Chapter

III. The Global Crisis and Banking Systems in Latin America and the Caribbean

Author(s):
International Monetary Fund. Western Hemisphere Dept.
Published Date:
May 2009
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Challenges from a Global Crisis

The global crisis raises essential questions and issues for financial systems around the world, including in the Latin American and Caribbean (LAC) region. In the near term, it is important to understand the spillover to LAC banking systems and the implications for the outlook and short-term policy responses. In addition, as lessons are now being drawn in advanced economies, a new policy reform agenda is emerging: what are the implications of these reform proposals for the region?

In examining these issues, this chapter first focuses on the key “starting conditions” from which LAC banking systems are confronting the global crisis. The emphasis is on banking systems because banks dominate the financial sector in most countries in the region (Box 3.1). We then identify four key channels of adverse spillovers of the global crisis and discuss how LAC banking systems are likely to be affected by each of these “real-life stress tests.” Finally, we discuss short-term policy responses to limit adverse financial and real effects and the scope for further strengthening financial regulation and supervision in the coming years.

Box 3.1.Financial Systems in Latin America and the Caribbean

Banks dominate Latin American financial systems and are the only financial institutions with access to liquidity facilities and other parts of the financial safety net. Foreign banks have a significant presence through branches and subsidiaries in about 10 countries in the region (see Chapter 4) and are the dominant players in other countries, including those in the Eastern Caribbean Currency Union (ECCU), El Salvador, Mexico, and Panama. Public banks manage more than 10 percent of deposits in Argentina, Brazil, Chile, Costa Rica, the Dominican Republic, Uruguay, and Venezuela.

Some countries (Chile, Brazil, Mexico, Peru, Colombia, Panama, and Trinidad and Tobago) have well-established domestic equity and corporate bond markets, as well as pension funds, a few of which have fairly close ties with global capital markets. Still, these capital markets are relatively small in comparison with those of advanced economies.

Private pension fund assets are sizable and growing—accounting for 8–20 percent of GDP in Bolivia, Brazil, Colombia, El Salvador, Mexico, Peru, and Uruguay and 60 percent of GDP in Chile.

We conclude that LAC financial systems overall are much better prepared and more resilient than in the past because earlier weaknesses, such as exposure to currency depreciation or reliance on external financing, have been greatly reduced, and important capital buffers have been built. This partly explains why six months into the global financial crisis, Latin American banking systems have managed the stress on their domestic economies well. In addition to the main improvements to the macroeconomic framework and vulnerability indicators, the successful—though not complete—implementation of a “first generation” of reforms in financial regulation and supervision, which vary by country and have often led to banking system consolidation, have played an important role. Of the ongoing spillovers affecting the region’s banks, we see credit risk as the most relevant concern, because the global recession reduces the profitability and income of the companies and households to which banks lend. In the near term, financial policies will need to continue responding to spillovers on a number of fronts. Over the medium term, policymakers may want to consider carefully the new agenda for a second generation of regulatory reforms that is emerging from the global crisis.

Starting Condition of LAC Banking Systems

Financial soundness indicators suggest that LAC banks continue to have some margin to tolerate moderate stress. In particular, financial soundness indicators constructed from aggregate country data suggest that LAC banks are solvent and profitable, at least on average, with systemwide capital and liquidity cushions that are helping them weather financial turmoil.

  • Most banking systems have healthy capital adequacy ratios, with a median of about 15 percent, well above the 8 percent mandated by the Basel II accord and the higher national regulatory limits.

  • The nonperforming loan ratio has been falling over the past few years to a median level of about 2.5 percent, although in 2008 it mildly increased in some commodity-importing countries.

  • The return on equity is consistently high across countries, with a median level of 20 percent in 2008, although it has been declining since 2006.

  • The return on assets is positive in all countries, with a median level of 2 percent a year and a tight distribution, although dispersion increased somewhat in 2008.

