. One of these complications has already been mentioned: sovereign risk. When financial institutions lend across national borders, they know that they cannot force borrowing governments to comply with the terms of their own financial contracts, and that governments may even prohibit private borrowers from complying. In the end, debts will be repaid only if it is in the interest of the borrowing government to do so. This places important restrictions on crossborder financial flows, which will be more severe the smaller the capacity of governments to commit themselves to future actions.

To the extent that foreign participants lend in domestic currency, they also face exchange rate risk, which they may not wish to bear. This is a particularly heavy burden for economically volatile regions such as Latin America. Arguably a more important consideration is that the existence of a national currency, and the currency exchange arrangements that accompany it, provide a mechanism through which governments can more easily interrupt payments to foreign individuals and institutions. Panama is an interesting outlier in this respect. With no national currency or central bank (the U.S. dollar is legal tender), Panama has substantially less ability to intervene in international payments than do countries where exchange controls can be imposed. This missing degree of freedom may be one reason for the relatively high perception of Panama's creditworthiness.

These considerations suggest that domestic financial market structures can affect international creditworthiness. This is supported by the recent decision of Standard & Poor's to relax the conditions under which private borrowers can obtain credit ratings above the "sovereign ceiling" when the borrower operates in a country with a currency board or a highly dollarized financial system. (Under a currency board, a country can issue domestic currency only to the extent to which it has foreign currency reserves.) The rationale for this decision was that either of these arrangements increases the difficulty of intervening in private payments, thus increasing the credibility of official commitments not to interrupt such flows during periods of weakness in the balance of payments. This enhanced official credibility in turn leads to greater creditworthiness and expanded market access for domestic firms.

Finally, foreign participants in domestic financial systems may be concerned that the legal system will operate to their disadvantage, particularly when systems operate in a less than fully transparent manner, simply because any rights that foreigners may have are protected by a political system in which they are not represented. And if the legal system is ineffi-

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cient, lacks autonomy, or is subject to the influence of important social or business groups, foreign residents may have particularly good reason to fear that local courts will neglect their interests. For some transactions, an agreement that disputes will be adjudicated in the courts of another country can alleviate some of these concerns, but this will not always be possible. Even when it is, problems remain: the chosen legal system may be powerless to enforce its decision, and the borrower's government may be uninterested in doing so.

In summary, deeper financial integration requires a domestic financial system that can effectively intermediate resources provided by the rest of the world, transforming the world's savings into financial products for use by domestic households and firms. Such a system is made up in part of competent financial institutions, domiciled at home or abroad, and operating in the local financial market. But these institutions cannot operate effectively in the absence of important public goods that governments must provide. A legal system must be maintained to adjudicate and enforce contracts promptly and fairly. Accounting standards and disclosure requirements must be developed and enforced. A regulatory and supervisory structure must be established and maintained. A lender of last resort must be created with the financial capacity to support solvent but illiquid institutions without resorting to inflationary finance, and with the technical capacity to reduce the likelihood that insolvent institutions will be bailed out along with the merely illiquid ones. Without these crucial public inputs, international financial intermediation is likely to be both limited in magnitude and uncertain in effect.

While this is true for all countries, not all of them are equally capable of providing these public inputs, and there is reason to believe that many countries in Latin America are at a comparative disadvantage in producing them.

Special Obstacles to Financial Intermediation in Latin America The role of the public inputs that we have emphasized is often neglected, perhaps because in the industrial economies their existence can be taken for granted. Just as fish are unaware of the water they swim in, so too we often fail to recognize the importance of the institutions and services that surround us, no matter how vital they are. But they cannot be taken for granted in Latin America.

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Latin America has been plagued by enormous macroeconomic and financial volatility: in terms of most nonmonetary outcomes, its economies are more volatile than those of any region of the world other than Africa and the Middle East. Although the region has stabilized in the 1990s, its monetary instability.during the previous two decades was in a class of its own.

Such volatility undermines those domestic financial institutions that are exposed to it, and their vulnerability to national economic shocks in turn amplifies the original disturbance. When bank depositors realize that a country-specific shock may threaten the viability of the local banking system, they attempt to escape that shock by withdrawing their deposits. If the central bank does not respond, the resulting liquidity shock forces banks to contract their lending to the nonfinancial private sector, thus deepening the original shock. This was the situation faced by Argentina in 1995. More typically, central banks will feel obliged to provide liquidity to the domestic banking system, increasing and in the end validating the public's fears of higher inflation and macroeconomic instability.

To prevent this destabilizing link between adverse macroeconomic shocks and the demand for domestic bank deposits, and to control the problems of moral hazard discussed above, financial institutions whose activities are highly concentrated in one Latin American economy need to be substantially more highly capitalized and more liquid than would be appropriate for institutions in a more stable environment. This, however, limits the financial system's capacity to mobilize financial resources and channel them to productive uses.9 Weak Public Capacity to Regulate and Supervise Financial Markets A second obstacle to financial integration is the public sector. Latin American countries have traditionally had weak public sectors, with limited technical and administrative capacities, and lacking the necessary autonomy from special interest groups to execute policies that benefit the general public.10 And although the reforms of the past decade should eventually result in a more focused and strengthened state, the Latin American state has in the short run been weakened by a decade of debt crisis and the fiscal retrenchment that followed it.

9

See Gavin and Hausmann (1996a) for a longer discussion of this point. Rojas-Sudrez and Weisbrod (1996) also emphasize the importance of enforcing capital requirements.

10 See Nafm (1995) for an extensive discussion of the state in Latin America, from which much of the following discussion is drawn.

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High Macroeconomic and Financial Volatility

PART THREE • MICHAEL GAVIN/RICARDO HAUSMANN

The limitations of the Latin American state are particularly important in exactly those areas where effective state action is most required for building a sound financial system. As we have noted, the public "infrastructure" required for a sound financial system includes a stable workforce of highly trained public servants. But reflecting overall scarcities of human capital in the region and limited fiscal capacity, public sectors have a hard time attracting personnel with the needed skills, which are also in great demand in the private sector. Wages of government officials in Latin America are low, both by international standards and in comparison with those provided by the local private sector. Reflecting these low wages and a high degree of political instability, turnover is high. This lack of continuity seriously undermines local technical capacity for credible supervision and regulation of the domestic banking system. It also contributes to weak capital markets, undermining the prospects for the development of effective market discipline. Moreover, many governments lack the financial resources required to carry out deposit insurance and lender-of-last-resort functions.

In short, Latin America today possesses a comparative disadvantage in providing the public goods required for an effective financial system.

The unstable macroeconomic environment threatens financial institutions whose business is largely confined within national borders. And deficiencies in the legal, regulatory and supervisory infrastructure limit the development of local financial intermediation by domestic and foreign financial institutions alike.

What is the appropriate policy response? We can think of two approaches to the problem. The first takes the current limited internationalization of Latin American financial markets, and works within that structure to build a more stable and efficient system. The main elements of such a strategy include: • Working toward the establishment of a more stable macroeconomic environment.

• Reforming the civil service, particularly in the bank regulatory bodies and the judiciary, with the aim of creating a public sector with the ability to credibly regulate and supervise the financial sector, and to adjudicate and enforce financial contracts.

• Ensuring that domestic banks are highly capitalized and liquid, and thus able to withstand the substantial macroeconomic and financial shocks that are likely to affect these predominantly local institutions.

These are laudable objectives. It is impossible to argue with the desirability of promoting a more stable macroeconomic environment, or of strengthening the public sector. Reform of the civil service and the judiciary is a necessary but long-term investment. But Latin America can ill afford to live with the present state of financial affairs while awaiting the

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results of these endeavors. And although a system that ensures that the domestic banking system is highly capitalized and liquid may be preferable to the vulnerable and crisis-prone system of the past, it carries with it an important cost in the form of a reduced capacity for and increased cost of financial intermediation.

In the section that follows we argue that some of these costs can be avoided if a somewhat different strategy is pursued, one that is not entirely a substitute for the first but rather complementary to it. Under this strategy, not all the ingredients of a stable and efficient financial sector would be "made" domestically; some would be "bought" in an international market. Such a strategy would alleviate the shortcomings of the state by easing its burden now, rather than waiting for the time-consuming process of building state capacity to bear fruit. It would allow for the importation of the expertise and financial strength of international financial institutions, but also, and arguably more importantly, it would permit the indirect importation through these institutions of key public inputs for a sound and efficient financial system.

How Can Internationalization Promote a Strong Financial System?

We have argued that Latin America faces two key financial problems: a scarcity of capital and a volatile, crisis-prone financial system. Both problems are, in large part, a reflection of the region's limited integration with world financial markets. This shallow integration is, in turn, largely attributable to weaknesses in the domestic macroeconomic and financial environment, which limit the effectiveness with which financial resources can be intermediated by domestic and foreign financial institutions alike, and therefore limit the region's capacity to tap the world supply of capital. These weaknesses in the domestic financial system are grounded in two causes.

The first is inadequate provision of the public goods required for a strong financial system, which reflects the fact that the public sector in Latin America often lacks the institutional and financial capacity to produce the complex services involved in managing a regulatory and supervisory structure. The second is the volatile macroeconomic and financial environment in which banks have had to operate.

Internationalization Can Promote Macroeconomic Stability There are two good reasons to believe that a financial integration strategy that involves the opening of domestic financial markets to foreign banks, and the diversification of domestic banks abroad, can promote financial stability. First, the overseas operations of international banks have access

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to their parent s stock of capital and international liquidity if they find themselves in trouble. Here an important distinction is to be made between branches and subsidiaries of foreign banks. If the foreign banking operation is in the form of a branch of a bank domiciled abroad, it shares the parent's capital, and the parent has a legal obligation to support the branch if it comes under pressure. If instead the operation is a subsidiary of the parent, that is, a separately capitalized legal entity, the parent company will have an interest in supporting it, to protect its own reputation, but no legal obligation to do so. Indeed, in a major crisis the parent bank may use the threat provided by its option to let the local subsidiary go bankrupt to extract concessions from the host government. This is not merely a theoretical danger: in the recent Argentine crisis some subsidiaries of international banks were denied support by their parent institutions.

This is one important consideration that weighs in favor of encouraging the establishment of local branches, rather than subsidiaries, of international banks.

Second, internationally diversified banks are likely to be more robust in the face of country-specific shocks simply because a substantial portion of their assets will be invested in regions unaffected by that shock.

This is particularly important for Latin America, because the highly volatile macroeconomic environment in which banks must operate raises the benefits of risk diversification. The increased resilience of banks should reduce the frequency of financial crises and increase confidence in the domestic financial system. In particular, depositors will have less reason to fear that a macroeconomic shock will bring down the banking system, and will therefore be less likely to engage in a destabilizing flight from domestic deposits when an adverse shock arrives.

The benefits for Latin America of international diversification are essentially identical to those now being reaped by the United States as it relaxes restrictions on interstate banking, which long inhibited the emergence of regional and national banks. These restrictions have in the past resulted in state-specific banking crises. For example, Texas banks were vulnerable to the collapse of oil prices in the mid-1980s mainly because restrictions on interstate banking increased their exposure to this statespecific shock. The situation for Latin American banks is, however, even more precarious than the Texan experience because the impact of the local shock on Texas banks was buffered by their participation in federally backed deposit insurance and their access to a federally organized lender of last resort. Together these factors reduced the likelihood that the shock would be amplified by a flight of depositors from the Texas banking system. Latin American banks do not enjoy analogous support.

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Figure 4 Volatility of Real GDP Growth in Latin America (In percent)

The benefits of diversification can also be seen by comparing financial developments during the Great Depression in the United States, where banks were small and geographically confined, and in Canada, where banks were permitted to establish branches throughout the country. In the United States, about a fifth of the banking system failed, and a third of the nation's banks disappeared as a result of failure or merger. Canada, meanwhile, experienced no panics or runs, although there was a 10 percent drop in the number of bank branches. Haubrich (1990) argues that these branch closures were macroeconomically less disruptive than the failures that occurred in the United States.11 Even if banks diversified only within Latin America, there are significant gains to be had. Figure 4 compares the volatility of GDP growth (as measured by the standard deviation) in several countries in the region with that of a regional "portfolio," weighted somewhat arbitrarily by real GDP. For every country except Colombia, the regional basket shows less, and in most cases substantially less, volatility than that observed in the individual country. For particularly volatile economies like Chile, Ecuador and Peru, 11 Calomiris (1990) provides evidence that geographical diversification within U.S. states may have been important. He notes that in the 1920s, states that did not permit branching experienced much higher bank failure rates than did states where within-state branches were permitted; this outcome reflects in part the greater diversification of multibranch banks.

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the diversified basket exhibits roughly half the volatility faced by the individual country. Even greater gains from diversification are found for the terms of trade (not shown), where the basket has substantially lower volatility than any individual country; for Ecuador and Venezuela the volatility of the basket is only a quarter that of the country's own terms of trade. Real GDP growth and the terms of trade are only two of the determinants of business risk for banks, but these figures nevertheless suggest that diversification within Latin America could provide banks with real opportunities to reduce risk.

To the extent that international diversification makes banks more resilient to national shocks, it will have an important stabilizing influence on the macroeconomy more generally. At present, Latin American financial systems often amplify national shocks. Fearing that a major shock threatens the solvency of the insufficiently diversified domestic banking system, depositors often flee, and their flight seriously aggravates the underlying problem. Weakening the link between national shocks and the solvency of individual banks could reduce or eliminate this amplifying effect, leading to a more stable financial system and macroeconomy. This, in turn, is likely to improve the quality of domestic financial intermediation and relax a key constraint on attaining deeper financial integration.

Internationalization Can Ease the Financial Regulatory Burden The presence of international bank branches can also strengthen the domestic financial system by easing the burden of regulation and supervision placed on the state, since branches are supervised by the home country authorities. Provided that the parent banks are domiciled in countries with adequate supervision, this relieves domestic authorities of responsibility for detailed oversight of the branches' activities. Since parent institutions have a legal responsibility to support their branches, and deposit insurance and lender-of-last-resort facilities would be provided to the parent, if required, by the home authorities, the financial burden facing the host country would be greatly reduced as well.

Arrangements would be required to insure domestic depositors in the foreign branch against failure of the parent. One possibility would be to negotiate coverage of the branch's deposits by the home country's deposit insurance arrangements. An alternative would be to organize a local deposit insurance fund, perhaps privately funded, in which international banks would be required to participate.

This strategy would not involve the dismantling of domestic regulatory and supervisory structures. It would, however, reduce the pressures on regulatory agencies, and it would diminish the stakes involved in the

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performance of supervisory agencies. This would allow domestic supervisors to focus their efforts in areas where they have comparative advantage vis-a-vis international supervisors, who would be indirectly supporting the domestic regulatory infrastructure of financial markets by overseeing the international banks that operate in the domestic market.

New Zealand provides an interesting example of this model. Its handsoff, market-based approach to regulation deemphasizes detailed inspection and supervision and instead emphasizes stringent disclosure requirements. The idea is that, with effective disclosure, the market rather than official supervisors will discipline excessive risk taking by banks. Some commentators have argued that this approach is easier for New Zealand than for other countries, because every bank in the country is headquartered elsewhere and is regulated and supervised in the conventional manner by the home country authorities. Advocates of the New Zealand approach argue that it would be viable even if many of the banks operating in the domestic market were not supervised by foreign authorities, but some at least concede that this minimalist approach to regulation is easier to adopt in New Zealand's circumstances. Just as foreign authorities assist New Zealand's regulators, so Latin America's regulators could ease their regulatory burden by taking advantage of the regulatory and supervisory services indirectly provided by the home country regulators of international banks from well-supervised financial markets.

Approaches to the Internationalization of Financial Markets If it is accepted that greater financial integration is desirable, the question that then arises is how to achieve it. There are three potential elements of such an approach: • Encourage the establishment of branches by international banks domiciled in countries with strong supervisory frameworks.

• Create a regional structure to facilitate production of the required regulatory and supervisory services, and foster coordination of efforts.

• Consider encouraging domestically chartered banks to expand abroad.

Encouraging International Branching As we have seen, international banks bring several sources of strength to the domestic financial system. They bring expertise that may not exist in the local market, and they may sharpen competition. Perhaps more importantly, they bring to the local market the financial strengths of the parent institution. Here branches offer an advantage over subsidiaries to the host

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country, for while subsidiaries are legally separate entities that can be, and at times have been, cut off by their parent institution during a crisis, branches are an integral part of the parent institution. And because they are regulated and overseen by home country regulators, branches are a means of "importing" the regulatory and supervisory services of the home country government, including its lender-of-last-resort and deposit insurance functions.

How should countries facilitate the establishment of international bank branches? One approach would be to attempt to harmonize to the extent possible the regulatory and industrial structures of the many countries involved, and then grant banks from these countries the freedom to do business in different countries under common ground rules. This approach has some appeal, but it is likely to prove unworkable, as did efforts in a similar spirit in Europe in the early 1980s. It would almost certainly be impossible to coordinate an agreement among the various countries on the appropriate, harmonized structure. The difficulties are in part logistical, and in part political, as many differences in bank regulatory and market structures are politically contentious matters. And it may be difficult or even economically counterproductive to harmonize banking structures overnight by fiat, because different systems of corporate governance have grown up around different national banking systems. One can imagine banking systems, nonbank financial markets, and the associated systems of corporate governance gradually converging to a common pattern, but it would quite likely be futile to try to harmonize banking systems while other aspects of the financial system remain diverse.

An alternative approach would take a page out of the European book.

The European Union has managed to eliminate barriers to the intra-European movement of banks, despite the persistence of important differences in national banking structures, by seeking to harmonize only the most essential elements of the regulatory and supervisory framework, agreeing to grant banks chartered in any member country permission to operate in the host market according to the same rules that apply in the home market, and trusting home country supervisors to oversee their activities.

A country in Latin America could accomplish much the same by, first, establishing a list of countries whose supervisory agencies are considered sufficiently capable of overseeing their banks' international activities; branches of banks domiciled in these countries would then be allowed to establish themselves and engage in business as they are permitted to do at home. Such branches would be expected to rely upon the financial resources of their parent, and in the event that the parent should run into difficulties, it would be expected to resort to the home country authorities for support.

The host country may want to establish an information-sharing arrange-

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ment with the home country supervisors to ensure that they are receiving the information they need, but the host country would be relieved of responsibility for supervising the bank directly.

By eliminating the need' to negotiate common standards or definitions of "adequate" or "equivalent" market access, this approach has the advantage that it is actually achievable. Indeed, it can be carried out unilaterally. Also, as noted above, it facilitates the importation of the parent institution's financial strength and the home country's regulatory and supervisory expertise and financial resources. However, because it permits foreign branches to do business just as they are permitted to do at home, this approach introduces an element of regulatory competition, creating the danger that domestically chartered banks will advocate the relaxation of prudential norms from the more stringent levels required by Latin America's volatile economic environment.

Creating a Regional Structure to Support Latin American Bank Regulation A major achievement of the International Monetary Fund (IMF) has been its role in improving the quality of central banking both in Latin America and in other regions of the world. The IMF has accomplished this by sharing technology and expertise accumulated in its activities around the world, by conducting and disseminating policy-relevant research on monetary and financial issues, and by reviewing policies and providing formal training to central bank staff.

No analogous institution supports commercial bank regulatory authorities in Latin America. But the need for such support is at least as great for the region's banking authorities as it is for its central bankers. Such an institution could help national authorities by exploiting economies of scale in solving the many common bank regulatory problems facing countries in the region, identifying and disseminating best practices, conducting and disseminating policy-relevant research on unresolved problems and new approaches to old problems, and helping to train staff from supervisory agencies. The institution could also provide a useful forum for the sharing of information about new regulatory initiatives and about economic and financial developments of relevance to bank regulators and supervisors. It could be a useful interface between national regulatory authorities and other relevant bodies, such as the Bank for International Settlements (BIS).

Finally, it would be a natural forum within which to secure regional coordination on banking issues, including coordination aimed at reducing the scope for regulatory arbitrage and other potential problems created by increased international integration.

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The question arises whether it makes sense for such an institution to be regional in scope, or whether these activities would be better placed under the auspices of a global institution such as the IMF, or of an expanded OECD or BIS. Economies of scale may argue for the latter, but in many of the institution's activities there are bound to be some equally important diseconomies of scale well before the number of countries reaches the world total. Although there is no reason to discourage initiatives at the global level, they are no substitute for a regional institution. Such an institution would complement arrangements that already exist for industrial economies. And the institution would be more productive if it were able to concentrate on issues that face Latin American economies. Although diverse in many ways, these economies face many common problems, which are often quite distinct from those of, for example, Africa, Central Asia or the South Pacific. Finally, a regional institution is a natural counterpart to the ongoing financial and nonfinancial integration of the region that has resulted from a variety of efforts, ranging from subregional trading blocs to the Miami Summit initiatives.