  • Although liquidity ratios have been falling, liquid assets were still at about 20 percent of total assets and 40 percent of short-term liabilities by end-2008 (Figure 3.1), which is adequate for noncrisis situations.1

    Although reassuring, financial soundness indicators have limitations, including that they often are backward-looking indicators and may reflect a long period of growth that has already passed a turning point. In addition, system data can mask the deterioration in financial conditions of individual banks, particularly those that are of small or medium size. As in any other recession, the need to provide additional bank capital—or even individual bank failures—cannot be ruled out.

Figure 3.1Latin America and the Caribbean: Financial Soundness Indicators, 2000–08 1/

Sources: National authorities; and IMF staff calculations.

1/ The official definition of soundness indicators vary by country. The solid lines indicate the median of the indicators across the countries in the group, while the shaded area contains the second to the fourth quintiles.

As in other emerging markets, bank balance sheets expanded rapidly in the LAC region over the past five years. In 2008, bank asset growth continued to be strong in commodity-exporting countries, but sharply decelerated in commodity-importing countries, which could reflect wealth effects arising from the sharp changes in relative prices. In most LAC countries, however, credit growth slowed considerably in 2008. From 2004 through mid-2007, credit growth had been expanding at very rapid rate, particularly in the form of consumer lending throughout the LAC region. The median credit growth rate has been on a clear downward trend since then, falling to 10 percent, from 30 percent at its peak.

  • Bank balance sheet structures in the LAC region have improved over time and appear stronger than in other emerging markets that are currently facing significant stress (Figure 3.2).

  • The domestic bank loan portfolio is well covered by a stable domestic deposit base.

  • LAC banks hold few of the “toxic assets” that have created havoc in advanced economies. Prudential regulation in many LAC countries established firm limits on banks’ exposure to complex derivatives and structured investment products. The bulk of banks’ foreign assets are kept in the form of bills and foreign exchange deposits abroad, with the more financially advanced economies in Latin America engaging also in equity investments and derivative transactions.

  • Banking systems in Latin America maintain balanced or positive net foreign asset positions, even without counting the foreign exchange reserve requirements held at the central bank in dollarized economies. This is in contrast to the situation in emerging Europe, for example, where bank funding increasingly has relied on foreign inflows.

  • In recent years, there has been a clear trend reduction in financial dollarization on both sides of the balance sheet, particularly in the highly dollarized economies of Bolivia, Paraguay, and Peru. The lower dollarization trend can still be verified when controlling for fluctuations in the real exchange rate, although dollarization appears to have slightly increased over recent months.

  • Although global banks are important players in LAC financial systems, they have funded most of their subsidiaries’ and branches’ positions with LAC deposits (see Chapter 4). They do not rely on wholesale funding from abroad to extend credit.

Figure 3.2.Latin America and the Caribbean: Banks’ Net Liability Structure

(Billions of U.S. dollars)

Sources: National authorities; and IMF staff calculations.

Domestic Private Sector Loans in Latin America and the Caribbean

(Percent of private sector deposits)

Sources: National authorities and IMF staff calculations.

1/ Weighted by the size of private sector loans and deposits outstanding expressed in U.S. dollars in each banking system.

Bank Foreign Asset Structure, 2008 1/

(Percent)

Source: IMF staff calculations.

1/ For each region, the chart shows the average of the percent structure in each country.

2/ Includes Brazil, Chile, Colombia, Mexico and Uruguay.

Despite the mostly favorable soundness indicators and balance sheet structures for the region, analyst perceptions of financial sector stability are not favorable for some countries in the region. For example, Standard & Poor’s banking industry country-risk assessment services place in the highest risk category the financial systems of several countries in the LAC region, typically those with high sovereign spreads. Market indicators suggest a moderate increase in the expected probability of default on debt obligations in some LAC countries, but these are not as high as in some advanced economies.

Expected Default Probability 1/

(Percent)
(Percent)
(Percent)

Source: Moody’s KMV.

1/ Expected default probabilities (EDFs) on the service of bank liability obligations are available for banks listed at stock exchanges. These banks represent between 30 and 91 percent of banking assets in the Latin American countries in the Figure. Mexico’s EDFs were excluded because they represent only 7 percent of banking system assets.

Financial System Impact of Selected Macroeconomic Risks

Latin American banking systems have so far handled the global financial crisis well, although the situation remains delicate. The most important risk factor for LAC financial systems now is the overall deterioration in economic activity and international trade, which can be expected to substantially affect the quality of bank loan portfolios. Several other risk factors are also relevant, but aggregate balance sheet structures suggest that these should not individually play a major direct role in the transmission of the global crisis to LAC banking systems. However, their effect will be stronger if they take place at the same time. They may also indirectly affect the health of banks in the system through their impact on onshore and offshore corporations and financial institutions to which domestic banks lend or that are related to the bank through their shareholders.2

Sharp contraction in growth and international trade

As the global financial crisis unfolds, the quality of the loan portfolio of banks in the region will likely be affected, as business conditions deteriorate, unemployment increases, and real wages and remittances diminish, compromising the ability of households to service their bank debt. The expected sharp slowdown in credit growth also will tend to expose any problem loans that may have been masked by the generally favorable economic conditions in the region. Nevertheless, deterioration in the quality of the loan portfolio is likely to have fewer macroeconomic implications than it would in other emerging markets because private sector credit as a share of GDP is relatively small.

Capital cushions will provide some breathing room. For example, the IMF staff estimates that the 18.3 percent capital adequacy ratio in Brazil as of December 2008 would allow for writing down up to 10 percent of the loan portfolio to the public and private sectors while remaining within the 11 percent regulatory limit. A similar exercise for Mexico would allow for writing down up to 11.8 percent of the loan portfolio while remaining within the 8 percent regulatory limit.

Although the large capital cushions provide protection against credit risk, they must also offer cover for the market and other risks borne by banks, including those in off-balance-sheet transactions. They also often provide cover for risks taken by financial institutions belonging to the same economic group.

Credit to Private Sector 1/

(Percent of GDP)

Source: IMF, International Financial Statistics.

1/ GDP weighted averages.

Sudden stop

Latin American banking systems appear to be well covered against foreign exchange liquidity risk arising from a sudden stop. In particular, most banking systems in Latin America have enough assets abroad to cover withdrawal of liabilities owed to nonresidents. Except for a few countries (Costa Rica, Guatemala, Jamaica, Nicaragua, and St. Lucia), the net foreign asset position of Latin American banking systems is either positive or negligible when compared with domestic deposits.

Although global banks have a sizable exposure in LAC countries (see Chapter 4), this exposure is mostly financed with local deposits as opposed to foreign borrowing. Moreover, the global banks operating in the region are widely considered “too big to fail” (indeed, their governments already have rescued some). Global banks’ operations in LAC countries are among the most profitable and well capitalized in the region. Thus, it might be reasonable to expect that the presence of global banks in the LAC region remains important. Nevertheless, there is always the risk that local subsidiaries of global banks could be instructed to transfer large amounts to the global banks’ headquarters, and some supervisors have moved to tighten related-party lending limits to cover this risk.

A separate risk is that a generalized lack of access to foreign borrowing may indirectly affect banking systems if it places stress on LAC firms, which may be on their loan portfolio or belong to the same economic group. Bank for International Settlements (BIS)-reporting banks lend and book outside LAC countries about US$300 billion to the governments and private sectors in the region. Although domestic governments and corporates hold about US$200 billion in BIS-reporting banks, borrowers and depositors do not always coincide.3

On the other hand, limited access to foreign borrowing may actually improve business opportunities for domestic banks. Reduced competition from abroad opens the possibility for banks to cater to large domestic firms that had been borrowing overseas. This may come at the cost of households and small and medium-sized enterprises, which may be displaced, and this has already happened in a few countries in the region. It may also raise credit risk by increasing the concentration of the loan portfolio.