Should Domestically Chartered Banks Be Encouraged to Expand Abroad?

As we argued above, the borders that circumscribe domestic financial markets and separate them from each other and from international markets have little economic or business rationale, and result instead from the fact that the activities of chartering, regulating and supervising banks require a government with coercive powers, which is found at the national and subnational but not at the international level. But these borders are not innocuous; to the extent that they require banks to forgo the diversification of country-specific risks afforded by international activities, they make a country's financial system more brittle and increase the likelihood that a macroeconomic shock will be amplified by a collapse of the domestic banking system.

If the international activities of domestically chartered banks put public money at risk, these activities will need to be supervised, just as their domestic activities are. International activities do involve some additional risks, which must be set against the benefits of international diversification emphasized above. They also introduce some complications into the regulatory and supervisory process, including the danger of regulatory arbitrage. If the capacity to regulate and supervise banks is low enough so that these additional complications outweigh the potential benefits of diversification, it may be prudent to discourage banks from expanding their activities abroad until regulatory capacity is improved. This improvement

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could be facilitated by creating an international facility to assist Latin American banking authorities in carrying out their tasks, and to coordinate their activities with those of other banking authorities.

Concluding Remarks Globalization is a fact of economic life, in nonfinancial and financial matters alike. Most informed observers are persuaded that deeper integration is not only inevitable but also desirable. But whenever several reform agendas are in place, questions of sequencing arise. Recently the view has gained ground that securing deeper financial integration should be postponed until nonfinancial integration is achieved, because of fears that initiatives in the financial area will be a source of instability.

We share the spirit of these concerns, but not the policy conclusions.

Our fear is that postponement of initiatives to secure deeper financial integration will itself be a source of instability, because it will freeze the region into a state of shallow financial market integration, in which international capital flows wash in and out of domestic financial markets that are illequipped to manage them. We also see the internationalization of financial markets as complementary to the trade liberalization and regional integration that are on the region's immediate policy agenda. Deeper and more efficient financial markets, closely integrated with world markets, are needed to finance the many investments that will be required to effect the adjustment to reforms of international trade and investment regimes, thus easing the adjustment process.

The approach to integration that we have discussed would mark a substantial innovation for many countries in the region, but it would not amount to starting from scratch. Indeed, there are already several useful precedents in the region. In particular, those countries that have chosen to (or have had to) dollarize their economies have often found that they lack the financial resources to perform the lender-of-last-resort function. This has created strong incentives for policymakers to promote financial integration by ensuring that banks operating in the domestic market have strong ties to foreign banks, from which they can draw financial strength during a crisis. Panama is an outstanding example, and the resulting integration of its domestic system with the international financial system may be part of the explanation for the Panamanian puzzle discussed above. Financial integration has also been an explicit strategy in Uruguay, where the devastating banking crisis of the early 1980s convinced policymakers to promote entry of major international banks into the domestic financial market. Today the Uruguayan banking system is dominated by subsidiaries of major international banks, and is stronger as a result.

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Financial integration is no panacea for financial markets, and even if it were, it would be no panacea for development, because financial markets cannot address all of the region's development challenges. Panama illustrates the truth of this as well: although its outstanding financial system has certainly benefited the country, it has not wrought a development miracle. Since there are no panaceas, policymakers need to set priorities according to the likely costs and benefits of alternative policy approaches, and should not reject approaches simply because they fail to solve every development challenge.

Policymakers throughout the Americas are now engaged in defining and implementing regional integration goals for the year 2005 called for in the Miami Summit. Those discussions have so far emphasized integration in the areas of trade and investment. Without questioning the importance of initiatives in these areas, policymakers should consider making the achievement of deeper financial integration an earlier rather than later target in the reform process.

Michael Gavin is Lead Research Economist and Ricardo Hausmann is Chief Economist at the Inter-American Development Bank.

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Brock, Philip, ed. If Texas Were Chile: Financial Risk and Regulation in Commodity-Exporting Economies. Washington, D.C. Mimeo.

Calomiris, Charles. 1990. Is Deposit Insurance Necessary? A Historical Perspective. Journal of Economic History 50(2): 283-95.

Calvo, Guillermo, Leonardo Leiderman, and Carmen Reinhart. 1996. Inflows of Capital to Developing Countries in the 1990s. Journal of Economic Perspectives 19(2): 123-39.

Dale, Richard. 1984. The Regulation of International Banks. Cambridge, U.K.: Woodhead-Faulkner.

Gavin, Michael, and Ricardo Hausmann. 1996a. The Roots of Banking Crises: The Macroeconomic Context. In Ricardo Hausmann and Liliana Rojas-Suarez, eds., Banking Crises in Latin America. Washington, D.C.: Inter-American Development Bank. . 1996b. Sources of Macroeconomic Volatility in Developing Economies. Inter-American Development Bank, Washington, D.C. Mimeo.

Gavin, Michael, Ricardo Hausmann, and Leonardo Leiderman. 1995. Macroeconomic Dimensions of Capital Flows to Latin America: Experience and Policy Issues. In Ricardo Hausmann and Liliana RojasSuarez, eds., Volatile Capital Flows: Taming their Impact on Latin America. Washington, D.C.: Inter-American Development Bank.

Gavin, Michael, Ricardo Hausmann, Roberto Perotti, and Ernesto Talvi.

1996. Managing Fiscal Policy in Latin America: Volatility, Procyclicality, and Limited Creditworthiness. OCE Working Paper No. 326, InterAmerican Development Bank, Washington, D.C. Haubrich, Joseph G. 1990. Nonmonetary Effects of Financial Crises: Lessons from the Great Depression in Canada. Journal of Monetary Economics 25: 223-52.

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References

PART THREE • MICHAEL GAVIN/RICARDO HAUSMANN

Hausmann, Ricardo. 1995. En camino hacia una mayor integration con el Norte. In M. Aparicio and W. Easterly, eds., Crecimiento econdmico: Teoria, instituciones, y experiencia internacional. Bogota: Banco de la Republica and the World Bank.

Hovakimian, Armen, and Edward Kane. 1996. Risk-Shifting by Federally Insured Commercial Banks. NBER Working Paper No. 5711. National Bureau of Economic Research, Cambridge, Mass.

Inter-American Development Bank. 1995. Overcoming Volatility in Latin America. In Economic and Social Progress in Latin America. Washington, D.C.: Inter-American Development Bank.

Nairn, Moises. 1995. Latin America's Journey to the Market: From Macroeconomic Shocks to Institutional Therapy. International Center for Economic Growth Occasional Paper No. 62. ICS Press, San Francisco.

O'Brien, Richard. 1992. Global Financial Integration: The End of Geography. New York: Council on Foreign Relations Press.

Pecchioli, R. M. 1983. The Internationalization of Banking: The Policy Issues. Paris: OECD. Rojas-Suarez, Liliana, and Steven R. Weisbrod. 1996. Building Stability in Latin American Financial Markets. In Ricardo Hausmann and H. Reisen, eds., Securing Stability and Growth in Latin America: Policy Issues and Prospects for Shock-Prone Economies. Paris: OECD. ter Wengel, Jan. 1996. International Trade in Banking Services. Journal of International Money and Finance 14(1): 47-64.

Tesar, Linda, and Ingrid Werner. 1992. Home Bias and the Globalization of Securities Markets. NBER Working Paper No. 4218. National Bureau of Economic Research, Cambridge, Mass.

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Guillermo de la Dehesa

Gavin and Hausmann have written a very interesting and stimulating chapter about the importance of finance for development. The chapter considers how to create a financial environment that will reduce the cost of capital in Latin America and improve the allocation of financial resources in a way that enhances efficiency and productivity. Although I find myself in agreement with most of the authors' main ideas, I have some comments to make about different issues that, in my opinion, deserve further thought and discussion in order to improve both the chapter's conceptual framework and its policy proposals.

The main assumption of the chapter is that perfectly integrated world financial markets lead over time to a convergence of capital-labor ratios across countries, and therefore of productivity and wages and incomes per capita.

This is expected to happen because capital tends to migrate from areas where it is abundant and has a lower return to areas where its risk-adjusted return is relatively high, and these for the most part are areas where capital is scarce.

These flows of capital should reduce the cost of lending in capital-scarce countries and improve productivity and incomes there.

This theoretical assumption does not always hold in reality, however.

Perfect integration of capital markets sometimes leads to convergence, and sometimes not. One can cite examples, both within the United States and among the members of the European Union, where financial integration not only has failed to equalize capital-labor ratios, but on the contrary has given rise to greater divergence. The main reason why the theoretical assumption does not always hold is that it is based on the standard model of international trade and factor mobility. This model takes as given two other assumptions that do not hold in the real world of today. The first is that countries involved in trade and factor integration all have economies of the same or similar efficiency. The second is that there are no economies of scale or scope and no externalities.

Countries in the real world exhibit large differences in total factor productivity, not just across but also within regions, for example in Latin America and Europe. There are also large economies of scale to be exploited, especially when the integration of markets is deeper. For these reasons capital mobility sometimes leads to capital flowing not to areas where it is more scarce, but in the opposite direction. The more efficient and productive countries or regions tend to attract capital from the less productive ones. At the same time, economies of scale tend to cause capital to accumulate in certain locations and certain markets at the expense of others.

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Comment

PART THREE • GUILLERMO DE LA DEHESA

Panama, which the authors offer as an example of deeper financial integration in Latin America, is a special case because it is a very small country. In any case, its experience does not support the notion that deeper integration leads to greater prosperity: Panama has had financial integration for more than 20 years, and still its income per capita is not much higher than that of Costa Rica or Peru.

Because of the problems that arise with financial integration of countries with large differences in productivity, both the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) have been cautious about proposing complete liberalization of short-term capital movements in developing countries. I myself am in favor of opening up the capital account completely, but such initiatives need to be undertaken in the right sequence and in the right domestic context, economic and financial.

The authors propose two alternative strategies for achieving deeper financial integration. The first is to domestically "make" an efficient financial system that attracts and allocates capital in a productive way. Governments choosing this strategy have to provide public goods that are often absent in Latin America, such as a proper legal system to adjudicate and enforce contracts, and a regulatory and supervisory structure that inspires confidence on the part of financial institutions and their clients. Such governments also need to create an environment of macroeconomic stability.

This strategy is by now a familiar one and is being pursued by a number of countries in Latin America, but it is a long-term strategy that requires time to change the culture and attitude of the financial markets.

The authors' second strategy involves, according to them, less cost and less delay in implementation. In this strategy countries "buy" in the international market the key public goods of a sound financial system. As described by the authors, this strategy is composed of three main elements.

The first element is to encourage international banks to open branches in Latin American countries. This allows the host country to import not only the financial expertise but also the financial strength of the parent institution and the regulatory and supervisory services of its home government. It is for this reason that the authors prefer foreign branches to foreign subsidiaries: the latter are regulated and supervised by the host country; hence there is no importation of these services.

This proposal has, in my opinion, a number of problems. First, if Latin America wants deeper financial integration, it cannot be achieved merely by opening the doors to the establishment of foreign branches. Banks tend to open very few branches in other countries. When they do, the purpose is usually to target certain large potential customers such as governments, leading domestic companies, the subsidiaries of multinationals, and

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COMMENT

165

Bank Atlantico BBV BCH BEX Santander Santander de Negocios

Branches

Subsidiaries

0 1 4 1 0 1

2 4 5 5 11 0

wealthy families. For this purpose they do not need to open more than two or three branches in the capital and in one or two other important cities.

Integration through branches will thus be relatively shallow.

Second, recent experience shows that foreign banks are entering Latin America through the partial or total purchase of local banks, which then become subsidiaries, not branches, of the foreign bank. The privatization of state-owned banks and the sale of insolvent commercial banks have made it possible for foreign banks to penetrate Latin American financial markets without opening many branches.

The activities of certain Spanish banks illustrate this trend. As Table 1 shows, these banks have adopted a clear strategy for penetrating Latin American markets: they have achieved large market shares in some countries through the purchase of major local banks. Expansion through existing local banks does not achieve the goal of importing foreign regulation and supervision, but it has many advantages for the foreign banks: they acquire local expertise, allowing them to adapt to the culture, tradition and tastes of the local customers. They also avoid the nationalistic bias encountered in most counties, which leads domestic clients to tend to prefer local to foreign banks.

Nevertheless, in the last few years many international banks have tended to reduce their foreign expansion, given that the benefits of geographical diversification have proved smaller than the costs. As shown in Figure 1, in a number of industrial countries, profits of domestic banks are larger than those of foreign banks. Moreover, U.S. banks obtain a much larger profit from their domestic than their foreign activities (Figure 2).This explains why in some industrial countries (but not the less industrialized ones), foreign banks' market shares have been stagnant or declining.

Moreover, the Spanish financial market shows that there are decreasing returns to scale in the opening of branches or subsidiaries. Table 2 shows that although the number of foreign bank branches has been increasing, deposits and loans have not increased accordingly. The result has been large losses in some of the foreign banks.

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Table 1. Spanish Banks in Latin America, 1995

PART THREE • GUILLERMO DE LA DEHESA

Figure 1 Profits on Domestic Versus Foreign Banks in Selected Markets (In billions of U.S. dollars)

Figure 2 Source of U.S. Bank Profits (In billions of U.S. dollars)

Third, greater financial integration among countries, achieved through the elimination of barriers to entry and exit and of transaction costs, does not always lead to an increase in the number of foreign branches and subsidiaries. As the transaction costs associated with capital movements fall and the establishment of financial operations and the free sale of financial products and services become totally free, foreign banks gain an incentive to supply some of those products and services from their home countries at lower prices or smaller margins, by exploiting economies of

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COMMENT

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Year

By balance sheet size

By loan volume

By total deposits

By number of branches

1982 1989 1995

6.8 9.8 12.2

7.4 9.7 10.6

1.3 5.6 5.6

0.8 3.3 5.7

scale. The recent experience with European financial integration shows that there are clear incentives to agglomerate the production of financial services in certain locations and to distribute them from there to other countries. This trend affects mainly those products that are highly standardized and can be distributed in large volume.

The second element in the authors' "buy" strategy involves creating a structure to support regionwide banking regulation. But why is a regional structure needed? If the IMF and the Bank for International Settlements (BIS)—both highly respected institutions with expert staffs and an excellent track record in central bank regulation—can do the job, why create a new structure just for Latin America? Banking regulation should not be very different from one region to the next. To create a new structure requires time and qualified people, who are already available at the BIS and the IMF. This second element also raises a question. Where do Latin American banking systems most need help: with regulatory problems or with supervisory problems? In my view, Latin American banking systems are more in need of qualified and efficient supervisors and inspectors, who can oblige banks to comply with existing regulations, than of new or more sophisticated regulations.

The third element in the "buy" strategy is presented more as a question than a proposal. Should domestically chartered banks be encouraged to expand abroad? I agree with the authors' conclusion that it is better to discourage banks from expanding until regulatory capacity is improved, but I would add that supervisory capacity needs to be improved beforehand as well.

I would conclude by saying that the title of the chapter should be changed. "Make" and "buy" are not two alternative strategies; as the authors point out, they are complementary strategies to be adopted in sequence. If countries do not first "make" the conditions within which banks can thrive, they will find it difficult to "buy" foreign expertise, regulation and solvency.

Guillermo de la Dehesa is Advisor to the President of Banco Pastor, Spain.

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Table 2. Market Share of Foreign Banks in Spain (Percent of total)

Guillermo O. Chapman, Jr. The chapter by Gavin and Hausmann provides a good description of the volatility that afflicts Latin American economies and the need for deepening their financial sectors. The chapter also points out several important features of the Panamanian banking system, which include low real interest rates—possibly the lowest in the region—and a high proportion of loans to the private sector in bank portfolios, even when offshore operations are excluded. Panama enjoys better access to international capital markets than do its neighbors, and the Panamanian government has limited capacity— indeed, almost none—to intervene in international transfers.

The Panamanian monetary system is strictly based on the use of the U.S. dollar as legal tender; some Panamanian coins are used, but all bills in circulation are dollars. The legal basis for this system is twofold: the Constitution, which dates from 1904, forbids the issuance of fiat money, and a law passed that same year established the U.S. dollar as legal tender. It should be noted that there is neither formally nor in practice any connection between the use of the dollar by Panama and the Panama Canal treaty with the U.S. Thus the transfer of the canal's administration to Panama in 1999 will not affect present monetary arrangements. The government's policy is to continue the present monetary system after the transfer.

In addition, the capital account of the balance of payments has been fully open for the past century. Panama's tax system is based on territoriality: it taxes only those activities that take place within its borders; thus, transactions that are managed from Panama, including banking transactions, are exempt from income tax. Interest on deposits is likewise exempt.

This follows from the fact that the capital account is open: with Panamanian residents free to deposit funds wherever they like—including the U.S.— taxation of interest would merely send deposits overseas.

Panama operates an open banking system in which the presence of international banks, especially the better-known ones, is welcome. There are no limitations on foreign banks' participation in the domestic market, and in fact their presence has been, over the past 35 years, a catalyst for the creation of new Panamanian banks, which now dominate the local market. The fear of foreign banks dominating the local market has proved unwarranted in Panama's case. Moreover, all banks, domestic and foreign, receive the same regulatory treatment—in other words, there is national treatment for foreign banks.

The advantages of this system include low real interest rates and low inflation. Panama has consistently had lower inflation rates than the United

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States. Fiscal discipline is another direct consequence of this system, not because Panamanian governments are more virtuous than governments elsewhere, but because they have to balance the books. Deficits can be financed only if the government can find a voluntary lender. One of the accompanying benefits is macroeconomic stability.

Panamas system has not been without difficulties, however. All adjustments to external shocks have to be made in real terms, by reducing production or employment, or some combination of the two. Since there is no central bank of issue, there can be no lender of last resort. Panama's banks therefore voluntarily maintain relatively high levels of liquidity: 30 percent of total deposits on average. If one eliminated from this calculation those banks that in effect have two levels of defense—that is, those foreign-owned banks that have recourse to their headquarters and, ultimately, to the central bank of their home country—the liquidity ratio for the remaining banks would be much higher.

Another implication of Panama's system is that the country cannot maintain an independent monetary policy. This, however, may not be as great a sacrifice as it appears: some distinguished monetarist economists, such as Allan Meltzer, argue that only three or four countries in the world are able to achieve true independence in their monetary policy.

Gavin and Hausmann raise the question of how Panama is able to maintain the high level of external indebtedness that it does. Panama's debt is indeed very high, although not as high as shown in the chapter. The 1996 figure for total external debt is 66 percent of GDP, and that for total external debt service is 5.7 percent of GDP. One explanation may be the high levels of foreign exchange relative to its GDP that Panama generates— a phenomenon strongly associated with the type of banking and monetary system that Panama operates.

Panama's experience leads me to advocate that financial systems in developing countries be opened to the participation of banks headquartered elsewhere, especially in the more developed countries. Also important in our economies—indeed absolutely necessary—is a bank supervisory system with the authority and the professional and technical recourses to do the job, especially where, as in Panama, there is neither a lender of last resort nor any form of deposit insurance, which might otherwise provide comfort to the banks. Norms for liquidity, portfolio diversification and capital should approach best international practice. And, ideally, the monetary system should be managed by an independent central bank that is strong and capable. If that is not feasible, the viable alternatives are either a monetary board or, following the example of Panama, full dollarization of the economy.

Guillermo O. Chapman, Jr., is Minister of Planning and Economic Affairs of Panama.

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COMMENT

George J. Benston

Gavin and Hausmann make a very good case for how to overcome the scarcity of capital available to firms and households in Latin America. They argue that restraints on the international availability of capital are not the problem, and I agree. They argue, and again I agree, that the problem instead is limitations on the local intermediation of domestic and foreign resources. Their chapter also indicates—although perhaps not as strongly as one would have wished—that there should be a real divide between monetary policy and banking regulation. The two are by no means necessarily connected. It is possible to have monetary regulation, including open market operations, without regulation of banks at all, or, alternatively, bank regulation without monetary policy. These are separate and different things.

The limitations we observe on local intermediation point to some specific problems with financial systems in Latin America. An effective financial system requires the provision of certain public goods. The macroeconomic environment should be stable, bank regulation should be effective, the judiciary should enforce contracts, and domestic banks should be well capitalized. But as the authors point out, the first three of these goals are hard and take time to achieve, and the last, they argue, is costly.

As part of the solution, the authors suggest opening domestic markets to entry by foreign banks. Citing the example of Panama, they argue that branches of foreign banks are preferable from the host country's perspective to subsidiaries or separately incorporated banks. They make the point that internationally diversified banks are more robust and can diversify a country's exposure to regional shocks. They would allow foreign banks to follow the banking regulations in their home countries rather than those in the host country, although they warn that this might result in regulatory competition and lead domestic banks to advocate the relaxation of prudential norms. I would disagree with that warning and instead cite as a model the Brussels banking directive of 1992, which allows any bank headquartered in the European Union to operate in any member country in the same way that it does in its home country. This, in my view, is an excellent way to relax banking regulations that restrict banks from innovating and from competing effectively.

The authors would also encourage domestic banks to diversify beyond their countries' borders, although they do not say whether or not such diversification should be within Latin America only. They also suggest that foreign banks insure their deposits through the deposit insurance

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scheme in their home countries. And they advocate training of bank supervisors and examiners at the regional level, which I think is a good idea.

I would like to suggest an alternative approach to this issue—one that is not necessarily contradictory to that of the authors but simply another way of looking at the problem. Such an approach begins by looking at the concerns of lenders, because it is they who must decide whether or not to make financial resources available to consumers and businesses in capital-scarce countries. In making that decision, lenders estimate expected real cash flows from which loans might be repaid. In doing so they consider macroeconomic and business conditions, collateral and the enforceability of contracts. They also consider the country's stability: political, price level, regulatory and legal. And they consider the opportunity cost of the funds at their disposal. Obviously, if macroeconomic instability is high, the risk of nonrepayment will be likewise high and, therefore, the cost of providing capital to borrowers in such an economy will be high as well— so high, conceivably, that no loans will be made. There is no point in lending money, even at a very high rate of interest, if it will not be repaid. That, in the end, is the cost of running an economy poorly. Likewise, if lenders cannot expect to get their money back when the loan falls due because courts will not enforce lending contracts, money will not be lent.

The concerns of depositors are also part of the equation. The safety of their deposits is paramount—they, too, after all, want their money back.

The return on their deposits, the deposit interest rate, is important as well.

They also take personal convenience—the location of bank branches and the availability of other means of accessing their funds—very seriously.

Foreign banks have some special concerns. A principal one is that they be able to repatriate profits. Some foreign banks are in the business of supporting developing countries, but not very many. Most want to make their invested resources pay as much as would the same resources invested anywhere else. Foreign banks are also worried about expropriation. One often hears the concern expressed that foreign banks might do damage to the host country. But the real danger is the other way around. A sovereign country can always tell its foreign banks that they have 24 hours to leave the country and must leave behind anything they cannot carry onto the plane.

What, then, can Latin American countries do to encourage local lending? First, they can put or maintain in place a fair judiciary that will enforce contracts. Regulatory costs also need to be kept to a minimum, because someone (usually the consumer) has to pay them. Macroeconomic stability is obviously important, for the reasons already mentioned. Foreign banks need protection from partial or complete expropriation. But

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COMMENT

PART THREE • GEORGE J. BENSTON

the bottom line is the same for any bank anywhere. If countries make it costly for lenders to make loans, many loans will not be made that would have been made otherwise, and the country will not generate or obtain as much capital as it could.

What can countries do to encourage depositors? Deposit insurance has its uses, but it should be limited to the less informed depositors, to reduce moral hazard. We live, unfortunately, in a world in which governments are going to bail out depositors. There is no point in trying to return to a world without deposit insurance. But if deposit insurance is limited to people with small accounts—say, $5,000 or $ 10,000—then the political pressures that arise from large numbers of people clamoring to bail out all depositors and, perhaps, the banks, can be limited. Persons holding larger deposits can, and should, look out for themselves, as they do with any other investment. There should not be, as the chapter suggests, a higher deposit guarantee for foreign branches. The branches of foreign banks should be required to provide only the same level of deposit insurance required of domestic banks.

Alternatively, deposits could be privately insured. There is no compelling reason why government has to provide such insurance. For relatively small amounts per account, insurance can be provided by private insurers holding diversified portfolios.

Other contributors to this book have made the assertion that banking is special. It is not special. Banks are no more difficult to understand than other businesses—indeed they are much less difficult to understand than almost any other investment that one can make. Demand deposits exist because people want a place to put money that they can access at very low cost to purchase goods and effect other transfers of wealth. This means that banks have to be concerned about runs. Bank runs are not bad; indeed, bankers' concerns about bank runs are good. One cannot eliminate the possibility of runs without eliminating the discipline on bankers to ensure that the deposits they hold are secure.

Capital requirements should be at least 10 percent of assets for domestic banks, including the subsidiaries of foreign banks. Countries should institute a program of structured early intervention and resolution for troubled banks such as the United States has established under the FDIC Improvement Act of 1991. That legislation created a series of predetermined triggers for intervention: if a bank's capital falls below a certain level, the authorities may, at their discretion, take action, and if capital falls below a certain still lower level, they must take action. Banks must be taken over before their capital falls to zero. The intent of such legislation, however, is that banks will never have to be taken over, because a private

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owner will presumably either sell, recapitalize or liquidate the bank rather than let a government agency take it over. This expectation has so far been borne out.

Foreign branches should not be subject to specific capital requirements, because there is no way to impose such requirements. If the bank is strong and well supervised by the headquarters country, and if the bank guarantees or collateralizes deposits, that is sufficient to protect depositors. Subsidiaries, on the other hand, should be subject to domestic requirements.

Supervision of both domestic and foreign banks should be limited to regular reporting, with some mechanism for verifying that the reports are not false or misleading. Independent accountants could play a useful role here. Banks should have effective internal controls and be audited to guard against insider dealings and possible fraud. The control of rogue banks is something that supervisory authorities must always be concerned about.

Foreign banks would be permitted to operate branches if the home country enforces capital requirements, but would have to be organized as separately capitalized subsidiaries if the home country's prudential supervision is weak, as was the case with BCCI. The often-expressed concern that foreign banks, if allowed entry, might come to dominate the domestic banking sector, is unfounded. Even if it happened, this would not be cause for alarm, because consumers would be served, perhaps better than before. And our concern, after all, should be for domestic consumers and borrowers, not for the jobs of domestic bankers. Moreover, as long as entry is not restricted, foreign banks will compete with each other as well as with domestic rivals. But, in any case, local banks should normally beat foreigners in open competition, because they have a tremendous cultural edge and greater knowledge of their customers. It is for this reason, in fact, that foreign banks usually hire locally, which also means that foreign banks will serve as a training ground for local bankers, preparing them eventually to work for domestic banks or even start their own.

George J. Benston is the John H. Harland Professor of Finance, Accounting, and Economics at Emory University.

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Approaches to Credible Safety Nets

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PART FOUR

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Peter M. Garber

A financial safety net is a government-orchestrated set of principles and operating policies aimed at preventing large disturbances at one or a few financial institutions from spreading to the entire system of financial intermediation. Such disturbances can arise because many claimants on the financial system lack information about the quality of investments backing their claims, and because those claims are in a much more liquid form than the corresponding assets. These inherent features of financial systems can, in extraordinary circumstances, lead to runs on troubled institutions, contagion effects on other institutions, problems in making payments, losses to third parties, and other externalities that can be prevented, in theory, at relatively low cost. Disturbances external to the financial system can also be magnified if they adversely affect the solvency of the system.

Thus, over the course of time, institutions of a financial safety net—lenders of last resort, prudential regulation, deposit insurance, and resolution schemes—have emerged to protect the capital of financial institutions and to avoid sudden disintermediation.

The financial system is in the business of efficiently allocating a society's savings to investments whose payoffs will be sufficient, under most economic outcomes, to make good on the promises made by financial institutions to the suppliers of those savings, To ensure the proper allocation of investment over time, institutions that fail to invest well enough to service their liabilities while generating adequate returns to shareholders should exit the financial industry through failure or liquidation, leaving the liability holders to bear the consequences as in any other industry. In this way, owners and management are most likely to make proper investment decisions.

By its nature, a financial safety net tends to undermine the accountability of owners, managers and other claimants on a financial institution by generating moral hazard: that is, unless the safety net is cleverly constructed, it enables the players involved to gain from taking riskier positions than they would otherwise. The financial system can then become more prone to crisis than in the absence of a safety net, requiring frequent and costly interventions.

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The Transition to a Functional Financial Safety Net

PART FOUR • PETER M. CAREER

To accommodate this tension between moral hazard and avoidable externalities, financial safety nets are carefully crafted mosaics whose pieces, in the best of worlds, should subtly fit together to push banks to behave as if there were no safety net, while still eliminating the externalities from the financial system. Thus, for example, we see very detailed prudential regulations accompanying lender-of-last-resort facilities and deposit insurance.

These regulations are designed to constrain the outcomes of the portfolio decisions of financial institutions to what those institutions would choose without subsidized liquidity support or deposit insurance. No system is perfect, however, and the one that emerges in a particular country can be interpreted as reflecting an assessment of and a balancing between the likely costs of, on the one hand, the negative externalities of a collapsed system and, on the other, the long-term misallocation of capital. The consensus view on which type of loss is worse tends to depend on the outcome of the most recent crisis.1 In practice, over a broad spectrum of countries, prudential regulations have been either weak on paper or poorly enforced, most often because of the political power of parties associated with financial system interests. Troubled institutions have often been bailed out or their problems otherwise resolved without the costs falling as promised on the principal decisionmakers and other claimants. Thus, political infeasibility makes the carefully structured mosaic of regulation and resolution more fiction than reality as a means of establishing proper incentives.

However damaging they may be, incomplete or weakly enforced regulations are not sufficient to lead to systemic financial problems. Problems occur when managers of financial institutions have a strong incentive to take unusual risk. Such an incentive exists when there is little actual equity capital or little franchise value in the institution. Especially in an era of liberalization and financial innovation, financial institutions tend to lose value because of increased competition, and the need emerges to rationalize the system through closures or mergers. If this does not happen, aggressive institutions will expand in contests for market share. It is no coincidence that difficulties in establishing effective financial safety nets have been so widespread. The need to rationalize the financial system of each country is a natural outcome of the globalization of markets. Given the 1 For example, Calomiris (1996) argues that the losses from bailouts are very large: the cost of the bailout of the savings and loan industry in the United States exceeded in real terms the direct costs of bank failures during the Great Depression; the Venezuelan bailout cost 16 percent of GDP in 1994; the Hungarian bailout cost 10 percent of GDP; and bailouts in Finland and Norway cost 8 percent of GDP. Calomiris takes the position that the costs of a financial safety net generally exceed the benefits. However, it is usually the fear of the potential for a major depression, rather than the calculus of direct losses to the banking system, that provides the ultimate economic rationale for an extensive safety net.

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incentives they face, financial institutions have readily found ways to circumvent the spirit of prudential regulations, leading to the sequence of banking failures observed across numerous economies in the 1980s and 1990s, regardless of the country's level of economic development. Banks without value are a locus of expansion and collapse.

Restructuring Safety Nets in Latin America The catastrophic Latin American exchange market and financial crises of the 1980s, which resulted in underinvestment and slow or negative growth for most of the decade, brought a much more conservative, technically oriented leadership to the forefront of economic policymaking by the early 1990s. The new policymakers were committed to several basic principles: that the inflationary financing that had been common in the region was in itself a devastating problem rather than a useful expedient, and was to be avoided even at great cost, and that the institutional structure of private and fiscal finance had to be radically changed. The new leadership was also convinced that ongoing government deficits, to the extent that they were not funding clearly profitable infrastructural investment, were to be eliminated. This view led to the wave of market liberalization and privatization that was the remarkable feature of many Latin American economies in the first half of the 1990s.

In concrete implementation, these principles were not prominent in the 1980s in most developing and industrial countries, nor are they even now in many important financial centers. The Latin American experience, however, showed the immense cost of not adhering to these principles, at least in the context of the 1980s. Thus, we have seen some implementation of them to address the crises of 1994 and 1995.

The ultimate goals of a safety net are not controversial, and its methods of operation are generally understood. Most countries are converging to formally similar systems of deposit insurance and prudential regulation. However, in Latin America—Argentina, Brazil, Mexico and Venezuela, in particular—the effectiveness of moving toward international standards in their safety net systems is problematic because of the difficulty these countries face in filling the already negative capital positions of their financial institutions.2

2

1 focus only on countries that have experienced recent crises rather than on those countries that did not pass through crises in the 1990s, such as Chile and Colombia. Rojas-Suarez and Weisbrod (1996) discuss how noninflationary macroeconomic policy coupled with a priority of resolving problem banks from the crisis of the early 1980s established a sound banking system in Chile, in comparison with those of Mexico and Argentina.

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TRANSITION TO A FUNCTIONAL FINANCIAL SAFETY NET

PART FOUR • PETER M. CAREER

This chapter examines several aspects of this convergence. To establish a baseline, the current status and transitional plans of financial safety nets are reviewed for three countries that have recently experienced financial crises—Mexico, Argentina and Brazil. The focus is on these countries' efforts to establish soundly financed safety nets and capitalized banks. The chapter also considers whether the reforms themselves may lead to increased efficiencies and sources of profit that can finance at least part of the cost of transition, and the extent to which financial systems that are open to international competition at the retail level can themselves make up for past losses without losing business to foreign competitors. Part of the chapter is devoted to analyzing the pitfalls that will emerge as insolvent entities attempt to avoid tightening prudential regulations, and as various aspects of the safety net are adjusted.

Interior Decoration of the Architecture: Type One Versus Type Two Errors in Bank Resolution Within the general architecture of the safety net, decisions must be made about what to do with institutions that get into trouble. In this context, two errors of policy can occur. The first can be labeled a type one error: the liquidation of a bank that is basically solvent, has franchise value, and should remain open. In a type two error, conversely, regulators fail to liquidiate an insolvent bank with no franchise value. As part of the interior design within the basic architecture of the safety net, supervisors must establish operating principles for the resolution of troubled banks, depending on their perceived probabilities and tastes for each type of error. Supervisors may establish principles under which they will quickly intervene and close insolvent banks to avoid type two errors, at the cost of closing many solvent institutions. But excessive zeal in closing institutions can make matters worse, and may even cause sound institutions to collapse in the fire-sale atmosphere of a liquidity crisis. Alternatively, supervisors may operate in such a way that they rarely liquidate a solvent bank, at the cost of keeping open many misbehaving, insolvent institutions. Indeed, the resolution principles may in turn dictate the basic architecture of the system.3 Banking problems have been resolved differently in various countries, especially in terms of their ultimate costs. In most cases, however, the process has been protracted. This has been true even in countries where 3

For example, the system in effect in Argentina before the advent of the Tequila crisis of 1994-95 sent the signal that troubled banks might have difficulty finding liquidity support or protection against bank runs that a deposit insurance scheme might have offered. This reflected the priority of preserving foreign exchange parity, but it also indicated a willingness to sacrifice even potentially solvent banks.

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banks have been rapidly closed, for even there the process has still had to play itself out in the courts.

In the interim, most countries have implemented policies of rolling the problem into the future, on the assumption that the problem is in part one of temporarily poor liquidity, associated either with a downturn in the business cycle or with an excessive pessimism on the part of the banks' creditors. Delaying resolution has the benefit of distinguishing (in hindsight) those banks for which the problem is temporary from those that are effectively insolvent—that is, of avoiding a type one error. The cost of such a strategy is that insolvent entities continue to function and run up additional losses, and this type two error effectively subsidizes the insolvent banks, while perhaps generating capital problems for those institutions that were solvent. The structure of incentives then drives even the solvent banks to take increased risk.

This tension causes authorities to take a stand on one side or the other on the rapidity of bank closures. Each authority develops, from experience, its own sense of what its operating principles should be. If the results of past banking crises indicate that the banking system was forced to consolidate excessively, then the operating principle will be to keep the banking system from shrinking too rapidly in the next crisis. Thus, the system will have extensive deposit insurance schemes, capital injection schemes, and heavy regulation of the banking and financial system to protect it from competitors, onshore or offshore, and to prevent it from taking excessively risky positions.

If no protracted economic downturn was associated with a previous banking crisis, or if the financing necessary to carry the banking system into the next growth phase proved difficult to obtain, the operating principle will be one that dictates less intervention in the banking system, and perhaps even extensive closure and consolidation of the banks, with depositors bearing the costs. This sort of solution is most palatable to free market economists, who take a dim view of government intervention because of the moral hazard issues. Therefore, one can readily place oneself on the side of virtue by espousing such principles.4 What might be interpreted as permanent and universal principles of a safety net operation thus in fact stem from ephemera—the memory of the most recent crisis—yet establish themselves in the operation of the regulatory system for years or decades thereafter. When the next crisis finally comes, these principles may prove unable to cope with it.

4

Typically, however, the embrace of virtue stems from necessity and the difficulty of finding a lender.

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PART FOUR • PETER M. CAREER

The most common structure for a financial safety net is one that ensures extensive facilities to provide liquidity, provides deposit insurance with relatively high limits per account, and allows insured banks to undertake a wide range of potentially risky business endeavors.5 (The system that existed in Argentina at the time of the Tequila crisis was a counterexample to this basic model: with foreign exchange policy managed in the manner of a currency board, and in the absence of deposit insurance, the provision of liquidity was limited.6) Within the standard safety net structure, strategies for supervision and regulation and intervention differ radically from country to country.

Before the 1990s, supervisory intervention was not triggered until a troubled bank's capital fell to zero, which in practice meant that the bank was by then seriously insolvent because of lax enforcement of the categorization of nonperforming loans and loan-loss provisions. Countries in Latin America now take Basel-type capital standards seriously, with the result that regulatory intervention will now occur at an earlier stage of insolvency.7 Of course, the definition of regulatory capital depends on the power and determination of supervisors and on the nature of the prudential regulations in effect, and these also differ across countries.

Many systems lack explicit deposit insurance, although it is clear that depositors expect either bailouts of the banks or ex post insurance protection in the event of a liquidation. In other systems, very limited deposit insurance is offered explicitly. Most often, such systems impose lifeboat schemes in which the Ministry of Finance or the supervisory authorities organize the takeover of insolvent banks by solvent ones, with the cost distributed among the remaining banks according to some formula, which 5

At the time of the banking problems in the United States in the late 1980s, the old Chicago school prescription of narrow banking—deposit insurance should be provided only to institutions that hold essentially riskless, short-maturity paper—was briefly resurrected. The idea was to insure only those institutions with direct access to the payment system and inform depositors in all other institutions that their deposits were uninsured. An immediate objection is that the uninsured part of the banking system would then revert to being prone to bank runs and the associated credit contractions—a problem that proved so severe in the Great Depression that it led to the current system of extensive deposit insurance. Indeed, Friedman and Schwartz (1963) praise the institution of deposit insurance as a key institutional change in the stabilization of the supply of money. A second problem is that the banks at the heart of the payment system are the key providers of daylight and overnight credit to the financial system. Barring them from credit provision to private borrowers would significantly raise the costs of many liquidity-hungry institutions, such as futures markets, and perhaps eliminate the business.

6 With the provision in 1995 of limited (and private) deposit insurance, Argentina has moved closer to . the standard structure.

'For example, the powers granted to U.S. regulators under the Federal Deposit Insurance Corporation Improvement Act of 1991 allow them to intervene strenuously while bank capital is still positive. Whether political pressures will deter them from actually doing so has yet to be tested, because, as it happens, U.S. banks have been highly profitable since the law's passage.

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the regulators may determine on an ad hoc basis. Sometimes the costs imposed on the acquiring party can be made up later through quiet regulatory forbearance on competitive or other matters. In France and Japan, such resolution methods were commonplace until recently.

Prudential Regulation: The Architecture's Mechanicals Prudential regulations are a well-accepted method of averting the moral hazard problems that arise in the operation of most financial institutions.

These institutions need certain guidelines and supervision to protect their claimants. The ultimate claimant in many banking systems is a deposit insurer, either implicit or explicit, which itself leans on the fiscal authority to back its guarantees. The fiscal authority must protect itself against excessive risk taking by insured institutions.

Prudential regulations may take several organizational forms. They may be rigid, effectively consisting of a code of conduct that bars any operation of the financial institution that is not explicitly allowed. Alternatively, financial institutions may be allowed to do anything that the regulations do not explicitly prohibit, provided they take reasonable precautions to avoid excessive risk. This approach generally gives rise to a more liberal environment, but it imposes on the authorities a responsibility to ensure, by mounting an extensive supervisory operation, that banks are not taking on undue exposure. Unlike a simple regulatory operation that determines whether or not a bank's activity conforms literally to a particular set of rules, supervision in a liberal environment must make quantitative assessments of the nature of bank risks.