Currency risk

Bank exposure to exchange rate risk varies by country but today is significantly smaller than in the past, when this type of market risk was often the region’s Achilles’ heel. Rapid currency depreciation can affect LAC banks directly and indirectly. The direct effect is through banks’ net open foreign exchange positions in their balance sheets, while the indirect effect is through deterioration in foreign exchange credit quality. Although information on net open foreign exchange positions is not readily available to the public for most LAC countries, supervisory authorities typically track these positions on a daily basis for all supervised institutions, since these are subject to quantitative prudential limits in most countries. To explore the direct exposure of banking systems in countries where information is not readily available, net open foreign exchange positions were computed from detailed aggregate standardized banking data submitted to the IMF for the publication of International Financial Statistics. The analysis confirms that aggregate net open foreign exchange positions are positive in most countries, but have been on a downward trend. In a few countries (e.g., Chile and Colombia), banks have used derivative instruments to manage their currency exposures.

Cross-Border Loans and Deposits 1/

Sources: Bank for International Settlements (BIS); and IMF staff calculations.

1/ Corresponding to cross-border, nonbank operations of residents of the LAC region with BIS-reporting banks. Shares computed from variables at 2007 prices and exchange rates.

2/ Deposits of residents in percent of their total deposits in both domestic and foreign banks.

3/ Loans of residents from foreign banks in percent of their total loans from both domestic and foreign banks.

Estimated Net Open Foreign Exchange Positions in Selected Latin American and Caribbean Countries, 2002–08 1/

(Percent of capital)

Source: IMF staff calculations.

1/ Area excludes the top and bottom 20 percent of the distribution. Included countries are Brazil, Chile, Colombia, Costa Rica, Dominican Republic, the ECCU, El Salvador, Guatemala, Honduras, Jamaica, Mexico, Nicaragua, Panama, Paraguay and Uruguay.

Exposure to foreign exchange credit risk, though smaller than in the past, remains substantial in the more dollarized economies. The falling level of credit dollarization in the few highly dollarized economies, however, has helped reduce credit risk arising from exchange rate fluctuations. Prudential rules are in place in several countries that effectively limit foreign exchange credit risk (Honduras, Peru, and Uruguay, among others).

On the other hand, significant currency depreciation since the Lehman Brothers collapse has so far been limited mostly to a handful of countries in Latin America that export commodities heavily. Currency depreciation in these countries has helped cushion the negative effect of plummeting commodity prices on the export sector and, ultimately, on the quality of the credit portfolio granted to export companies. Still, it is too early to assess the full net effect of these developments on the quality of banks’ loan portfolios.

An indirect source of credit risk from exchange rate fluctuations may arise from large corporate exchange rate losses. Corporate coverage to exchange rate risk, however, has reportedly been generally improving over the past few years (see the November 2008 REO). One exception is the losses associated with foreign exchange derivative positions affecting some firms in Brazil and Mexico in late 2008.

Asset price deflation

Asset price deflation gives rise to another form of market risk. Banks’ direct exposure to stock market fluctuations varies by country. Median bank holdings of shares are relatively small, at about 5 percent of capital, but are considerably higher in some of the larger countries. Such figures should be viewed as an upper bound for the amount exposed to short-term fluctuations in stock prices, as only a subset of the shares owned will be on banks’ trading books.4 In addition to the direct effects on bank books, stock price drops may have an effect on aggregate demand and output associated with the destruction of financial wealth—but this channel is thought to be weak in LAC countries, as market capitalization is generally low and because share ownership tends to be highly concentrated among the wealthiest individuals. In the LAC financial sector, the stock exchange collapse has affected pension fund assets in a few countries, eroding household wealth (and this, in time, could become a fiscal liability). For instance, in Peru pension assets fell by nearly 20 percent in nominal terms between end-2007 and February 2009. In other countries, the effect has been smaller, given tighter limits on pension fund investments at the stock exchange (e.g., Mexico).

Banks’ exposure to real estate prices takes the form of the value of collateral on its mortgage portfolio. Latin American banks typically show the mortgages they originate on their banking books (unlike recent practice in the United States, where banks securitized some of the loans they originated and took them off their balance sheets, at least temporarily), and the value of the property serves as an important source of collateral. Reductions in real estate prices can affect the banking system if they are large enough to encourage default. Nevertheless, Latin American exposure to real estate is still small, and mortgage lending has not been among the fastest credit growth areas in Latin American countries. In particular, the share of mortgage loans in total household credit has been on a declining trend in many countries (e.g., Argentina, Bolivia, Brazil, Colombia, Peru), with more private sector credit granted directly in the form of consumer loans or credit cards. In a few countries, the mortgage portfolio has been increasing, albeit from a low base (typically still below 30 percent of the total household loan portfolio). The mortgage exposure is somewhat larger in countries in the ECCU.