Regardless of how rigid the rules or how close the supervision, however, some banks will fail. Failures may occur one at a time, because of the idiosyncratic behavior of certain banks, or they may occur simultaneously throughout the banking system. Almost always, bank failures signal a failure of prudential regulation. The ability of regulators to carry out their task is regularly undermined by an inadequate allocation of resources to their activities. Problems may emerge for technical reasons, such as lack of a good accounting or legal system that can see through complicated corporate structures and force a consolidated accounting to prevent the hiding of bad assets in subsidiaries. Or they may occur because a lack of resources limits on-site inspections, or because the enforcement powers of the supervisor are weak.8 Often the regulators are familiar with their banks' problems in detail, but political pressure deters them from exerting their formal powers.

8

De Juan (1996) provides an extensive list of how the methods that supervisors have at their disposal to contain insolvency can readily fail. In each case, the underlying problem is a lack of political will to enforce the regulations. See also De Krivoy (1996) on the requirements for supervision and regulation.

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TRANSITION TO A FUNCTIONAL FINANCIAL SAFETY NET

PART FOUR • PETER M. CAREER

Various restrictions can be used to control the growth of bank balance sheets. These include reserve requirements, capital requirements, direct regulation of the types of assets that banks may hold and the liabilities they may offer, and prohibitions against excessive concentration of assets or risks in particular sectors. Thus, for instance, a rule might forbid lending to the real estate sector beyond a prescribed multiple of the bank's capital. Individual banks may be prevented from growing excessively fast.

To set the general culture of a bank and to foster competence and honesty, fitting and proper rules governing senior management and controlling owners may be imposed. To ensure adherence to minimum capital requirements, rules governing loan classification, provisioning, and accounting standards are also established.

Such restrictions aim to avoid the standard trouble spots in a banking system. A bank expanding too fast is usually considered an early warning signal of problems. Every bank has a limited amount of risk management capacity; sudden expansions of loans must surely outstrip its ability to expand that capacity, especially because the bank is probably taking on riskier clients. Also regarded as an early warning of bank problems is excessive lending to a single borrower or sector. Another danger sign is selfdealing among management and owners.

All such activities can be proscribed through regulation. Nevertheless, such proscription is inadequate by itself to prevent problems in banks from arising from those very activities. Modern banks can readily avoid regulations, either in a straightforward manner or by going offshore or engaging in off-balance-sheet activities, which violate the intent, if not the letter, of regulations. Preventing this kind of avoidance requires a stringent regulatory environment in which the supervisor can, through consolidated supervision, reach through the bank and all its corporate affiliates, onshore and offshore, to prevent regulation from being circumvented. Because regulations can be circumvented in an extremely sophisticated manner, equal sophistication is required of the supervisor (see Folkerts-Landau, 1996, p. 103). The supervisor must have the power and will to issue ceaseand-desist orders to prevent various activities from being undertaken. If they are undertaken anyway, the supervisor must have the power to remove officials and penalize or even close the banks. And this power must be exercised before the bank has maneuvered itself into a negative capital position and created a liability for the deposit insurer.

All these requirements for successful prudential regulation are truisms, and they appear frequently in the statutes authorizing the activities of bank supervisors. The problem, of course, lies in exercising these powers. Closing down or stringently disciplining a bank is in all countries an inherently political act. It is usually relatively easy to close a small bank;

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closing a large bank requires, to a much greater degree, the assent of the political authorities. The latter tend to avoid closure and overregulation of banks, because they rely on them, both to undertake investment projects that are politically beneficial to them, and as funding mechanisms for their own activities. Banks may offer politicians a means of providing unappropriated expenditures to a particular region or sector. Regardless of the nature of the benefits or costs emanating from the banking system, this means that the banks have powerful political protection that can subvert the actions of the regulators.

Ideally, the banking sector should channel its resources into lending that is suitable for it: relatively low-risk, liquid investments that can be made to generate cash in a short time to meet the demands of liability holders. If claimants are likely to demand cash denominated in foreign currency, the bank's investments must be able to generate quick payoffs, or the bank itself must be able to unlock lines of credit in foreign currency to meet these demands. In this way, an exchange crisis can be separated from a banking crisis rather than go hand in hand with it.

How do the various restrictions in the arsenal of prudential regulation channel capital? Liquidity requirements on banks must define which types of securities qualify as liquid; if binding, these requirements force an increase in demand for those securities that meet the definition, and reduce the funding costs of the institutions that issue them. These institutions can then increase their overall investment activity and shorten the maturity of their liability structure. If these institutions are prudently run, they will indeed concentrate on projects that can be liquidated quickly, so that the regulation will be effective in enforcing greater liquidity on the banking system. If they are not, the liquidity position of banks will prove a mirage in time of crisis, when the issuers of the securities cannot produce the demanded cash as quickly as needed. If the securities that satisfy liquidity requirements include government securities, this lowers the cost of government funding. Nevertheless, if the securities are to be mobilized in a liquidity crisis, as is the purpose of a liquidity reserve, there must be a ready secondary or repurchase market for the securities; otherwise their purpose will be defeated through deep discounting.

Reserve requirements force the banking system to hold demand claims on the central bank in an amount equal to some fraction of on-balancesheet deposits. Together with a limitation on the expansion of bank reserves, reserve requirements control the on-balance-sheet expansion of the banking sector. Because deposits at the central bank generally pay belowmarket (or even zero) interest rates, an increase in reserve requirements widens the spread between the interest rate that banks charge for loans and the rate they pay on deposits. The increase in spreads leads to

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disintermediation, with the banks' business going either to financial institutions not subject to the requirement or to offshore banks (which are often affiliated with the domestic banks). Domestic banking institutions can also avoid reserve requirements through the use of derivative products.

Risk-based capital requirements directly restrain the expansion on bank balance sheets of those assets classified as risky; simultaneously, however, they tend to increase the riskiness of those assets that are held in this category in order to cover extra capital costs.9 When capital requirements are imposed, banks tend to circumvent them by seeking loopholes in the definition of what constitutes capital. This leads to resistance to classifying loans as nonperforming, through restructurings or the capitalization of interest payments due on old loans. In turn, the funding of these rollovers forces deposit rates to be bid up and funds to be channeled into losing projects. Problem banks will then expand at the expense of sound banks.

Banks will also strive, through market manipulation, to avoid marking money-losing securities to market: for example, assets will be held off the market so that market prices need not be recorded. Activities that are subject to a risk-capital requirement will also be driven off the balance sheet, where they attract a lower requirement. For example, an on-balance-sheet holding of equities might be converted into a swap or a structured note that is highly leveraged but that has a relatively small capital requirement.

A ban on holding securities on margin or on short sales will mean that equity holders will not be forced to join the general scramble for cash in a liquidity crisis, and thereby reduce the potential magnitude of the demand for cash. Such a ban, however, reduces the liquidity of securities markets, thereby forcing up yields and reducing their desirability as a source of funding. This is desirable in economies that are essentially illiquid— yields on securities should reflect the degree of illiquidity. Nevertheless, bans on margin buying tend to push such activity offshore, through overthe-counter derivative markets.

Who Should Pay to Fill in the Negative Capital in Banks?

The list of candidates for covering the losses of failed banks is short: the taxpayers, the equity holders and managers, the borrowers, and the depositors. Inevitably, the taxpayer will directly pay for much of the loss, to the extent that the government bonds and other paper injected during the crisis liquidation of the insolvent banks are not monetized. The exigencies of the crisis dictate that public credit must paper over the problem ini-

'The Basel risk categories can be used to determine varying risk-based premia for deposit insurance.

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tially, but the government can later reach out to recover part of the loss.

Who bears the loss and who escapes are crucial determinants of public expectations about the next crisis and therefore shape the nature of the moral hazard that builds up in the wake of the immediate crisis.

The equity holders are natural candidates to shoulder losses, as they were best placed to determine the risk position of their failed banks.10 In the absence of fraud, however, it is difficult to do more than strip the owners of their equity in the bank. This may be a weak disincentive: a risky bank can record high profits for years, richly rewarding its owners through dividends. By self-dealing through complicated corporate structures, owners can take even more out of the bank and send these gains abroad. It is notoriously difficult to recover much of these depredations in civil proceedings. Especially with institutions considered too big to fail, a bailout effort is often undertaken, with capital injections, loan purchases, preferential access to central bank foreign exchange, or other concessions, which leaves the original ownership in place.

Smaller depositors are rarely forced to pay directly for losses in banks when there is deposit insurance.11 Thus, they have little incentive to control the behavior of banks by withdrawing retail deposits. Larger depositors generally can remove their funds before the bank collapses. However, depositors can be made to pay for past losses indirectly if they are kept captive to the banking system through restrictions on the provision of competitive products.12 Banks can then widen their spreads and pay belowmarket rates on deposits. This will increase the profitability of banks and perhaps bring them back to solvency. Alternatively, it will allow them to pay the high insurance premia that may be required to restore deposit insurance funds to solvency. Finally, to the extent that depositors are captive to banks, inflation can reduce the real value of the loss to the system.

Going after depositors through forced restructuring, however, creates a problem for the next crisis. Instead of being passive bystanders, depositors will stage a run and perhaps prematurely precipitate a liquidity crisis.13 10 Rojas-Suarez and Weisbrod (1996) provide three basic principles for resolving bank crises in a way that avoids inflationary finance. First, ensure that those parties who have benefited from the failed institutions' risk taking bear a large portion of the cost of restructuring. Second, take prompt action to prevent the expansion of problem institutions through credit expansion to risky borrowers and capitalization of interest due on outstanding loans. Third, give priority to bank restructuring by dedicating public revenues to extinguish the problem without inflation.

11 Exceptions are the Mexdollar deposits of 1982 and the resolution of Argentina's banking problems at the end of that country's hyperinflation.

12 However, efforts to liberalize financial systems and encourage competition imply that customers are now much less tied to their banks.

13 In addition, the many small depositors in a banking system aggregate to a large number of votes. In the Rhode Island banking crisis of 1991, the state initially resolved not to pay off the depositors of the closed institutions. This resolve crumbled when large numbers of well-dressed octogenarian ladies were shown regularly on the news broadcasts hurling themselves in protest in front of the politicians' limousines.

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Efforts can be launched to make borrowers, whose defaults triggered the credit problems, repay their debts. In many countries, however, it is legally difficult to force payment or to seize debtors' property. Even if it can be taken, the value of the property serving as collateral will obviously have fallen below the amount of the loan; even so, experience has shown that the eventual disposal of such property can pay for much of the cost of resolving a bank. The broader problem with collecting from borrowers is that their loss of collateral and inability to acquire more credit will generally precipitate a severe economic downturn that may worsen the banking crisis.

The resolution of a systemic crisis generally involves mergers and consolidation of what had been an overbanked system. Thus, two additional potential sources of bank revenue can emerge in the restructured banking system. One arises from a reduction in competition that allows a widening of spreads, so that future bank depositors and borrowers pay part of the cost of the resolution. The other arises from a rationalization of the production of bank services that permits a closure of branches and a reduction of bank personnel. To the extent that the increased revenue of the remaining banks can be tapped, it can serve as an additional source for financing the cost of resolution.14 Status of Banking Systems and Safety Nets in Mexico, Argentina and Brazil Mexico The reprivatization of the Mexican banking system from June 1991 to July 1992 was accompanied by financial liberalization. Credit controls and reserve requirements were removed, interest rates were freed to be set by the market, and banks were granted permission to offer U.S. dollar-denominated accounts and new financial products.15 The reprivatization of 18 commercial banks raised 38.6 billion new pesos (about $ 12 billion). Banks were purchased at prices 2.2 to 3.1 times book value.

Buyers reportedly borrowed heavily to finance their purchases, so that the reprivatized banks were revenue-hungry from the outset.16 Loans 14 One of the requirements for the injection of Norwegian government capital into that country's troubled banks was that they reduce their operating costs. See Drees and Pazarbasioglu (1995) for details.

15 For an analysis of the competitiveness of the Mexican banking system at the time of reprivatization, see Garber and Weisbrod (1993).

16 The three largest Mexican banks are Banamex, Bancomer, and Banco Serfin, with shares of the deposit markets of 21 percent, 20 percent, and 13 percent, respectively, and similar shares of the loan markets. Their risk-weighted capital was 11.7 percent, 10.5 percent, and 8.9 percent, respectively, in September 1994.

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by Banamex, Mexico's largest bank, grew by 40 percent in 1992,48 percent in 1993, and 18 percent in 1994. Loan growth for the other two large banks, Bancomer and Banco Serfin, was similar, except that Banco Serfin's loans grew by only 27 percent in 1993, a recession year. For smaller banks like Banco Mexicano, loans tripled in the two-year period 1992-93. The expansion was accompanied by increasing fractions of mortgage and consumer lending in the loan portfolio. In addition, foreign currency loans amounted to 22 percent of the loan book.

Even before the crisis, the expanded loan book had been performing poorly. Past-due loans in September 1994 were 9.1 percent, 7.5 percent, and 9.7 percent of the portfolios of Banamex, Bancomer, and Banco Serfin, respectively. Loan-loss reserves at these banks were 46 percent, 37 percent, and 31 percent of their past-due loans, respectively. In addition, the Mexican banks had taken large, unbalanced positions in the over-the-counter derivatives markets that would generate further major losses in the crisis (Garber, 1996).

Before their sale, banks had mainly been lenders to the government, with their allocation of assets decided through directed lending and strict reserve requirements. After reprivatization there was strong growth in private lending. An ever-tightening supervisory system played catch-up with the banks, with the adoption of the Basel capital requirements and stricter loan-loss reserve requirements. Although Mexico was moving rapidly toward stronger supervision and regulation, the problems in the banks that became visible after reprivatization led to speculative behavior that further weakened them.17 Supervision and regulation were in the midst of being updated when the crisis overwhelmed all such efforts. Apparently, the attempt to liberalize the system and simultaneously to construct a regulatory apparatus to control it was too ambitious.18 In previous banking crises, Mexico had protected both depositors and bank owners, and the 1995 crisis was no different. The first official response, in January 1995, was a program to provide temporary capital injections to bring bank capital back to the Basel minimums. The capital injection program was operated by FOBAPROA, the deposit insurance fund.

In addition, a program to restructure some of the loans in the banks was "Liquidity ratios in the six largest banks averaged 9.3 percent at the end of 1993 and 14.4 percent at the end of 1992. For Bancomer and Banco Serfin, the end-1993 liquidity ratios were 6.4 percent and 4.3 percent, respectively, while for Banamex the ratio was 23 percent.

18 The Banco de Mexico (the central bank) and the Comisi6n Nacional Bancaria (the national banking commission) supervise the Mexican banking industry, engaging in surveillance of credit institutions, formulation of regulations, supervision, and the approval of banking officials. The banking commission has recently merged with the Comisi6n Nacional de Valores, the regulator of the securities markets. The required capital ratio is the Basel ratio of 8 percent. In a departure from the normal Basel standards, 80 percent of revaluation reserves of fixed assets and real estate subsidiaries may be included in tier 1 capital. This constituted 45 percent of total equity in 1994.

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begun, and part of their loan portfolios was bought by FOBAPROA, also with the intent of recapitalizing the banks. Losses from the purchased loans will be shared with the banks. These recapitalizations and restructurings were funded through loans from the Banco de Mexico to FOBAPROA or with government bonds. FOBAPROA passed the funds through to the banks, and the funds were then redeposited in frozen accounts in the Banco de Mexico. Thus, to the extent that these loans are not repaid as the economy recovers, they presumably will eventually be a charge on the government.

By the end of 1995, nonperforming loans in the banking system amounted to about 98 billion new pesos, or about 12.2 percent of the loan portfolio. With the addition of the 38 billion new pesos in loans acquired

by FOBAPROA in the last half of 1995, nonperforming loans would have been 17 percent of the portfolio. The authorities had intervened in six banks, five of which had been reprivatized in 1992. Five banks had made use of the capital injections program; and 13 banks had undertaken loan sales to FOBAPROA. The total fiscal cost of these programs was put at about 84 billion new pesos, about the dollar value of the proceeds from the reprivatization, or 5.5 percent of GDP, by the end of 1995 (Ministry of Finance, Mexico, 1996).

In the face of a problem of such magnitude, it is difficult to impose a radical restructuring of the financial safety net to address the failings that emerged in the crisis. Nevertheless, even as the programs to restore bank capital have been implemented, some efforts to restructure the banking system have been launched. It is clear that the banking sector will have to be consolidated, so that within a few years only six to nine of the 18 reprivatized banks will remain.19 A much less restrictive attitude toward foreign banks has also emerged through regulatory and legal changes. Foreign banks were encouraged to increase their equity positions in Mexican banks in order to ease the recapitalization problem. For example, Probursa became an affiliate of a Spanish bank, Banco Bilbao Vizcaya, and the Bank of Nova Scotia took a 55 percent controlling interest in Inverlat. The Bank of Montreal bought 16 percent of the shares of Grupo Financiero Bancomer, and 13 large foreign banks were authorized to open banks in Mexico in 1995. Legal changes allowed foreign banks to increase their equity holdings in larger Mexican banks to 49 percent, and foreign banks can now acquire Mexican banks whose capital is less than 6 percent of the system's capital (Ministry of Finance, Mexico, 1996, p. 20).

19 The real value of loans to the private sector in the portfolios of the commercial banks fell by about 40 percent from December 1994 to April 1996. The banks basically are in the business of trying to collect on old loans, and the system has suffered disintermediation as commerce has resorted to an expansion of trade credit.

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The lesson absorbed by the Mexican authorities is that, although they were rapidly coming to grips with a highly risky banking system prior to the crisis, the regulatory structure did not evolve quickly enough in its powers or in its information-gathering ability to stem the crisis. Thus, the supervisors' grip is being tightened to prevent excessive risk taking in the future. A notable aspect of this initiative is the requirement that the banking system move to the more stringent Generally Accepted Accounting Principles by 1997. Furthermore, the use of value-at-risk methods to determine market risks and proper capitalization of such risks was made mandatory in the second half of 1996.

These are the sorts of changes in supervision and regulation that one would expect where the basic outlines of the financial safety net include full deposit insurance and bailouts of banks and borrowers. Tight supervision is then the only way to avoid moral hazard. Nevertheless, the presence of insolvent banks that are allowed to continue operations—"dead banks walking"—serves as a continual threat to circumvent regulations. Those institutions that have poor prospects should be severely restricted in their ability to expand.

Argentina At the time of the 1994-95 Tequila crisis, the Argentine safety net was formally the least protective of bank owners and depositors of any major financial system in Latin America. There was no deposit insurance, and the liquidity facilities that might have been provided by the central bank, the Banco Central de la Republica Argentina (BCRA), were limited. Furthermore, Argentina had a history of making depositors pay part of the cost of insolvent banks. High capital requirements and actual levels of capital in the banks meant that the banks generally were strong enough to withstand the liquidity test posed by the crisis and the high interest rates that followed. The high liquidity requirements provided banks with a source of ready cash to pay off depositors.

The institutional organization of the safety net was such that the Argentine banking system responded to the crisis in a manner reminiscent of the behavior of the pre-Federal Reserve U.S. banking system. Distrustful depositors ran on the weaker banks, taking out about $8 billion, or about 18 percent of all deposits in the system. The financial system as a whole, orchestrated in this case by the central bank rather than a private clearinghouse, had to mobilize the limited amount of available reserves and distribute them among the banks. For example, the BCRA offset about $5 billion of the run through rediscounts and repurchase agreements, by releasing its excess foreign exchange holdings, and by reducing reserve re-

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quirements. The large liquidity holdings of the banks themselves covered the rest of the cash withdrawals. Some of the weaker small banks were forced to close and were merged with the surviving banks.20 Ultimately, the fiscal cost of the banking crisis was small, amounting to no more than 1 percent of GDP. (The solvency of the provincial banks remains problematic, but this was recognized before the crisis.21) Nevertheless, the banking system is still experiencing severe problems.22 Argentines have expressed satisfaction with the behavior of their banking system and its safety net in the crisis, at least in comparison with the Mexican experience. Nevertheless, the subsequent economic downturn, also typical of the aftermath of a pre-Federal Reserve style banking crisis, has been quite severe and has been followed by the resurgence of a large fiscal deficit. This has been interpreted as a bad equilibrium resulting from a liquidity crisis.

Thus, in a sort of deja vu, there has been some effort to move away from this most laissez-faire of systems through institutional changes aimed at ameliorating some of its harshest features and at reducing the chances of a similar crisis. The changes amount to finding additional sources of liquidity for a lender of last resort and providing some deposit insurance.

Since May 1995, banks have been required to provide deposit insurance through a private, guaranteed fund for demand deposits up to $10,000 per account and up to $20,000 for deposits maturing in more than 90 days.

Risk premiums charged to the banks are determined according to Baseltype risk classifications. To the extent that it is credible, this system is intended to keep small depositors from participating in a bank run. (It is recognized that the deposit insurance fund will be insufficient to pay off large failures.) In addition, liquidity requirements have replaced reserve requirements and have been set at 16 percent against demand accounts and at lower percentages for time deposits, depending on their maturity.23 20

Forty-five institutions were either merged or suspended, and new laws were passed to ease the takeover of troubled institutions. Also, two funds were created, one with funding from multilateral lenders to privatize provincial banks, and one with funding from the sale of Bonos Argentines (government bonds) to support private banks and encourage mergers. International Bank Credit Analysis (IBCA), an international bank credit rating agency, has argued that some of the mergers were somewhat precipitate. Stronger banks purchased heavily discounted loan portfolios from the weaker banks so that they might have liquidity during the runs. In classic fashion, the heavy discounts in some cases converted a liquidity problem into a solvency problem.

21 The Argentine banks may have proved stronger than the Mexican banks in part because they had had less time to expand their balance sheets after macroeconomic stabilization, and because Argentine legal and tax restrictions had not yet been reformed. Therefore, Argentine banks had not moved into extensive use of the sort of derivative products that added to the losses of the Mexican banks.

22 Although central bank reserves and bank deposits have recovered, the merged institutions continue to show losses. Depositors, aware of the large amounts of problem loans remaining, have lost confidence.

Banks are staying liquid by placing funds in government paper or the securities of large corporations.

23 The liquidity instruments can take the form of reverse repurchase agreements with the BCRA, using Argentine government dollar-denominated bonds (letras de liquidez), which are placed in accounts

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Finally, and most recently, the BCRA has invited high-quality international banks to offer it contingent repurchase agreements for Argentine dollardenominated securities—that is, options for the BCRA to engage in such repos—and has received offers for a total of about $7 billion. This would allow the BCRA to mobilize Argentine government securities received from banks in reverse repurchase agreements to generate dollar liquidity.

Brazil Brazil's banking problems are a direct result of the distortion of the country's financial system during the hyperinflation of the early 1990s. The implementation of the Real Plan in 1994 served either to unmask the insolvencies that had accumulated in the system or to launch banks into risky operations to make up for lost inflation revenue.24 Thus, the Brazilian bailout and restructuring schemes have been primarily retrospective, aimed at liquidating the distortions of inflationary finance, including the distorted organization of the banking system. Welch and Armstrong (1996) estimate the negative net worth of the system at about 90 billion reals, of which about 45 billion has already been funded by the Brazilian authorities through bond sales and injections.25 The restructuring of the system has involved the closing of many smaller banks and the takeover of some of the larger ones by stronger institutions, although strong political pressures have delayed the resolution process.26 In the recent period of relative price stability, banks lost a major source of revenues from their float operations, which they attempted to offset with rapid growth in lending rather than by expanding their intermediation of government debt. As in Mexico and Argentina, banks lacked a risk management culture, yet had to adapt their human capital and systems to the problems of the new environment. Thus, loans in the banking system grew by about 50 percent in the second semester of 1994. The credit squeeze of 1995 triggered illiquidities in the weaker banks, and the authorities took this as an opportune moment to consolidate the system.

maintained by the BCRA; or private liquid securities held in custodial accounts managed by Deutsche Bank, New York; or domestic liquid securities along with a put option for those securities on a highquality foreign bank.

"The discussion in this section is based on Welch and Armstrong (1996) and on various IBCA reports.

"Most of the remaining problem is associated with the Caixa Economico Federal. Although this institution, which is part of the system for funding housing construction, has not done new business for 10 years, its losses accumulate at the rate of interest. Another ongoing difficulty stems from the provincially owned banks, which have strong political protection.

26 Welch and Armstrong provide several examples of how difficult it is politically to impose such restructurings on the banking system. The phenomenon is also discussed in Rojas-Suarez and Weisbrod (1996) and Calomiris (1996).

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In response to the banking insolvencies, the Banco Central do Brasil acquired increased power to lay the costs of future problems on bank owners, beyond the loss of invested capital. In addition, to address the problem of excess capacity in the banking system, it developed a strategy of pushing for consolidation of the system through merger and acquisition.27 The central bank developed a program for restructuring and strengthening the financial system. The subsidization of consolidation through this program can, however, strongly encourage expansion by small banks, which can quickly become almost too large to fail. This may in the future create an environment of excessive risk taking.28 This points to a general problem in the industrial structure of those banks involved in mergers and acquisitions. Who will do the mergers and acquisitions? Will it be the biggest banks, which already are systemic in their risk, too big to fail, and the source of potential future problems? Or will it be the medium-sized banks, whose managements see themselves as those that will be allowed to fail in the event of a solvency problem? If there is a benefit from being too big to fail, medium-size banks will scramble to grow into too-big-to-fail institutions themselves, and they will pay excessive premia for the banks and assets thrown on the markets. Also, whereas the old management of the moribund banks may have been relatively conservative and disinclined to play double or nothing, the managements of the acquiring banks will be much more aggressive, repeating a phenomenon observed in the early stages of the U.S. savings and loan crisis.

Some Steps Toward Functional Safety Nets Foreign Bank Capital Once the initial problems of the banks have been addressed so that capital in the banking system as a whole is no longer negative, banks can be recapitalized by allowing and encouraging their acquisition by foreigners.29 Even if the acquired banks are structured as subsidiaries, typically there will be a close association between parent and subsidiary. Ideally, the par27 Although Brazil has many small banks, the banking industry as a whole is concentrated: the five largest banks control 55 percent of bank assets, and the next five an additional 15 percent.

28 See Welch and Armstrong (1996, pp. 6-7), who point to the case of the Banco Excel, which became large purely through the acquisition of the assets of Banco Econ6mico.

29 As already noted, Mexico has encouraged foreign banks to take over some of the country's smaller banks and has increased the amount of equity in the larger banks that foreign banks may acquire. Peru has privatized some large banks through foreign acquisition, and foreign banks have bought some of the already privately owned banks. The Colombian government privatized some of the banks it had acquired during the crisis of the early 1980s, selling them to Venezuelan banks, and controlling shares in other privately owned banks were bought by international banks (see Garcfa-Cantera, 1994, 1996).

Colombia's actions were not, however, driven by crisis, as in other countries.

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ent bank, to preserve its own reputation, will take steps to ensure that the subsidiary will not run into solvency or liquidity problems.30 If, instead, a foreign bank enters the country in the form of a branch, its own national deposit insurance covers the risk to depositors. Finally, an additional set of regulators, uninfluenced by local political concerns, will appear on the scene to examine the bank. Of course, the principal concern of these regulators is with the parent bank; they will worry about the subsidiary only to the extent that it is connected to the parent. Indeed, foreign regulators have the incentive of reducing unduly close ties with the parent bank, so that the subsidiary might have to subsist on its own access to the market.

With immediate knowledge of the domestic banks, foreign subsidiaries may channel liquidity into the country in time of crisis.31 In addition, through their greater competitiveness, they can impose an upgrade in the risk control systems and business practices of domestic banks.

On the downside, foreign banks may be less subject to domestic political pressures in their lending and investment decision making. It is a classic view that foreign banks tend to be cherry-pickers, stripping the profitable wholesale domestic market, to the extent that it still exists, from the domestic banks and leaving them only the riskier retail market.32 Also, foreign banks, once in a market, are adept at using their international connections and expertise to pick apart the domestic regulations and earn profits in that manner. They push domestic banks into the more risky and speculative markets while simultaneously providing the operating tools for the domestic banks to engage in such operations. Of course, it is difficult to stop foreign banks from providing these tools—they can always operate offshore and provide the same services to domestic banks while taking much of the wholesale business of the domestic banks in any case.33 30 Liquidity is not necessarily readily available, however. During the Mexican crisis, some foreign private investors pulled funds from Citibanks Mexican subsidiary to reduce their exposure to that country, forcing the parent to sell the assets backing the deposits as they came due. The parent could have lent funds to carry the position until maturity, but it decided that it had already lent enough to its subsidiary, and so it forced a liquidation loss. Citibank required its Mexican subsidiary to acquire liquidity on the market and not through its parent. On the other hand, funds were readily available to the subsidiary in Mexico itself, because the bank was perceived as a higher-quality, lower-risk entity. It could pay 4 percentage points less than Banamex or Bancomer on deposits, but it actually discouraged deposits because it did not perceive sufficient lending opportunities, including high-spread lending to the largest banks. Thus, it did not serve as a source of liquidity in the teeth of a liquidity crisis.

31 More likely, however, the risk control programs at corporate headquarters may require the foreign subsidiary to cut off liquidity lending—direct lending and even repos—to domestic banks in a crisis, in a scramble to reduce counterparty risk.

32 Foreign banks often serve the large domestic companies with significant international names. They generally take such customers to the Euromarkets, where they underwrite their medium-term notes and Euro-commercial paper. Trade finance and foreign exchange business with large domestic corporations are also done offshore. A foreign bank might have a small onshore balance sheet, but its operation in the host country may support an offshore balance sheet that is four or five times larger. Thus, staffs at foreign banks will generally be large relative to their onshore balance sheets.

33 See Garber and Weisbrod (1993) for an expansion of this argument.

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A further accusation made against foreign banks is that they often will not channel capital toward those sectors regarded domestically as vital to development. The domestic banking system, on the other hand, by virtue of regulators' control over charters and the possibility of regulatory abatement in return for compliance, can be encouraged to undertake such lending. Foreign banks may be excessively conservative and thereby reduce the amounts and direction of investment. Domestic banking systems often fall into problems because they have a wider-ranging field of investment. It may be better to have an occasional crisis, as long as capital can move in a direction that the national polity prefers.

Capital injections from foreign banks into the banking system are often neither easy to obtain nor benign. In the presence of widespread insolvencies, foreign banks may fear that they will be assessed, after having made their investment, to pay for past failures along with the rest of the banking system.34 Thus, they may hesitate to undertake an onshore investment, preferring instead to transact business with domestic institutions from offshore.

Finally, a sudden admission of foreign banking competition into a system with low capital can further reduce the franchise value of domestic banks and lead to a secondary crisis within a few years, as domestic banks compete to retain market share. A drive for market share generally implies an undeipricing of products. Only through strict control of the expansion of the domestic banks can this secondary crisis be avoided.35 Supervisors will then appear to favor the newly arrived foreign banks, making control of the domestic institutions politically problematic.

Developing Secondary Markets A lack of liquid secondary markets for banking assets has severely restricted the operation of the safety net. Secondary markets do not function well for several reasons: a lack of legal standing for some market operations, slow clearing and settlement systems for securities, and legal encumbrances on taking collateral on defaulted loans.

34

For example, in 1992 an Amsterdam bank, having just set up a subsidiary in Paris, was unexpectedly assessed by French authorities according to an obscure formula, along with the rest of the banking system, to pay for the resolution of a failed French bank.

35 The relatively strict system of Argentina can be interpreted as inviting a movement of business from tightly restricted onshore banks to foreign-owned banks located offshore. The high liquidity requirements serve to drive wholesale business offshore, especially because of the unique ability to use dollars in payment of interbusiness obligations. All that is required is a well-functioning payments channel to New York. This leaves only middle-market firms and small depositors in Argentina. Banks then need only do essentially cash business onshore.

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Rojas-Suarez and Weisbrod (1996) argue that the institutional development of secondary markets in assets and claims held by the banking system is desirable as a backstop to the resolution of troubled banks and as a means of transition to a permanent safety net. They recommend the establishment of the legal structures necessary for secondary markets to develop in the principal assets held by banks. The ability to market the assets of failed institutions reduces the cost of their resolution and, indeed, makes ex ante prescriptions to resolve rapidly troubled institutions more credible. Ready secondary markets imply that the supervisor can finance much of the cost of resolution through quick asset sales and therefore needs to place less pressure on scarce financial resources when liquidating the portfolios of closed institutions. The actual closing of institutions then becomes a viable threat, reducing the probability that troubled institutions will be bailed out through capital injections. Costs can be reduced, because foreclosed assets in the hands of supervisors tend to depreciate rapidly.

Although in many secondary markets liquidity cannot be created overnight, hindrances to the development of such liquidity can be removed.

For example, arranging for same-day systems of settlement of government and other securities can foster an overnight interbank repurchase market and smooth the liquidity requirements of individual banks. Same-day settlement is also vital if the central bank is to function effectively as the lender of last resort: it can receive instant delivery of dematerialized securities and engage easily in repurchase operations with foreign banks to complete the chain of liquidity. This is the rationale behind the recent Argentine initiatives to streamline settlement and arrange credit lines with foreign banks. It is a logical fine tuning of the Argentine safety net architecture and makes autonomous runs on the Argentine banking system less likely.

Liquidity in markets, however, is a double-edged sword. Making assets readily available for liquidation in an emergency also makes them available as good collateral in normal times. Thus, banks can more easily mobilize their liquid assets in establishing leveraged positions through offshore over-the-counter derivative products. Adverse market price movements can then trigger margin calls that quickly wipe out the liquidity reserve.36 The surveillance capacity of consolidated prudential regulation must then be augmented to detect such operations.

Private Deposit Insurance In fine tuning its financial safety net, Argentina has, as noted above, introduced a private deposit insurance scheme for small deposits in which banks 36

See Garber (1996) for a description of such a phenomenon in the Mexican crisis of 1994.

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TRANSITION TO A FUNCTIONAL FINANCIAL SAFETY NET

PART FOUR • PETER M. CAREER

are required to participate. Private deposit insurance schemes have a long and fairly uniform history: they eventually fail. A primary reason for their failure is that such schemes are generally launched in limited geographical markets or in situations in which the insurance principle cannot function.

For example, most banking systems are heavily concentrated, with a few large banks and several dozen or more smaller banks. If any large bank fails, the insurance fund will be inadequate to cover the losses, so the deposit insurance is not credible for depositors in large institutions. If a regional economic downturn occurs, numerous small banks may become insolvent at the same time, so the insurance lacks credibility in this context as well. Only in the case of an idiosyncratic failure of one or a few small banks will deposit insurance pay off.

Thus, the small banks have an incentive to take risks, unless they are controlled by the supervisor. In this context, the deposit insurer—i.e., the larger banks—will want the power to supervise the insured institutions and to take regulatory action. Thus, the large banks must have a strong voice on the board of the insurer and in its management. This means that the large banks may be able to use the insurance scheme to thwart competition from the small banks. The large banks, in turn, must be guaranteed by the government for the scheme to work in the event of a large bank failure.

Most private deposit insurance schemes provide for assessment of additional contributions from the remaining solvent members should the insurance reserves become exhausted. This power often turns out to be illusory, however, as members refuse to hand over their liquid assets in the teeth of what surely will be a liquidity crisis.

Finally, requiring banks to have deposit insurance in order to engage in banking business may itself cause a seizing up of the banking market and a forced closure of the banks should the insurance fund be declared insolvent. To prevent this, the government must inevitably intervene with funding.

For the scheme to be at all credible, it must involve an assurance that the government will not permit the insurance fund to become insolvent; this effectively makes deposit insurance a public institution, even if it is organized as a private one. The benefit of a private scheme is that the government need not reveal explicitly the extent of its guarantee. Thus, small depositors may be less likely to precipitate a run than in the presence of no insurance at all. Alternatively, knowing that there is more moral hazard than in an uninsured system, and knowing that they may be forced to suffer large losses, depositors may be more likely to test the system.

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The basic architecture worldwide of financial safety nets provides for a system of similar institutions: a lender of last resort, deposit insurance, and prudential regulation. The nature of the banking systems, resolution methods, and prudential regulation that the safety nets backstop does differ across important banking markets, but prudential regulation is converging as a result of the crises of the 1980s and 1990s to a model of consolidated regulation, strict capital requirements, and similar accounting principles. The safety nets and the detailed mechanisms of their operation can be functional in those banking systems whose banks have value, in that they enhance existing incentives to reduce excessive risk taking resulting from moral hazard. In countries such as some in Latin America whose banking systems suffer seriously from negative capital positions and overbanking, these formalisms of the safety net may not be functional in reducing excessive risk taking because of the strong incentive for banks to double their bets for survival. Thus, the first order of business has been to eliminate the negative capital positions of the banks through capital injection, liquidation and merger. The hole has been filled for now with the injection of government paper, part of which is expected to be financed through the rising revenues of anticipated economic recovery. A recovery would also restore some value to nonperforming assets and thereby reduce the problem.

Pending a recovery, the role of the safety net has been to restrict growth in the troubled banks to prevent an echo of the crisis in the next few years until the public finances and the courts can eliminate the problem. In the meantime, some financial safety nets and banking industrial organizations have been adjusted to account for the lessons of the recent crises. These changes are double-edged swords. In many markets, restrictions have been removed on the entry of foreign banks to bring more capital and liquidity into the system and to improve risk control methods. The downside may be to force domestic banks to take riskier positions to maintain market share. In one country, a private deposit insurance scheme has been implemented to calm small depositors; the downside may to create more moral hazard and increase the likelihood that small depositors will test their banks.

Finally, efforts are under way to make interbank markets more liquid, thereby making it easier to operate the lender-of-last-resort service; as a negative effect this may allow banks to mobilize newly liquid securities as collateral in the construction of risky leveraged positions.

Peter M. Garber is Professor of Economics at Brown University.

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Calomiris, Charles W. 1996. Building an Incentive-Compatible Safety Net: Special Problems for Developing Countries. Paper prepared for the conference on "Policy Rules and Tequila Lessons," Buenos Aires, Argentina, August 12.

De Juan, Aristobulo. 1996. The Roots of Banking Crises: Microeconomic Issues and Supervision and Regulation. In Ricardo Hausmann and Liliana Rojas-Suarez, eds., Banking Crises in Latin America, pp. 83102. Washington, D.C.: Inter-American Development Bank.

De Krivoy, Ruth. 1996. Crisis Avoidance. In Ricardo Hausmann and Liliana Rojas-Suarez, eds., Banking Crises in Latin America, pp. 171-92. Washington, D.C.: Inter-American Development Bank.

Drees, Burkhard, and Ceyla Pazarbasioglu. 1995. The Nordic Banking Crises: Pitfalls in Financial Liberalization? IMF Working Paper WP/95/ 61 (June). International Monetary Fund, Washington, D.C. Folkerts-Landau, David. 1996. Comment. In Ricardo Hausmann and Liliana Rojas-Suarez, eds., Banking Crises in Latin America, pp. 103-5. Washington, D.C.: Inter-American Development Bank.

Friedman, Milton, and A. J. Schwartz. 1963. Monetary History of the United States, 1867-1960. Princeton: Princeton University Press.

Garber, Peter. 1996. Managing Risks to Financial Markets from Volatile Capital Flows: The Role of Prudential Regulation. International Journal of'Finance and Economics 1(3): 183-96.

Garber, Peter, and Steven R. Weisbrod. 1993. Opening the Financial Services Market in Mexico. In Peter M. Garber, ed., The Mexico-U.S. Free Trade Agreement. Cambridge, Mass.: MIT Press.

Garcia-Cantera, Jose. 1994. Colombian Banking System. Research Report, Salomon Brothers, Latin America Equity Research Department (June 28).

1996. Peruvian Banking System. Research Report, Salomon Brothers, Latin America Equity Research Department (July 1).

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Ministry of Finance, Mexico. 1996. Consideraciones Sobre la Evolucion del Sistema Bancario Comercial Durante 1995 Mimeo. (July).

Rojas-Suarez, Liliana, and Steven R. Weisbrod. 1996. The Do's and Don'ts of Banking Crisis Management. In Ricardo Hausmann and Liliana Rojas-Suarez, eds., Banking Crises in Latin America, pp. 119-51. Washington, D.C.: Inter-American Development Bank.

Welch, John, and Christine Armstrong. 1996. Emerging Markets, Latin America: The State of Brazil's Banks II. Topical Report (July 15).

Lehman Brothers, New York.

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TRANSITION TO A FUNCTIONAL FINANCIAL SAFETY NET

Michael Foot

Although I agree with much of Peter Garber's interesting chapter, there are two points with which I firmly disagree. The first is his statement that "almost always, bank failures signify a failure of prudential regulation." I agree that supervisors often get it wrong, and as he says, they often suffer from a lack of resources, inappropriate political influence, inadequate power and authority, and so on. But in a capitalist system there has to be the occasional bank failure to demonstrate that the system is doing its job. The supervisor should be measured against the still demanding but not impossible task of identifying any failure early enough so that its effects upon the depositors of the failed bank, and more widely within the system, are as limited as possible.