Bank Holdings of Shares in Selected Latin American and Caribbean Countries, 2002–08 1/

(Percent of capital)

Source: IMF staff calculations.

1/ Area excludes the top and bottom 20 percent of the distribution. Includes data for Brazil, Chile, Colombia, Mexico, Uruguay, Costa Rica, Guatemala, Honduras, Costa Rica, Dominican Republic, El Salvador, Nicaragua, Panama, the ECCU, Jamaica, and Paraguay.

Implications for Prudential Regulation and Banking Supervision

The sharp deterioration in the macroeconomic environment calls for a state of alert in banking supervision. The LAC region has some breathing room before risks from the global recession fully materialize, and financial supervisors and regulators have the opportunity to make the most of it. Significant progress in prudential regulation and banking supervision has been made in the region, but there is still scope for further improvement (Figure 3.3).

Figure 3.3.Compliance with Basel Core Principles 1/2/

Sources: IMF’s standards and codes database and Rennhack and others, forthcoming.

1/ Regional average of the percentage of principles largely or fully compliant in each category.

2/ Albania, Algeria, Andorra, Anguilla, Antigua and Barbuda, Armenia, Aruba, Australia, Austria, Azerbaijan, Bahamas, The, Bahrain, Bangladesh, Barbados, Belarus, Belgium, Belize, Bermuda, Bolivia, Bosnia and Herzegovina, Botswana, Brazil, British Virgin Islands, Bulgaria, Cameroon, Canada, Cayman Islands, Central Economic African Monetary Union, Chile, Colombia, Cook Islands, Costa Rica, Côte d Ivoire, Croatia, Cyprus, Czech Republic, Denmark, Dominican Republic, Eastern Caribbean Central Bank, Ecuador, Egypt, El Salvador, Estonia, Finland, France, Gabon, Georgia, Germany, Ghana, Gibraltar, Greece, Guatemala, Guernsey, Guinea, Guyana, Honduras, Hong Kong, Hungary, Iceland, India, Indonesia, Iran, Islamic Republic of, Ireland, Isle of Man, Israel, Italy, Jamaica, Japan, Jersey, Jordan, Kazakhstan, Kenya, Korea, Republic of, Kuwait, Kyrgyz Republic, Labuan (Malaysia), Latvia, Lebanon, Lithuania, Luxembourg, Macau, Macedonia, former Yugoslav Republic of, Madagascar, Malta, Marshall Islands, Mauritius, Mexico, Moldova, Montserrat, Morocco, Mozambique, Namibia, Netherlands, Netherlands Antilles, New Zealand, Nicaragua, Nigeria, Norway, Oman, Pakistan, Palau, Panama, Paraguay, Peru, Philippines, Poland, Portugal, Qatar, Romania, Russian Federation, Rwanda, Samoa, American, Saudi Arabia, Serbia, Seychelles, Singapore, Slovak Republic, Slovenia, South Africa, Spain, Sri Lanka, St. Vincent and the Grenadines, Sweden, Switzerland, Syrian Arab Republic, Tanzania, Thailand, Trinidad and Tobago, Tunisia, Turk and Caicos, Turkey, Uganda, Ukraine, United Arab Emirates, United Kingdom, Uruguay, Vanuatu, Yemen, Republic of, Zambia.

The immediate focus has rightly been on close supervision of high-frequency developments and early-warning systems to detect and correct problems that could become systemic. In some countries, this has required enlarging the information set available to supervisors, including off-balance-sheet operations of banks, household indebtedness, real estate prices, and other collateral values, among others. In other countries, it has also involved gathering information on the health of firms in the economic group to which the bank belongs.