My second disagreement is with some of Garber's remarks on the pros and cons of involving foreign banks. In particular, I would cite as a strong plus, and not a "downside," the fact that foreign banks may be less subject than domestic banks to domestic political pressures in their lending and investment decisions. I am sure his argument is correct, but I would draw exactly the opposite conclusion. If the domestic authorities want to influence the pattern of lending, they should do so explicitly, through transparent subsidies, and not opaquely through nods and winks to the banks.

This is not to suggest that foreign banks are angels, but neither are they charities. It is also worth remembering that foreign banks are not always as good as they would like to believe at the critical task of assessing the creditworthiness of domestic firms.

Let me now offer three thoughts on Garber's broader analysis. First, should the authorities spell out in advance how they will deal with a banking crisis? In countries where the central bank is also the bank supervisory authority, the technical if not the political power to act as lender of last resort lies in the same hands as the detailed knowledge about banks and the banking system arising out of the supervisory process itself. A supervisor outside the central bank has the latter only. Both offices, however, would normally agree on the desirability of constructive ambiguity, to use Gerald Corrigan's well-known phrase—that is, of not spelling out exactly who would be protected or under what circumstances the authorities would act. On the other hand, there may still be real value in setting out at least the general considerations behind lender-of-last-resort decisions. The present Governor of the Bank of England did so in November 1993, and this action was of considerable help in explaining our decision 16 months later not to rescue Barings Bank. The Bank of England was reluctant to get involved in

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the Barings case. As Walter Bagehot put it in the nineteenth century, "Any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank."

In setting out the conditions for lender-of-last-resort decisions, two issues had to be addressed. What effect would the failure of the institution have on the system as a whole? And what should be done to protect the system from contagion? We set out five criteria. First, we would explore every avenue leading to a possible commercial solution before committing public funds. Second, if a bank did receive such funds, any losses would fall first on the shareholders and any gains would go to the Bank of England as lender of last resort. We have found several times over the last 20 years that what looks unsellable at the bottom of the economic trough is actually very attractive and financially viable years later. Third, we aim to provide liquidity, and we will not, in normal times, support a bank that we know to be insolvent. That was one of the criteria that Barings clearly failed.

Fourth, we look for a clear exit, so that we can get as much of our money back as possible. Fifth, we usually try to keep the fact that we are providing systematic support secret at the time. Of these five precepts, I believe that the fifth is the most controversial. But our experience has been that if people know we are concerned about systemic fragility, and that we have judged it necessary to intervene, it could and has led to a wider loss of confidence.

But all five of these criteria are worthy of consideration in a developed or a developing market economy.

My second thought, also drawn from our experience, is that given the bewildering array of uses to which supervisors can put their limited resources, they should try to focus on the lessons that history has taught about the causes of bank failures. The Bank of England has just completed a study of 22 bank failures and near failures over the period 1984-95. It was found that the overwhelming source of bank problems in the United Kingdom in that period was poor management, as reflected most obviously in inadequate systems and controls, less often in poor strategic thinking, and still less often (but still frequently) in poor credit assessment. Inappropriate group structure, connected lending, and outright fraud found their place, but a limited one, in the list of causes.

Although every country's history will be different, there are still lessons to be learned from experience elsewhere. It is to the credit of a number of the international organizations that a growing body of comparative work is rapidly becoming available from which to draw. This information is particularly useful in the case where an economy is undergoing the major shock of coming out of a period of rapid growth and spiraling asset prices. We have now seen the consequences of such a transition in a number of industrial and developing countries. Supervisors, if they are wise,

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can be better equipped than before to run suitable scenarios, or "stress tests," for their institutions. This demonstrates to the banks the quality of their strategic thinking and contingency planning, allowing them to take precautionary measures earlier in the cycle.

My final observation is that, although I am wholeheartedly behind the idea of making at least some bank assets more liquid to help cope with unexpected liquidity problems, one has to be very skeptical of how much difference that will make in practice. Of course, supervisors can and should monitor banks' liquidity and, on occasion, will want the liquidity position strengthened significantly in the face of a perceived threat. But in studying the structure of banks' balance sheets in the United Kingdom and abroad over the last 20 years, I was surprised by the extent to which they still differ from those of securities firms, both in the relative ease with which banks can raise funds without offering collateral, and in the difficulty they have in getting a significant proportion of their assets into reasonably liquid form. The questions I have raised about when to invoke the lender-of-lastresort function are going to continue to demand the attention of policymakers and bank supervisors, I fear, for a long time to come.

Michael Foot is Executive Director of the Bank of England.

Comment Miguel Mancera

Peter Garber s chapter on the transition to a functional safety net in Latin America is both interesting and insightful. He clearly describes the historical, political, economic and social considerations pertaining to the design and operation of such a safety net. He also brings to fore the trade-off between avoiding the negative externalities of a collapsed system and avoiding the perverse economic incentives that safety nets can foster. The chapter's conclusions and recommendations should certainly be heeded by those entrusted with the improvement of financial safety nets in Latin America and elsewhere.

My comments will relate mainly to Garber s references to the Mexican case. Regarding the origins of Mexico's recent banking crisis, Garber states that buyers of nationalized banks in Mexico borrowed heavily to finance their acquisitions. This turned the privatized banks into revenuehungry institutions, encouraging both rapid growth in lending and large unbalanced positions in the over-the-counter derivatives market. Garber

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rightly adds that the increased appetite of the privatized banks coincided with the liberalization of credit intermediation. But other elements also helped spur the rapid growth of bank credit to the private sector and explain the poor quality of many loans.

Mexican commercial banks had been undergoing profound changes in the two or three years preceding privatization. One factor that contributed to these changes was the shift away from relatively riskless portfolios, consisting mostly of loans to the government, to risk-prone lending to the private sector. Before the 1990s, the government had run large deficits financed with loans from the banking system, and neither the public administrators of commercial banks nor the supervisory authorities worried much about the risk of bank portfolios. In fact, by the end of the 1980s bank credit to the private sector had become a rather small proportion of total bank assets. Not surprisingly in such an environment, the capacity of banks to evaluate risk deteriorated in terms of both the number and the qualifications of the personnel devoted to risk analysis.

An extraordinary expansion of bank credit to the private sector then followed, from 1990 to mid-1993. The supply of bank credit available to the private sector grew as the public sector deficit fell sharply, a surge of capital inflows entered from abroad, financial liberalization restored the intermediation function of banks, and reserve requirements and mandatory lending to the government were gradually eliminated.

The expanded supply of bank credit to the private sector was viewed at the time as a most favorable development: at last, the private sector was gaining access to the resources it needed to increase production and improve living standards. Private sector demand for bank credit was rather strong, thanks to several factors: favorable expectations for the overall Mexican economy, the need to modernize and expand Mexico's industrial plant to compete in a more open economy, the need to correct an appalling housing shortage, higher perceived permanent income, consumers' desire to replace obsolete stocks of durable goods, and borrowing requirements to finance the acquisition of state enterprises being privatized. Each of these was in itself a desirable outcome of Mexico's stabilization policies and structural reforms. But their coming together with certain other developments eventually led to the nonperforming loan problem. First, the crowding-in effect produced by the correction of endemic disequilibrium in public finances compelled banks to scramble for private credit customers at a time when their staffs and systems were inadequately prepared to assess credit and market risk. Second, at the margin, the composition of credits to the private sector shifted conspicuously toward consumer spending (particularly in durable goods) and housing. Third, dollar-denominated credit to the private sector grew rapidly until the beginning of 1992, when

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the central bank imposed restrictions on the increase of foreign currency liabilities of the commercial banks. Finally, prudence was not always a guiding criterion in extending or demanding credit.

All of these developments entailed increased exposure to risk, especially in light of the following considerations. First, whereas government debt is almost risk-free, private debt is not. Second, consumer and mortgage credits tend to be riskier than loans to firms, because the former are particularly cumbersome to resolve in the legal arena in case of default.

This renders collateral for such lending of little use. Finally, dollar-denominated credits are subject to exchange rate risks.

Several important prudential measures were adopted during this period. The central bank imposed limits on commercial bank liabilities denominated in foreign currency. Commercial banks were required by the Mexican Treasury to observe the Basel capital standards. The former National Banking Commission imposed strict provisioning for loan losses.

By late 1993, moral suasion by the central bank had prompted a good number of banks to apply more rigorous standards for granting credit. In general, supervision was tightened. However, the supervisory ability of the National Banking Commission had waned during the long years when banks had lent little to the private sector.

In the wake of the assassination of presidential candidate Luis Donaldo Colosio in March 1994, interest rates increased substantially and remained high. This placed added strain on the commercial banking system, where the problem of bad loans had already begun to emerge and was exacerbated by the 1993 economic slowdown.

At the end of 1994, a full-fledged exchange rate crisis erupted, adding fuel to a major banking crisis. As is well known, the Mexican authorities implemented a variety of programs to safeguard the integrity of the financial system. These programs were developed with the following principles in mind: first, preventing systemic risk while protecting the legitimate interests of depositors and other bank creditors; second, helping debtors strained by the macroeconomic crisis; third, resisting political and other pressures to bail out stockholders of financial institutions; fourth, avoiding expansion of central bank credit; fifth, minimizing the fiscal costs of the policies adopted to overcome the crisis and distributing these costs over a number of years; sixth, interfering as little as possible with the normal functioning of markets; and seventh, implementing measures that would be both simple and transparent to foster confidence in the overall package.

The package included various programs aimed at responding to specific needs. In early 1995, a dollar liquidity facility and a temporary capitalization program were launched. Programs to directly help debtors were

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then made available in several stages. Their objective was to ease the burden of some of these debts and prevent the spread of nonpayment practices by debtors in general. Direct support to debtors (homeowners, agricultural enterprises, and small and medium-size firms) was provided through the government's absorption of a portion of interest payments and of the principal. For troubled but viable banks, a number of programs were introduced to induce stockholders to inject fresh capital. To this end, the government purchased two pesos worth of qualified loans in banks' portfolios for every peso of new capital paid in by stockholders. The banks, however, continue to administer the loans and to share the pertinent risks with the government. Restrictions regarding equity participation in commercial banks have been eased, with the aim of attracting new investors, both foreign and domestic. The authorities have intervened in nonviable banks, restored them to health, and resold them. An institution designed along the lines of the Resolution Trust Corporation in the United States was created to sell off those bank assets in government hands. In addition, another agency was established with the sole purpose of assisting large corporations in restructuring syndicated bank loans. The new National Banking and Securities Commission has taken a number of steps to strengthen banks. It has established even stricter requirements for reserve provisioning, and has mandated the adoption, effective January 1,1997, of accounting standards similar to the Generally Accepted Accounting Principles in the United States. New capitalization rules following the Basel criteria impose capital requirements that take both credit and market risk into consideration.

Mexico's banking sector remains fragile, but the danger of collapse is largely past. The characteristics of the safety net will have to be modified.

For many years the Mexican financial system has worked under a scheme of total, implicit protection of bank deposits. This scheme has proved valuable in times of stress in the financial system, as highlighted by the fact that no bank panics have occurred in Mexico's modern history, except for a few days of politically inspired disruption in September 1976. Moreover, the severely disruptive effects of bank failure on the real economy have been avoided.

Despite this positive record, a system of deposit insurance that completely guarantees bank deposits is costly and gives rise to well-known problems of moral hazard. As Garber recognizes, in Mexico's current difficult financial environment it does not seem timely to tamper with a long-held tradition of assuring depositors that their resources are safe. But in the future, as Mexico's financial system strengthens and the quality and availability of information on the individual situation of financial intermediaries improve, it would be advisable to seek ways to gradually reduce the

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PART FOUR • MIGUEL URRUTIA

present degree of deposit protection. If progress toward a more limited deposit insurance scheme is to be made, it will be necessary to reduce the information problems that prevail in the financial system today. In theory, complete information would enable market participants acting on their own to supervise and correct the behavior of financial intermediaries. In practice, however, information problems are difficult to eradicate, and in this regard the practice of credit rating by specialized agencies should be encouraged. Adequate supervision and regulation will then be able to complement, not substitute for, the discipline exerted by the market.

Miguel Mancera is Governor of the Central Bank of Mexico.

Comment Miguel Urrutia

I would like to focus on a particular arch in the architecture of public safety nets. There is no question that concern for moral hazard makes it dangerous to offer unlimited insurance to financial intermediaries. But a corollary is that, for governments to be able to allow imprudent banks to fail, some sort of insurance scheme for small depositors is necessary and desirable. Even if there were no systemic risks involved, a policy of allowing financial intermediaries to fail would not be politically viable without insurance for small depositors. In addition to deposit insurance and good supervision, there is also a place for reserve requirements in economies vulnerable to shocks from capital flows.

Michel Camdessus noted in his contribution to this book that some developing countries face greater volatility in capital flows and in their terms of trade than do the industrial economies. I believe that the safety net in such countries should be designed with special features to address that problem. Reserve requirements are a useful, additional insurance against liquidity problems. High capital requirements alone do not solve the liquidity problems generated by a run on deposits, if, as one assumes, the required capital is not invested in liquid assets.

Even in well-developed and deep capital markets, good assets will trade at a discount in a liquidity crisis, especially one generated by an external shock. In Latin American economies, liquidity crises will often be the result of such external shocks. If the central bank is the lender of last resort, it can provide the needed liquidity, but only to the extent that it has external reserves. If it wishes to avoid an abrupt devaluation, which often

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leads to exchange rate overshooting and serious problems in the financial sector, as Miguel Mancera observes in his comment, the central bank can only provide liquidity backed by international reserves. Immediate liquidity can be provided as long as the monetary aggregate Ml is lower than international reserves. However, in the short term the relevant relationship is that of the broader aggregate M3 to international reserves, and obviously M3 will always be much the larger of the two. Moreover, as time deposits come due, the foreign exchange assets of the central bank will come under additional pressure. If long-term assets are liquidated rapidly in the midst of the external shock, the value of assets in the financial system will fall, paving the way to a financial crisis.

In the final analysis, therefore, it is prudent to avoid too high a ratio of M3 to international reserves in countries with large and volatile financial flows. A good idea may be to institute a reserve requirement to minimize the possibility that a fall in M3 will be greater than the stock of international reserves. In setting a level for the reserve requirement, policymakers should take into account the volatility of monetary aggregates.

In the case of Colombia, a series of simulations, taking into account the composition of deposits and the volatility of various deposit types, has suggested that an average reserve requirement of 8 percent would avoid solvency problems generated by runs against the peso. This is an interesting result, because it is not as high as might have been imagined. Had the result been, say, 40 percent, it would have posed a much less tractable policy problem. If indeed one can minimize the risk of a volatility problem with a reserve requirement of such small magnitude, it seems worthwhile to consider such a scheme in the general architecture of the public safety net.

A final question is whether these reserve requirements should be remunerated. The answer depends on the profit-and-loss situation of the central bank. If reserve requirements are remunerated, they should have no effect on the cost of credit or on the ability of the domestic financial sector to compete with entrants from abroad.

Miguel Urrutia is General Manager, Banco de la Republica, Colombia.

Comment Edwin M. Truman

I read Peter Garber's chapter not from the perspective of an academic, or that of a central bank governor, or even that of a bank supervisor, but from

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that of a former academic who has spent 25 years working closely with central bank governors and, greatly to my surprise, much of the past 15 years working closely with bank supervisors. From that perspective, I found myself nodding in agreement with most of what the chapter says. But I began to wonder, if this safety net business is all so obvious, why do countries find it so difficult?

A problem inherent in banking is the mismatch between the low liquidity of a bank's assets and the high liquidity of its liabilities. It is this mismatch that generates the need for a safety net. Yet any safety net that one might construct brings, in turn, its own set of problems, the greatest of which is the creation of adverse incentives, or moral hazards: banks operating within a safety net tend to take on too much risk and to shift the consequences of poor outcomes to others. Garber identifies the many difficulties associated with building a bank safety net that avoids or at least minimizes these adverse incentives.

The social contribution of the banking system lies in its efficient allocation of financial resources. Unless a safety net is accompanied by a very clever (and yet-to-be-developed) risk-adjusted system for pricing, it will endanger achievement of that objective, normally by skewing banks' lending toward loans that are overly risky. A menu of bank supervisory practices has been developed to counteract this tendency, although it is conceptually possible that, as a consequence, the system will be induced to take on too little risk. In any case, a contributing factor in many Latin American banking crises has been that political factors, either microeconomic or macroeconomic in origin, have prevented the implementation of robust supervisory regimes. On the microeconomic side, bank supervisors have in some cases not been given sufficient authority or resources to do their jobs, and in other cases political considerations limited the actions that supervisors could take. This is not a phenomenon unique to Latin America. On the macroeconomic side, weak policies have undermined banking systems, and weak banking systems can, in turn, paralyze macroeconomic policy.

This suggests that the challenge of building a safety net with sufficient safeguards against moral hazard goes beyond merely identifying a set of prudential regulations that limit moral hazard in the presence of a lender of last resort and deposit insurance. The challenge is one of political economy.

With this in mind, it may be useful to identify the banking sector's major actors and the interests of each, as an aid to understanding how these actors might be convinced that a banking system that allocates financial resources efficiently may better serve their longer-term interests.

The four main groups of actors are those whom Garber identifies: the gov-

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ernment (as a stand-in for the taxpayers), bank owners and managers, bank depositors and other creditors, and bank borrowers.

Consider first the government. Some governments may use the banking system as a means of implementing economic development policies, viewing directed lending as an acceptable element of bank supervisory policy. Although some governments have no doubt had success with such policies, there is also no doubt that they can contribute to banking crises.

The recent crises in the Nordic countries stemmed in part from policies of directed lending that encouraged banks to allocate financing without concern for economic returns. The U.S. savings and loan crisis was partly caused by the political motive—the promotion of home ownership—behind the nurturing of the savings and loan industry.

It should not cause controversy among economists to suggest that policies of directed lending are distortionary. They do not encourage the efficient allocation of resources, nor do they encourage sound banking practices. In effect, such policies are a tax on the banking industry. A less distortionary approach would involve direct government subsidies to the industries that the government considers crucial to economic development.

Such an approach would have the additional advantage of being more transparent.

Garber suggests another reason why political considerations may interfere with prudent bank supervision. Political authorities may rely on banks to undertake investments that are politically beneficial to themselves, or they may use banks as funding mechanisms for their own activities.

Such authorities may be even less likely to favor making such government transfers transparent. Garber advances these arguments in the context of describing what he terms the "downside" of turning to foreign sources to recapitalize the banking system. I was, by the way, quite surprised to hear such novel, infant-industry arguments from an academic economist.

The problem with regard to bank owners and managers is, of course, the distortion of incentives, or moral hazards, introduced by the safety net.

The good news is that moral hazard should not be a significant threat to bank soundness if banks are well capitalized. When a bank is well capitalized (something that is easier said than defined), its owners have sufficient funds of their own at stake to make them reluctant to take on excessive risk. As the U.S. savings and loan crisis amply illustrated, moral hazard incentives can be greatest when a bank's net worth is near (or below) zero.

Thus, as Garber notes, a top priority of authorities in a banking crisis must be to ensure that insolvent banks are either closed or recapitalized quickly.

Otherwise bank owners have strong incentives to gamble and are likely to find ways around prudential regulations, leading to greater losses in the long run.

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PART FOUR • EDWIN M. TRUMAN

Again, however, we must consider the incentives of the political authorities to close or to recapitalize banks promptly. They may be reluctant to do so for a variety of reasons. One of these is the fact that, when an entire banking system is near the brink of insolvency, the source of new bank capital almost invariably has to be the government, at least initially.

But the general public may view such a massive and open expenditure of public funds unfavorably, as recent experience in the United States and Japan has abundantly shown.

Recognition of this bailout problem in the United States led to the adoption of the "prompt corrective action" approach, designed to force bank supervisors either to require the strengthening or closing of ailing banks before significant losses are incurred. Here I must underline, however, one of the footnotes in Garber s chapter: this new policy has not yet been tested under conditions of systemwide weakness. In addition, such a policy falls under the general category of ex ante prudential regulation, and it may be difficult to enact such a regime before a crisis occurs.

Finally, the political authorities are not the only actors who may seek to operate banks as something other than efficient economic enterprises.

Owners of commercial banks may also use their institutions for their personal financial ends. Such behavior, which essentially amounts to looting the bank, is most likely to occur where banks go virtually unsupervised and the owners do not fear prosecution for fraud. This suggests that the regime of banking supervision is only part of the story. An effective legal infrastructure—one that, among other things, enforces laws protecting both depositors and the safety net from fraud—is also essential.

The third set of actors to consider is the depositors. Without a safety net, as Garber emphasizes, bank depositors will run on a bank if they think their deposits are at risk. The liquidity mismatch between bank assets and liabilities makes bank runs costly and helps justify the safety net. But with a safety net in place, depositors have no incentive to monitor their bank. Is there any way to improve depositors' incentives short of abandoning deposit insurance altogether?

Two methods widely used in other parts of the insurance industry are copayments and deductibles. A copayment, as applied to deposit insurance, would mean that the insurance would protect only a fixed fraction of each deposit. A deductible in this context would mean that a fixed amount of loss would be borne first by the depositor. Both these methods, however, fly in the face of one of the primary social objectives of deposit insurance, which is to protect the small depositor. Thus, in practice, deductibles are unheard of, and systems using copayments are rare. More commonly, countries instead set limits on the amount that deposit insurance will cover.

The ability of limited deposit insurance schemes to increase deposi-

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tors' incentives to monitor their banks, and decrease the likelihood that they will stage a run, depends on two factors. First, it depends on the ability of depositors to assess the value of a bank's assets. Yet one common reason given for the existence of banks is economies of scale in the valuation of assets. This suggests that small depositors may find it too costly to monitor their banks. However, strong accounting and disclosure requirements for banks can help improve the monitoring capability of depositors, especially large depositors. Second, the strength of the incentive to monitor depends on the credibility of the government's limits on deposit insurance. In some countries there are no de facto limits.

Some evidence suggests that governments can credibly limit the de facto application of 100 percent deposit insurance. In the wake of its banking crisis in the early 1980s, Chile adopted a very limited deposit insurance scheme. Deposits are insured only up to $2,500. Recent work by economists at the Federal Reserve suggests that this limit is credible. Chilean banks pay interest rates that are related to measures of their risk. That fact, along with the limit on deposit insurance, provides bank depositors with an incentive to monitor their banks. As an aid to this process, Chile's bank supervisors publish information about their own assessments of bank asset quality.

This returns us to the question of the structure of the government's incentives, and thus to the realm of political economy. Theory and evidence tell us that it is possible to limit the safety net. But will the political system be able to implement the required measures?

The fourth group of actors is the borrowers. Their incentives are greatly influenced by two factors. First, do the legal infrastructure and social attitudes favor the repayment of debt? That is, are laws in place that enable lenders to seize collateral in case of default? And do societal norms attach a stigma to the nonrepayment of debt? Second, are banks being run as economic enterprises, or are they expected to satisfy short-run social or political goals? If the banking system is being used to favor certain industries, banks may fail to develop adequate risk measurement standards and monitoring techniques. For their part, the favored firms, which are not paying an appropriate risk premium on their borrowings, may likewise feel themselves exempt from the discipline of the marketplace.

To conclude, we know a great deal about various viable regulatory alternatives for providing a safety net and limiting moral hazard, but we know much less about the political economy of implementing those alternatives. As Michel Camdessus notes in his contribution to this book, it often takes a crisis to establish a political consensus in support of needed change.

Edwin M. Truman is Staff Director of the Division of International Finance, Board of Governors of the Federal Reserve System of the United States.

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Ricki Heifer

The United States has been working to perfect its system of banking regulation and supervision, including the safety net, for two centuries. The process has been neither quick nor easy. A lasting national banking authority, the Office of the Comptroller of the Currency, was established only in 1863, and the central bank, the Federal Reserve, was not founded until 1913. In one regard, however, the United States has led in banking, not followed: the Federal Deposit Insurance Corporation (FDIC) today manages the oldest national deposit insurance fund in the world.

Some 9,000 banks failed in the United States in the four years before the FDIC was created in 1933. In that first year of operation the FDIC sent 4,000 examiners into the field to qualify banks for deposit insurance. In the following year only nine insured banks failed.

Deposit insurance proved so successful in stabilizing U.S. financial markets that that stability began to be taken for granted in the succeeding 50 years. No one, however, repealed the business cycle. The failures of more than 1,400 U.S. banks from 1982 through 1994, apart from the 1,250 savings and loans that failed during the same period, reminded us that guaranteeing savings can be a costly business, but may ultimately be necessary to stabilize the banking system in times of stress.

As Peter Garber points out, deposit insurance is just one of four major strands from which the financial safety net is woven. The other three are the central bank, which as lender of last resort stands ready to provide money to banks facing temporary liquidity problems; prudential regulation of financial institutions; and a system for resolving bank failures. Two related lessons emerged from the experience with deposit insurance and prudential regulation during the recent crisis in the United States: namely, that prudential regulation is vital to the health of a deposit insurance fund, and that it is essential to limit the moral hazard presented by deposit insurance.

A few numbers tell the story of how banks in the United States fared in the 1980s and early 1990s. In 1982, the bank insurance fund stood at $13.8 billion. Even with an increasing rate of bank failures, by year-end 1987 it had reached $18.3 billion. By the end of 1991, however, the fund's books showed a negative balance of $7 billion. The fund also set aside a large reserve—at one point as high as $16.3 billion—for anticipated bank failures. The FDIC was forced to draw on the full faith and credit of the U.S. government, borrowing from the U.S. Treasury for working capital to resolve bank failures. At one point that lending totaled more than $15 bil-

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lion. By August 1993, all those loans from the Treasury had been repaid with interest, although reserves for anticipated failures were still below $ 1 billion as of the end of 1994. As some of the anticipated failures did not occur, however, the reserves set aside for them were brought back into the balance of the fund, and the deposit insurance premiums that banks pay were greatly increased, so that today the fund has a positive balance of more than $26 billion. For commercial banks, the safety net sagged, but it did not fail.

For savings and loan associations, however, the safety net failed to hold. Their deposit insurance fund was not just depleted in an accounting sense during the crisis, but bankrupted. The U.S. government created a new government agency to resolve the numerous savings and loan failures, assigned responsibility for building a new savings and loan deposit insurance fund to the FDIC, and, to make a clean break with the past, changed the name of the savings and loan regulator.

Not only did the savings and loan insurance fund fail, but so did the system of supervision for savings and loan institutions. In fact, the fund failure was a direct result of the supervisory failure. The immediate cause of many savings and loan failures was high interest rates, which eroded the value of home mortgage portfolios. In some cases, however, the immediate cause was negligence, gross negligence, or even criminal activity. There is also little doubt that during the savings and loan crisis, inadequately capitalized thrifts took excessive risks, thus adding to the costs of that debacle. The first lesson we drew from our experience was that deposit insurance must be combined with a system of effective prudential regulation, with adequate on-site examinations and appropriate penalties when prudential standards are violated. Without strong supervision, deposit insurance simply becomes a public resource that risk takers can exploit.

This brings us to the second lesson: The design of an effective safety net involves a basic tradeoff. Increasing the stability of the system through the safety net increases the possibility of moral hazard—in other words, of encouraging risky behavior. The objective must be to strike a balance that minimizes the moral hazard of deposit insurance, while at the same time providing stability to the system.

Deposit insurance can give bank managers the incentive to increase risk, both by investing in riskier projects than would otherwise be undertaken, and by increasing leverage. Deposit insurance shifts these risks onto the deposit insurer, and ultimately, if the insurer is a public agency as it is in the United States, onto the taxpayer. In other words, it creates a onesided bet. If the risk pays off in higher yields, the insured institution wins, but if it creates losses, the insurance fund loses. Deposit insurance, if too broad, can encourage risk—the less bank managers have to lose, the more

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PART FOUR • RICKI HELPER

incentive they have to take excessive risks.

To address the problem of moral hazard, the FDIC has over the past few years instituted a number of reforms, three of which I will describe here: higher minimum capital standards, risk-related insurance premiums, and the least-cost test for resolving bank failures.

Higher minimum capital standards are enforced through a policy of "prompt corrective action" when the capital of troubled institutions erodes.

Traditionally, U.S. banking regulators have had a great deal of latitude in dealing with troubled institutions. As a matter of practice, primary banking regulators—state banking authorities or the Office of the Comptroller of the Currency—typically closed an institution only after its capital had been exhausted. Under the new system of prompt corrective action, which went into effect at the end of 1992, federal regulators are required to begin a variety of supervisory actions if the capital of an institution falls below strictly defined minimums. The farther an institution falls below the minimums, the more severe the required supervisory actions become. Those actions include—but are not limited to—imposing restrictions on dividend payments and other capital distributions, limiting management fees, curbing asset growth, and restricting activities that pose excessive risk to the institution. Early intervention allows the FDIC to preserve some of an institution's franchise value and thereby limit losses to the insurance fund.

More important, minimum capital standards and prompt corrective action are intended to curb excessive risk taking, so that regulators will not have to intervene.

The principle embedded in prompt corrective action is gradation of risk and the appropriate regulatory response: the less capital a bank has, the smaller is its financial cushion for losses, and the greater risk it poses to the insurance fund. The greater the risk, the more attention it should receive from regulators.

This principle of gradation of risk and response is also reflected in our system of risk-related deposit insurance premiums. For almost 60 years, all institutions insured by the FDIC paid the same premium per dollar of deposits into the fund, regardless of the risk their lending activities posed.

Beginning in 1993, banks and thrift institutions were divided into nine groups, depending upon the risks they presented to their insurance funds.

The greater the risk, the higher the premium the institution pays. Part of that risk calculation is based on the level of capital, and part on supervisory factors such as asset quality, loan underwriting standards, and management. Risk-related premiums promote safety and soundness and address the issue of moral hazard by giving institutions a financial reward—lower deposit insurance premiums—for improving their condition, increasing their capital, and maintaining a lower risk profile.

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One other new requirement imposed in 1991 also affects moral hazard, although less directly than prompt corrective action or risk-based insurance premiums, by giving uninsured depositors—those with deposits in excess of $100,000—incentives to place their uninsured funds in banks that avoid taking excessive risk. Five years ago, Congress told the FDIC that, when resolving bank failures through sale of the institution to a new owner, the agency had to accept that proposal from a potential purchaser that was the least costly to the deposit fund of all the proposals received. In effect, that requirement exposes uninsured depositors to greater loss than before. In more than half of all bank failures in 1992—66 out of 120— uninsured depositors received less than 100 cents on each dollar above the $100,000 level. This represented a significant increase from 1991, when fewer than 20 percent of failures involved a loss for uninsured depositors.

Although the number of bank failures in 1992 was lower than in previous years, the number of uninsured depositors experiencing a loss was significantly greater.

As we saw in the 1980s and the early 1990s, the U.S. governments guarantee of the deposit insurance fund stabilizes the nation's banking system. It would be prohibitively expensive for a private sector insurer to provide a similar guarantee. Further, a private sector insurer would not be able to borrow from the U.S. Treasury for working capital as the FDIC can and did. Without that authority, and without the resources of the deposit insurance funds, a private sector insurer would have to raise premiums to cover losses whenever banks come under stress—in other words, just when they are least able to afford higher premiums.

There is an old saying that experience is a hard teacher: first you get the test, then you learn the lesson. In the 1980s and early 1990s, U.S. banks and bank regulators were tested by events. The lessons were costly, but they were learned: prudential regulation and moral hazard cannot be safely ignored. Having learned that lesson, the FDIC today is working to monitor, assess and address risk to the banking system more effectively to avoid substantial losses to the two deposit insurance funds it manages and to avoid falling back on the underlying guarantee of the American taxpayer.

Ricki Heifer is former Chairman of the U.S. Federal Deposit Insurance Corporation.

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Conclusions and Policy Debate

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PART FIVE

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Liliana Rojas-Sudrez

The papers and discussions at the conference that led to this book reflect an important shift in Latin American policymaking with respect to financial regulation and supervision. That shift began in the late 1980s but reached its full impetus only after the Mexican financial crisis of 199495. Long gone are the days when policy strategy was conceived as a tradeoff between economic growth and efficient and market-oriented financial systems. Long gone, too, is the view that "financial regulation" and "financial repression" are synonymous. The current policy approach with respect to financial markets in Latin America is largely based on two fundamental pillars. The first is the recognition of a strong interrelationship between safe, sound and efficient financial markets and the maintenance of macroeconomic stability and sustained growth: one cannot be achieved without the other. The second is the view that regulation and markets should complement—not work against—each other. The views expressed in this book confirm that this new approach to policy is here to stay.

With agreement reached on the fundamental direction of the new approach, the current policy debate has turned toward issues of design.

As was noted in the introduction to this book, there is now a consensus that the Latin American regulatory and supervisory framework should converge to international standards, and the policy issue is how to design the transition toward that state of convergence. Here the debate is hot and ongoing. Some believe that convergence should take place as quickly as possible, while others argue for caution, pointing out that the particular features of Latin American economic and financial markets today demand careful consideration, at least in the short run, of regulatory and supervisory practices that differ from those applied in more industrialized and stable countries. In a nutshell, the current policy debate centers on the question, What works best for Latin America now? This concluding essay seeks to glean the most important insights from the exchange of views on this question, underlining those areas where agreement has been reached and identifying those where further deliberation and research are still needed.

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PART FIVE • LILIANA ROJAS-SUAREZ

A meaningful analysis of Latin American financial markets, and of the regulatory framework that guides their activities, can only be performed in the context of the new international financial landscape. The main trends within this new financial environment can be characterized in three words: globalization, liberalization and competition. All three are proceeding apace in a dynamic coevolution driven by the rapid pace of technological development. The regulatory challenges derived from this new environment are great. One of the most pressing dilemmas for regulators was clearly stated

by Andrew Crockett: how to reconcile the need for national diversity in financial systems with the benefits of international convergence. Although regulators all around the world must grapple with this problem, it is a particularly thorny one for developing countries, where the stage of development and the strength of domestic financial markets remain far short of what has been attained in the industrial countries.

Recognizing that the path toward convergence will be long and difficult, a number of international organizations, supranational committees, and groups of countries have joined efforts to propose international guidelines to help developing countries design the process of financial reform.

These guidelines focus on identifying principles and minimum conditions, based on a wealth of recent experience with severe financial problems worldwide, whose adoption will give developing countries a chance at achieving financial stability.1 The increasing concern of industrial-country regulators for the attainment of financial stability in developing countries is itself the result of the trends in international markets already mentioned. In a global and increasingly integrated financial environment, the threat of contagion effects extends beyond national frontiers. The danger that a financial disturbance in a single local market may have systemic international effects is too great to be ignored. Given the increasingly strong financial interrelationships between industrial and emerging markets, both in terms of crossborder capital flows and in terms of the spread of international banking operations through branches and subsidiaries, it is only natural that local fragilities have become a global concern. But as Lawrence H. Summers pointed out, there is an additional reason for the industrial countries' con1 The two most widely publicized sets of guidelines are that of the Basel Committee on Banking Supervision and the report of the Working Party on Financial Stability in Emerging Market Economies of the Group of Ten. (See the discussion of these proposals and the bibliographic references in the introduction to this book.) In addition, the International Monetary Fund has set up a mechanism for the dissemination of high-quality macroeconomic and financial data: the Special Data Dissemination Standard.

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cern: in many recent crisis episodes in emerging markets, the international community has been called upon to provide the necessary funds to arrive at a resolution. Such intervention has proved necessary because the costs of resolving the crisis far exceeded the fiscal capacity of the countries involved—a situation that is complicated by their limited creditworthiness in private international capital markets.

Moreover, the ability of international institutions to support developing countries' efforts to achieve and sustain macroeconomic stability can be severely hindered by the eruption of crises in their financial systems.

Recent history provides abundant examples—including several from Latin America—of policymakers who deviated from their fiscal and monetary objectives in the face of banking crises. Even more serious, the departure from macroeconomic stability that accompanies a financial crisis does not seem to be a short-term phenomenon; instead it has important and lasting consequences for the country's capacity to grow. The enormous resources devoted to dealing with the crisis (and to repaying the associated foreign loans) often must be diverted from worthwhile alternative uses. Spending on education and health is known to be of crucial importance in achieving sustainable growth, yet it is precisely these budgets that are so often raided to pay the costs of crisis management. Michel Camdessus cited grim figures on the high cost, in terms of GDP, associated with resolving banking crises in a number of Latin American countries, and he emphatically called on countries to pledge to implement policies that would prevent the eruption of such crises once and for all.

But international guidelines, no matter how well thought out, have two important and inherent limitations. First, guidelines based on consensus among countries with very different economic and financial characteristics cannot at the same time be tailored to each of those differing characteristics. Therefore any such guidelines must remain at the level of general prescriptions. The second limitation is related to the first: international guidelines have little to say about how they shall be implemented. Indeed, how these guidelines are adopted and adapted to local conditions remains at each country's discretion. In the words of Andrew Crockett, "Better financial markets cannot be imposed from abroad."

What Is the Most Appropriate Regulatory and Supervisory Framework for Latin America?

As already noted, there is today full agreement that the regulatory and supervisory framework in Latin America should converge in the long run toward international standards. However, agreement remains to be reached on a number of transitional issues, such as the speed of adjustment, the

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sequencing of reforms, and, most important of all, the implementation of transitional regulatory and supervisory practices in the immediate future.

Again, some believe that, in the immediate term, Latin America should adopt regulatory and supervisory standards that best fit the region's specific features. Those who take this view argue that present international standards were originally designed to fit the needs of the largest industrial countries, not those of developing countries. For example, Pedro Pou reminded the conference that the landmark Basel Accord established a level playing field for banking institutions in a group of industrial countries that had already reached a high degree of financial market integration, one that Latin America has yet to achieve. In his view, the objective of establishing standards appropriate for each Latin American country individually is more important that establishing common standards.

Rojas-Suarez and Weisbrod argue that the special features of the environment in which Latin American financial markets operate can be divided in two groups. The first group consists of problems that can be solved with corrections in the regulatory structure and with the adoption of international standards. Among these are the lack of appropriate accounting standards and reporting systems, inadequate classification of nonperforming loans, and deficient legal frameworks. There is agreement that without appropriate accounting practices, capital-to-asset ratios are meaningless. Moreover, as William Ryback observed, given the significant differences in accounting methodologies across countries in the region, comparisons of capital adequacy make little sense. However, with time and adequate resources, these difficulties can be managed, and indeed several countries in the region have already made significant progress. For example, as Eduardo Fernandez Garcia reported, new accounting principles for banks, consistent with international practices, are currently being implemented in Mexico.

The second group of features identified by Rojas-Suarez and Weisbrod include more fundamental characteristics of the environment; these are more difficult to deal with in the short term. Among them are, first, a high degree of economic volatility, which implies that individuals and firms are exposed to much greater uncertainty regarding interest rates and other financial variables than in the more industrialized countries. The second is a severe shortage of trained staff capable of effective supervision. The third is the presence of political interference, which thwarts the proper enforcement of regulations, including the closure of failing financial institutions. In this regard Charles Goodhart noted that, in a number of emerging markets, government-sponsored lending has been at the root of fragilities in the banking system, and that among its effects has been the weakening of privately owned commercial banks. A fourth feature is a high concen-

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tration of ownership of assets, both financial and real, which hinders adequate supervision of financial activities even when rules for consolidated supervision are in place. A fifth feature, related to the previous one, is the lack of liquid markets for bank shares that would allow bank owners to satisfy capital requirements with little difficulty and at little risk to themselves. When equity markets are large and liquid, it is difficult to finance a majority equity stake in a bank using loans from related parties; when they are not, investors with a majority stake in a bank can offset that position with a loan from the same bank, or from a bank owned by a related party (which may be a nonfinancial corporation, and hence outside the purview of bank supervisors).

It is the second set of features that impose the most serious constraints on the effectiveness of importing industrial country standards into Latin America in the short run. For example, Rojas-Suarez and Weisbrod show that these features constrain the effectiveness of the capital-to-riskweighted-asset ratio as a supervisory tool, even when an appropriate accounting system is in place. The central purpose of this standard is to reduce the incentive that bank stockholders have to take risks at the expense of the public safety net available to banks. In industrial countries, where efficient markets for bank stocks exist, the price of bank equity reflects investors' perceptions about the quality of the bank, and a reduction in that price provides an important incentive for bank managers to improve the soundness of their operations. In such an environment, the capital markets complement the role of the supervisor: supervisors can force stockholders to write down the value of their investment when the bank runs into difficulties, and the market can provide additional injections of fresh capital. In Latin America, in contrast, the lack of robust equity markets reflects a scarcity of outside investors who can replenish bank capital in a crisis. In a number of recent banking crises in the region, bank regulators have had to design programs to inject regulatory capital into failing banks— for example, exchanging nonperforming loans for government bonds—to maintain the appearance of high capital ratios. These market conditions in Latin America subvert the intent of capital requirements, since bank owners perceive that the authorities will not be in a position to force a reduction in the value of stockholders' investment during a systemic crisis.