Extraordinary arrangements to provide liquidity have arguably helped avoid at the margin deposit runs arising out of fear and unrelated to banks’ underlying financial situation. Central banks in many countries in the region have created new facilities to provide domestic and foreign currency liquidity in case of need. Unlike in earlier external crises, many countries have been able to ease monetary conditions, which has helped banks on the liquidity front. The scope for providing liquidity assistance has of course been limited by the monetary framework in place, particularly in countries with fixed exchange rate arrangements or those that are fully or highly dollarized. Some country authorities have also looked for alternative sources of medium-term funding for banks or set up government programs aimed at attenuating credit risk borne by banks. Some public banks have played a supporting role (see Chapter 2).

Periodic stress tests are playing a crucial surveillance role. Supervisors know that off-site analysis can provide clues about possible problems, but the complete impact on the bottom line or in capital requirements of a specific stress scenario can be assessed only with information only at disposal of top bank management. Besides regular on-site inspections, stress tests can provide early-warning signals. Exercises in which the central bank and the supervisory agency cooperate can be particularly useful (with the central bank providing the macro framework and the supervisory agency coordinating with banks on the impact of this scenario on their balance sheets and profitability). This type of exercise could highlight, for example, currency exposures arising from financial contracts that may be difficult to detect from balance sheet data.

Given the external environment, it would seem prudent to closely review the existing bank resolution frameworks, safety net arrangements, and strategies for dealing with systemic risk. This may involve preparing contingency plans for worst-case scenarios and identifying necessary improvements to the legal and regulatory arrangements, to be able to pass them quickly in case of need. Granting supervisors legal protection and power to act on behalf of the financial stability of the country is arguably at the top of the agenda in some Latin American countries. Safety net arrangements are in place in most Latin American countries, but only a few have fully developed a framework for dealing with systemic crises. Even without passing a new law (or needed amendments), which could be counterproductive in the current environment, it could pay to have a draft ready for congressional discussion in case of emergency.

Medium-term agenda

In adapting the medium-term agenda to the current environment, supervisors are following closely the lessons on prudential regulation and banking supervision that are emerging from the global financial crisis. Preliminary discussions point to the need to (i) expand the perimeter of regulation by reevaluating what is considered a systemic institution, which would require strong regulation; (ii) make consolidated supervision more effective; (iii) adapt existing regulatory and institutional practices to reduce procyclicality; (iv) strengthen public disclosure practices for systemically important financial institutions and markets; and (v) give central banks a broader mandate for financial stability, which would give greater attention to controlling credit and asset booms (Rennhack and others, forthcoming).

The discussion about the perimeter of regulation stresses the fact that any financial institution that can threaten the financial system should be strongly regulated and supervised. Supervisors should be able to flexibly determine at any time which institutions fall within the perimeter of strong regulation and which are left in an outer perimeter of lighter regulation. Banks will always be highly regulated because they have direct access to the country’s financial safety net. Nonbank systemic institutions must be under close scrutiny because they could disrupt and compromise confidence in the financial system. These may include institutions with strong linkages to large banks, any large financial institution (including off-balance sheet items), highly leveraged institutions, and those that play a key role in the financial infrastructure, such as custody, clearing, settlement, or payments.

Most Latin American countries already have broad regulatory and supervisory perimeters, although some systemic institutions are arguably insufficiently regulated and supervised. Examples of possible systemic nonbank financial institutions include insurance companies, offshore financial institutions, credit unions, cooperatives, investment funds, finance companies, and mutual funds. Incorporating systemic institutions into the strong regulatory and supervisory perimeter is clearly a more pressing issue in countries with sizable nonbank financial institutions and domestic capital markets, although recent examples of systemic risk have arisen in some economies with less developed financial systems.

In light of this risk, strengthening consolidated supervision is a major medium-term goal for most of the region. The importance of this issue stems from the prevalence of large financial conglomerates, offshore and regional banking (Central America and the Caribbean), and the significant presence of global banks in many countries in the region. Consolidated supervision is in the early stages in most LAC economies, although significant progress has been made in others. The key is to resolve shortcomings in the legal framework for consolidated supervision and to make memorandums of understanding effective by creating mechanisms that institutionalize information sharing and cooperation. Developing effective consolidated supervision with advanced countries will remain a major challenge.