A number of experiences in Latin America suggest that capital requirements have not contained the expansion of bank risk. In recounting Ecuador's recent banking problems, Augusto de la Torre pointed out that, contrary to the intention of capital requirements, rapidly growing capital has been a signal of deteriorating bank capital in Ecuador. Capital was growing rapidly not because it was "real" new capital, but because banks were creating fictitious capital, recycling deposits through nonbank finan-

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cial institutions, whose supervision was not coordinated with that of the banking system.

There is a consensus that the features of the second type in the RojasSuarez and Weisbrod classification impose important constraints on the effectiveness of industrial country standards. However, not everybody believes that these problems are so daunting that improved regulation and supervision cannot tackle them. For example, Eduardo Fernandez Garcia argued that, even under conditions of excessive wealth concentration and weak capital markets, more solid supervision can do much to eradicate unsound practices by bank owners. Charles Dallara agreed, adding that other countries in Asia and Central Europe are grappling with many of the same problems.

But, Rojas-Suarez and Weisbrod argue, even with the benefits that an improved regulatory and supervisory environment would bring to the region, the real issue is what can policymakers do now, while such a system is not yet in place and while capital markets remain weak, to prevent further eruptions of banking crises in the region. Their answer is to look for markets that are functioning; these may provide information that can aid regulators in assessing the quality of banks. The evidence from the Mexican and Argentinian banking crises of 1995 strongly suggests that the market for bank liabilities, especially deposits, provides supervisors with important information about the quality of banks before a crisis occurs. In both countries, the banks that experienced the most severe problems during the crisis had been paying, before the crisis, higher interest rates on their liabilities than other banks.

Thus an important policy recommendation for the transition is to reinforce markets that are functioning relatively well. For example, regulators should encourage the public offering of certificates of deposit, so that investors (and supervisors) can compare the rates offered by the various banks. Publishing interbank bid and offer rates would also improve the flow of information about bank quality. These efforts, however, can only be effective if authorities limit the scope of deposit insurance, so as to encourage large depositors to demand premiums to supply funds to risky banks.

These recommendations complement those improvements in the regulatory and supervisory framework that require a longer period of time to take effect.

Approaches to Financial Market Structure The silver lining of many a financial crisis is the opportunity it provides to restructure and reform the financial system. The opportunity now open to policymakers is to consider alternatives that may determine how the fi-

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nancial landscape may look in the future. Among the restructuring possibilities, one crucial issue is the subject of an ongoing debate: What should be the range of permissible activities for banks? Views on this issue tend to focus on one of two different dimensions. The first of these may be called the sectorial dimension; here the choices range from so-called narrow banking, in which banks are permitted to invest only in short-term, highly liquid assets with very low credit risk, to universal banking, in which banks are allowed to operate as financial supermarkets offering a large variety of financial services. The second dimension is the international one, in which the choices range from strengthening the existing domestic financial system, without deliberate recourse to "importing" effective financial intermediation, to fully internationalizing the system and relying on foreign banks for the provision of most financial services.

Narrow versus Universal Banking In economies hit by severe, costly, and difficult-to-resolve banking crises, such as many in Latin America, it is only natural to ask whether it would serve the interest of financial stability to restrict the scope of banks' activities, and whether alternative institutions could provide some of the financial services that households and firms demand. The question is a difficult one, however, because it requires resolving a number of related issues, from the feasibility of developing, in a relatively short time, nonbank financial institutions that could offer the services now provided by banks, to the efficiency with which nonbanks could provide these services.

George Kaufman and Randall Kroszner review these issues in great detail. Their analysis of the benefits and costs of alternative financial structures takes into account the fact that the main goal of financial sector authorities is to achieve a system characterized by both high performance and stability. Not surprisingly, the chapters most important conclusion is that one size does not fit all. Indeed, the authors argue that which financial structure will prove most beneficial for a given country depends upon the context in which that structure operates. In particular, "the regulatory system and the incentives it generates often affect financial efficiency and stability more than does the country's banking structure." This conclusion is especially clear when considering the goal of financial stability. In systems with weak regulatory and supervisory frameworks, restricting bank portfolios may result in fewer bank failures, but not necessarily in greater overall financial stability—the deficiencies in the regulatory structure may merely cause risk to be shifted from banks to nonbanks. On the other hand, universal banks allowed to carry more risky assets may be subject to larger losses, but the diversification of their activities may give them greater sta-

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bility. However, universal banks are often closely interconnected with the rest of the financial system and with nonfinancial firms, so that the potential systemic effect of a bank failure could be greater than in a narrow banking system.

The analysis of efficiency issues produces similarly inconclusive results. For example, universal banking may result in higher concentration in the banking industry and therefore less competition, whereas narrow banking, although it may lead to less concentration, may prevent banks from realizing the efficiency gains available from economies of scale and scope.

Does narrow banking, by keeping banks out of certain financial activities, protect the banking system from political manipulation? Unfortunately, here, too, the answer is inconclusive. Since the definition of "safe" assets that narrow banks may hold is determined by the authorities, the temptation remains for policymakers to make "safe" synonymous with "government or government-related," which in turn increases the incentives of policymakers to finance fiscal deficits with bank deposits.

There is already a considerable consensus on these results. Despite their very different country experiences, contributors to this book from Japan, New Zealand, and the United Kingdom all attributed the performance of their countries' financial systems to the effectiveness of the regulatory and supervisory structure in which they operate. Moreover, all agreed that the design of the financial system is not a once-and-for-all decision, but a process that evolves as domestic and international markets evolve.

As Brian Quinn put it, "financial structures are dynamic and evolve over time, influencing and being influenced by all the other forces at work in a developing economy."

This point of view was supported by Toyoo Gyohten, who was quick to acknowledge that the problems now confronting the Japanese banking system (a system typically characterized as universal) result from regulators' lack of willingness to modify their approach in the face of profound changes in the world economy. The Japanese regulatory system was designed after World War II, as part of the process of reconstruction. Interestingly enough, that regulatory structure, based on strict controls and government intervention in bank activities, was chosen as a way to ensure financial stability. But by not taking into account the subsequent changes in the financial environment brought about by globalization, Japanese policymakers failed to recognize that the system's lack of efficiency would itself interfere with financial stability. Thus a system that can work well under certain economic and financial conditions can fail to perform if it does not adjust to a changing environment. Adaptability, rather than an irreversible fixing of the financial structure, is key to achieving both financial efficiency and stability.

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Richard Lang also acknowledged the importance of designing a country's financial structure to suit its specific circumstances. New Zealand, a large proportion of whose banking system is foreign-owned, welcomes the efficiency and stability that reputable international banks bring to its financial system.

Where does this discussion lead us in the consideration of alternative financial structures for Latin America? Does the inconclusive result— that no single optimum financial structure fits all situations—leave policymakers in Latin America adrift, wondering whether they have made the right choice? Not necessarily—some important lessons for Latin America emerge from the discussion. First, it is comforting to see that the wide differences in financial structure observed among the industrial countries have not impeded their efforts at coordination, or even, in the case of the Western European countries, the achievement of financial integration.

Second, the emphasis on the interaction between financial structures and financial markets implies that policymakers in Latin America can look to the market for signals about what is the most appropriate and effective financial structure for their countries. This point is consistent with the earlier discussion on financial regulation and supervision. Third, and this is related to the previous point, policymakers in Latin America need to recognize that the financial structures they have inherited need not be fixed for all time, or even for the medium term. Given the wave of reforms now taking place in the region, with privatization and consolidation of financial systems proceeding apace, new financial structures may emerge. Again, that would be no more than what one would expect from a transition. The important point is that it would be a serious mistake to lock in any given financial structure without considering the possible future evolution of market forces.

Domestic versus Foreign Provision of Financial Services As discussed above, Latin America has not escaped the sweeping forces of globalization. Indeed, a major challenge faced by Latin American policymakers—and discussed at length in the economic policy literature— is how to manage large and volatile international capital flows to the region. Although these flows represent potentially valuable resources that can promote growth, their presence may also conflict with domestic policy objectives such as price and exchange rate stability. Nor have capital flows been the only sign of globalization—the subsidiaries of foreign banks have also been increasing their presence in several Latin American countries in recent years, providing an additional indicator of the internationalization of financial markets.

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The capital inflows that several Latin American countries have experienced may seem large from their own perspective and from the historical perspective of the region as a whole. But the real question is how these flows compare with those to other regions of the world, and how does Latin America stack up when other frequently used indicators of financial market integration are applied to the region. Michael Gavin and Ricardo Hausmann present data showing that, by these indicators, Latin America still suffers from a scarcity of capital, both real and financial. They conclude that the region's integration in world financial markets has been and remains very incomplete. Their argument is straightforward: the essence of financial market integration is that capital should move from regions where it is abundant to those where it is relatively scarce. These capital flows should contribute to the equalization of both capital-labor ratios and the cost of capital in all regions. No such equalization, however, has taken place in Latin America—a fact that is reflected in several ways: in the low productivity of labor in Latin America, where, on average, workers only have about one-third the capital available to their counterparts in industrial countries; in the high cost of financial capital faced by firms and households in the region; and in the severely limited variety of financial products and services available.

Why has Latin America's integration in world financial markets remained so shallow? Gavin and Hausmann stress the weakness of domestic financial systems as a crucial factor: inefficiencies in financial market intermediation mean that Latin American financial institutions cannot appropriately channel large inflows of international capital into productive investments. Aware of these deficiencies, international investors, even in the absence of formal official barriers, direct less investment to the region than would otherwise be feasible, and prefer to invest only through shortterm, rapidly reversible financial instruments. It follows that deeper financial integration requires competent financial institutions, whether foreign or domestic, operating in local financial markets.

As the discussions throughout this book have made clear, financial institutions cannot operate effectively in the absence of an appropriate legal, regulatory and supervisory framework. Gavin and Hausmann note that these factors are essentially public goods. They argue that effective financial intermediation is highly intensive in these and other publicly provided inputs.

The issue for debate is not whether these government inputs should be provided, but whether it is necessarily the government of the country receiving the capital inflows that should provide them. Gavin and Hausmann find reason to believe that many countries in Latin America do not have comparative advantage in the production of these inputs. Consis-

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tent with the view held by others that the special features of Latin American economies today impose severe constraints on the capacity of domestic authorities to apply and enforce regulatory and supervisory procedures designed for industrial countries, Gavin and Hausmann call for consideration of alternative suppliers of these needed public services. In their view, one such alternative is to "import" these public goods by encouraging the opening of domestic financial markets to foreign banks.

The argument is twofold. First, foreign-owned banking operations, especially if established as branches, would have access to liquidity and capital from their parents in case of trouble. Moreover, because of the portfolio diversification that characterizes international banks, these operations would be more robust to country-specific shocks, and this would reduce the probability of financial crisis in countries in which they are active. Second, because foreign-owned branches are supervised by the home country authorities, their presence could mitigate the problems associated with the present regulatory and supervisory deficiencies in Latin American countries. George Benston agrees with this approach but argues that policies designed to motivate branches of foreign banks to operate in Latin American countries need to take into account foreign banks' concerns. Two of the most important of these are the ability to repatriate profits and the assurance that foreign-owned assets will not be expropriated.

This alternative, Gavin and Hausmann hasten to clarify, does not mean forgoing efforts to improve the capacity of domestic governments to apply and enforce an effective regulatory and supervisory framework. Instead it means recognizing that any such effort will take time, and that meanwhile the region cannot afford the risk of additional financial crises. Indeed, as Guillermo Chapman argues, strengthening the domestic supervisory capacity of a country is essential even in countries such as Panama, where foreign banks account for a large share of banking activity.

Not everybody is in full agreement with the Gavin and Hausmann approach. For example, Guillermo de la Dehesa maintained that, although their argument has merit, some recent trends in the world economy will limit the effectiveness of their approach. First, foreign banks are less inclined to open branches than subsidiaries, even when permitted to do so, as the experience of Spanish banks operating in Latin America demonstrates. Second, there is a worldwide trend among international banks to reduce their foreign expansion, as they have found that the costs of such expansion exceed the benefits of diversification. Instead international banks are finding it more beneficial to supply some financial products and services from their home countries, by exploiting economies of scale. Peter Garber added that, even if a country were to succeed in attracting foreign

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banks, a sudden injection of foreign bank competition into a system with low capital could further reduce the franchise value of domestic banks; this in turn could lead to a banking crisis after a few years, as domestic banks attempt to retain market share by extending riskier loans.

The controversy will continue over whether the weight of financial strengthening should be put on "making" at home or "buying" abroad the necessary ingredients. But consensus has been reached that the achievement of financial market integration should be a high priority for Latin American policymakers.

Approaches to Credible Safety Nets Public safety nets for financial institutions, including deposit insurance and lender-of-last-resort facilities, exist in both industrial and developing countries. The extent of their coverage, however, varies widely. In some countries coverage is well defined and rather limited; in others the terms of the guarantee are implicit, but there is a generalized perception that financial institutions, particularly banks, will be granted extensive support in time of trouble.

The justifications for safety nets, explicit or implicit, differ, but there is a consensus that safety nets and financial regulation should complement each other in achieving their common objective of financial stability. To the extent that private financial institutions do not fully absorb the costs of resolving banking crises, public safety nets create a moral hazard problem: the availability of public funds increases the incentives of bank owners and managers to take excessive risk, because they can transfer that risk to the public sector and therefore to taxpayers. There are two alternative ways of minimizing this moral hazard problem. The first, advocated by Pedro Pou among others, is to keep the public safety net quite limited in scope and promote the establishment of a wholly privately financed deposit insurance fund. The second is to keep public deposit insurance in place but complement it with a strong regulatory and supervisory apparatus that discourages banks from increasing the risk of their portfolios.

The United States and other industrial countries have chosen the latter alternative. As Ricki Heifer explained, the U.S. system is based on a policy of taking "prompt corrective action" when the capital of troubled institutions decreases. The main principle is one of gradation of risk and the regulatory response: banking regulators, rather than waiting for the capital of an institution to be exhausted before closing it, are required to initiate certain supervisory actions when a bank's capital falls below a specified level, to take further action when it falls below a still lower level,

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and so on. These actions, by constraining the capacity of problem institutions to take further risks, preserve some of the franchise value of banks and therefore limit the potential losses to the deposit insurance fund.

Michael Foot added that when a bank does receive financial support from the public sector, any losses should fall first on the shareholders, and any eventual gains should go to the public provisioner of the safety net, whether it is an insurance fund or the central bank in its role as lender of last resort.

As to whether deposit insurance should be publicly or privately provided, most experts and market participants argue for the former. This belief is based on the perception that policymakers regard the costs of not rescuing banks in cases of systemic failure as too large to be palatable.

Among these costs, the large recessionary impact of a severe curtailment in the availability of bank credit is perhaps the most feared. Given this general perception, two practical arguments call into question the credibility of private deposit insurance funds. The first is that in the case of a systemic crisis that includes the failure of one or more large banks, the resources of the private insurance fund will be insufficient to cover the losses, and eventually public funds will enter the picture. The second is that, unlike a public insurance scheme, a private scheme cannot borrow from the government when necessary; therefore, to cover the additional expenses incurred in a crisis, a private sector insurer would have to raise the premiums charged to participating banks at a time when the banks can least afford such increases. Peter Garber puts the matter bluntly: "Private deposit insurance schemes have a long and fairly uniform history: they eventually fail." In his view, a private deposit insurance fund can be made credible only if it has the government's assurance that the fund will not become insolvent; this, however, makes deposit insurance in effect a public institution even if it is organized as a private one.

A basic principle for the effectiveness of deposit insurance emerges from this discussion together with others in this book: deposit insurance cannot work in a system where banks lack capital in an economic sense, whatever their accounts may show. As Edwin Truman observed, there is no way of avoiding moral hazard if the owners and managers of banks have nothing at stake when deciding how much risk to take on. But what the discussions in this book have demonstrated is that this is precisely the problem faced by Latin America. As the chapter by Rojas-Suarez and Weisbrod shows, one result of the particular economic and financial characteristics of Latin American economies, and the lack of an appropriate regulatory and supervisory framework that fits these characteristics, is that the quality of bank capital is low. Under these conditions, no safety net yet devised can achieve the goals for which safety nets are designed; instead,

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safety nets in Latin America tend to work in the opposite direction, creating greater incentives for bank risk-taking than prevail in industrial countries.

It is therefore not surprising that a major policy debate in the region now focuses on how to design a safety net that works while at the same time building the necessary bank capital that will make the safety net credible and sustainable. Here the debate leans in the direction of prudence.

For example, as Garber argues and as most financial experts agree, excessive coverage of insured deposits needs to be reduced, but this should not be done suddenly at a time when banks are perceived to be weak. A sudden change in policy carries the danger of precipitating a large run of deposits out of the system. Indeed, this is the problem faced by the Mexican authorities today. As Miguel Mancera recognized, Mexico needs to seek ways to gradually scale back its deposit insurance system, which guarantees the full value of all bank deposits, but it seems inappropriate to undertake drastic changes at a time of financial difficulties in the banking system.

The real issue is one of timing and sequencing.

What, then, can Latin American countries do in the immediate future to make financial safety nets more effective? Some authorities, including Miguel Urrutia, argue that, by increasing the liquidity position of banks, reserve requirements can complement the regulatory and supervisory package that accompanies the safety net. Reserve requirements can be seen as additional insurance against liquidity problems, and therefore may reduce the need to use additional public funds should bank liquidity positions deteriorate. However, the use of reserve requirements to strengthen banking systems in Latin America is still a subject of intense debate.

On the other hand, there is no controversy that the first order of business in achieving a functional safety net is to eliminate the negative capital positions of banks. As already noted, the particularities of Latin American economies and financial systems pose great obstacles to any such effort, but capital injections, liquidations, and mergers can help. Here, foreign capital has proved essential in complementing scarce domestic capital. A number of Latin American countries, including Mexico and Argentina, have already made significant progress in that direction. In their efforts to build a safe and sound banking system, many countries may find that the number of financial institutions that can safely operate in their economies is much smaller than the number operating today. The real test is whether policymakers are willing to stick to their commitment of promptly intervening in an institution that displays early signs of problems. After all, what makes a safety net functional is a credible threat that an insolvent institution will not be allowed to remain in operation.

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At least two common threads run throughout the discussions in this book.

The first is the conviction that the particular economic and financial features of Latin American economies today call for the design of a regulatory and supervisory infrastructure that best fits those peculiarities. The second is the recognition that the globalization of financial markets has brought additional challenges to the design and implementation of that infrastructure. Dealing with the transition toward international convergence is not only a complicated endeavor but a risky one as well: serious mistakes today can create severe deviations from the achievement of safe and sound financial systems in the region on a sustainable basis. Many of these transitional issues and challenges have been discussed thoroughly in this book, but a number of others remain for further analysis and discussion: • It is now widely recognized that strong financial institutions are essential for liberalized financial markets to intermediate domestic and international capital flows in an efficient and sound manner, but how much strengthening is needed before the remaining constraints on the free movement of capital flows can be removed?

• Experience elsewhere in the world, for example in Europe, demonstrates the benefits of regional financial market integration. But how much can realistically be expected from concerted agreements among Latin American countries to work toward such integration? Given the large disparities between countries in the region, not only in regulatory and supervisory procedures but in the development of financial markets, should efforts concentrate first on strengthening financial systems in individual countries, or is there scope for achieving a joint agenda in the medium term?

• A related point is that the resources needed to enforce financial regulation are scarce in the region, and what resources exist are not always of high quality. Does this call for a concerted effort to pool resources among countries? Does the region need a centralized institution that could coordinate the allocation and pricing of these resources?

• The discussions in this book lead to the conclusion that reforms to strengthen financial systems in the region should be so designed that markets work with rather than against regulators and supervisors. Is it too early for Latin American countries to consider the new initiatives being undertaken in some industrial countries, where part of the burden of supervision is being shifted from the public sector to the managers and boards of directors of financial institutions themselves? Can a gradual approach to take these initiatives into account be designed?

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PART FIVE • LILIANA ROJAS-SUAREZ

• If, as the discussions in this book recognize, it will take time to reduce the economic and financial volatility of countries in the region and improve their international creditworthiness, is there an additional role for international organizations to help in accelerating this process? Are there practical means through which these organizations could go beyond the support of specific reforms?

These are just a few of the issues that remain to be dealt with in building safe and sound financial systems in Latin America. Each will require much additional research and policy debate before it is resolved.

And because most of these questions extend beyond national frontiers, that debate will have to be regional in scope.

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