Countercyclical prudential regulation is an area worth exploring. The regulatory systems in the region do have features that give rise to procyclicality, including, under certain crisis scenarios, capital adequacy standards, provisioning requirements, and accounting rules. Some countries in the region have already moved in this direction by adopting, for example, countercyclical provisioning requirements (Box 3.2). Countercyclical prudential regulation, however, could be counterproductive, especially in countries that have not established a good policy track record. As in any other type of countercyclical policy, a relaxation in the present requires a tightening in the future, which often gives rise to a “time-inconsistency” dilemma in which the incentives for tightening may diminish.

Box 3.2.Forward-Looking Provisioning Considerations

Several countries have tried to make banks set provisions taking into account the risk profile of the loan portfolio over the entire cycle. Spain pioneered this approach in 2000, and a few Latin American countries have introduced similar schemes: Bolivia (2008), Colombia (2007), Peru (2008),1 and Uruguay (2001). Countercyclical provisioning essentially consists of building provisions during a period of high growth, which can be used during periods of low growth to cover the rising nonperforming loans. The provisions built during the upturn are typically called “statistical” or “countercyclical” to differentiate them from the “specific” provisions that are assigned to individual problem loans. The mechanics consist of converting the countercyclical provisions into specific ones as needed. Country regulations differ in how much must be provisioned during the upturn, depending, among other things, on the existing loan classification and the method for determining the position in the cycle, and the conditions for converting countercyclical into specific provisions.

1 Peru introduced temporary countercyclical provisions based on financial margins in 2000.

Conclusions

Most banking systems in Latin America are facing the global financial crisis from a position of strength. They have built significant capital and liquidity cushions that have helped them absorb moderate shocks and have followed financial policies that have contained risk. Six months after the Lehman Brothers collapse, no Latin American banking system has faced a banking crisis. With little direct exposure to structured investment products and toxic assets, which caused stress in advanced economies and other emerging markets, the regional banking systems have balanced or positive net foreign assets and net open foreign exchange positions. They rely mainly on a local deposit base for financing their loan portfolios, with relatively little direct impact arising from liquidity shortages in international financial markets.

Nevertheless, LAC banking systems are operating in an adverse environment and are likely to suffer significant stress arising from the rapid slowdown in economic activity, which could erode confidence if not managed properly. A major challenge will be to limit the feedback between the real and financial sectors. Although banking systems appear resilient, if the crisis were to last longer than anticipated (as envisaged in our downside scenario), there is always the risk that some isolated cases of banks under stress may need to be addressed by national authorities, for which a timely review of the bank resolution framework will be key to ensure that nonsystemic and individual cases are managed in an orderly way. In this regard, many authorities in the region have taken appropriate measures to ensure orderly domestic liquidity conditions and the continued flow of credit.

The sharp deterioration in the macroeconomic environment calls for a state of alert in banking supervision. The immediate focus should be on close supervision of high-frequency developments and early-warning systems to detect and correct problems in financial institutions that could become systemic. It will be important to make progress in contingency planning, financial safety nets, and bank resolution frameworks. In the medium term, country authorities may want to consider an agenda that incorporates the lessons that are being drawn from the current global international crisis. These include expanding the perimeter of strong regulation to all systemically important financial institutions, strengthening consolidated supervision, and reducing procyclicality in prudential regulation, among others.

Note: This chapter was prepared by Jorge Iván Canales-Kriljenko. The chapter draws in part on a forthcoming paper on implications for the LAC region of global financial and regulatory reform (Rennhack and others, forthcoming).

Aggregate banking data provide a useful reference for describing banking system trends but cannot, of course, signal financial stress in individual banks. Still, aggregate banking data do give some indication of the health of systemically important banks given their significant weight in the total.

Recent examples of this type of contagion include the financial meltdown of Trinidad-based CL Financial Group and fraud accusations against Antigua-based Stanford Financial Group.

Nevertheless, they often do coincide, given the high level of wealth concentration in some countries in the region.

Many LAC countries have already adopted accounting standards that require marking to market bond and equity assets held in the trading book, generally except those held to maturity.

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