I Introduction
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund
  • | 2 https://isni.org/isni/0000000404811396, International Monetary Fund

Abstract

In late 1994, several Latin American economies, particularly Mexico and Argentina, experienced sharp reversals of international capital inflows that had characterized the previous four years. The immediate cause of the reversals was the loss of international investor confidence in these countries’ ability to defend their exchange rate and in the authorities’ ability to service their external debt on a timely basis. Short-term interest rates rose to extraordinarily high levels. Because many borrowers could not afford to service their debts at these high interest rates, the credit quality of domestic banks’ loan portfolios deteriorated dramatically, creating concerns about the solvency of the banking systems in these economies.

In late 1994, several Latin American economies, particularly Mexico and Argentina, experienced sharp reversals of international capital inflows that had characterized the previous four years. The immediate cause of the reversals was the loss of international investor confidence in these countries’ ability to defend their exchange rate and in the authorities’ ability to service their external debt on a timely basis. Short-term interest rates rose to extraordinarily high levels. Because many borrowers could not afford to service their debts at these high interest rates, the credit quality of domestic banks’ loan portfolios deteriorated dramatically, creating concerns about the solvency of the banking systems in these economies.

The current crisis has occurred during a period of economic and financial reform in Latin America. After almost a decade of macroeconomic and financial difficulties, since the last part of the 1980s and the beginning of the 1990s, many Latin American countries have undertaken major transformations of their economic structures. These efforts have included not only comprehensive stabilization programs aimed at correcting macroeconomic imbalances but also deep structural reforms designed to improve the efficiency of market mechanisms in pricing and allocating resources among the different sectors of these economies.

Among the reforms, the restructuring of financial markets was crucial. Latin America does not stand alone in having learned the lesson that difficulties in the financial sector may conflict seriously with policy objectives as governments have had to abandon their fiscal and monetary targets to rescue insolvent or troubled financial institutions. Several industrial countries, including the United States and three Nordic countries, are among the recent cases where banking difficulties have had a severe impact on the fiscal stance. Within the Latin American region, the banking difficulties experienced in a number of countries following the eruption of the debt crisis in the 1980s imposed constraints on policymakers that, in some cases, lasted for almost an entire decade.

As policymakers again face challenges similar to those faced in the 1980s, it is important to assess whether the financial reforms implemented in the early 1990s have strengthened their hand in dealing with financial crisis. By reviewing the experiences of Latin American countries with the restructuring of their financial sectors since 1982, this paper derives lessons regarding the most effective ways to deal with banking difficulties in developing countries. It then discusses whether these lessons have been put into practice during the latest crisis. A sample of five countries—Argentina, Chile, Colombia, Mexico, and Peru—is used for this purpose.

In addition, the paper analyzes policy issues associated with the long-run health of the financial system: (1) the proper design of policies to respond to large and volatile flows of capital having the complementary objectives of maintaining long-run macroeconomic stability and a healthy financial system; and (2) the effect on bank soundness of increased competition from recent developments in domestic capital markets.

Section II sets the stage by presenting a framework for analyzing banks’ behavior. A lack of transparency in the legal and accounting infrastructures is the main feature that defines the special role of banks in developing countries: because investors cannot rely on the legal infrastructure to aid in evaluating the creditworthiness of borrowers, they search for alternative methods of evaluation. One method is for lenders to force borrowers to remain liquid by restricting their borrowing opportunities to short-term funds and carefully monitoring their cash flow; that is, in these financial systems liquidity becomes a primary proof of solvency. In developing countries, banks are in a unique position to intermediate between borrowers and lenders because they are the only nongovernment issuers of short-term liabilities.

A sound banking system issues the appropriate loan contracts and establishes the appropriate monitoring procedures to maintain borrower liquidity. Conclusions regarding the behavior of banks in this environment are based on incentive-driven arguments: where policymakers put in place mechanisms to motivate banks to perform their role of maintaining borrower liquidity, bankers become well equipped not only to evaluate properly the risks they undertake, but also to develop “workout” programs with their borrowers if sudden adverse shocks weaken the quality of loans, thereby leading to banking difficulties. Thus, although a strong banking system does not mean that banking difficulties can be prevented altogether, it implies that problems are faced promptly and bankers have incentives to restore defaulted borrowers to performing status.

Section III uses the framework described above to examine the resolution of banking crises in the sample of five Latin American countries during the 1980s. The discussion shows that the strength of banks at the onset of the crisis and the quality of central bank leadership were important determinants in how quickly public confidence was restored to the financial systems in the sample countries. Countries are grouped by the strength of their banking systems at the inception of the banking crisis. In those countries where the strength of the banking system was greater, bank supervisors and bankers were able to respond to the crisis with a credible program to restore confidence in the banking system; although the programs involved a substantial increase in credit, the soundness of the rescue programs prevented the eruption of inflation. In sharp contrast, in those countries with relatively weak banking systems, banking regulators further aggravated the problem by attempting to take over the role of banks as direct lenders; that is, supervisors removed authority from bankers, substituting the credit judgment of the central bank or the government directly. In those cases, credit expansion was associated with big inflations as the public realized that the credit extended would not be repaid in real terms.

By the early 1990s, many of the perceived mistakes of the 1980s were corrected, and comprehensive efforts were made to liberalize financial markets and strengthen bank supervision. However, by the end of 1994, the reformed systems of two of the five sample countries—Mexico and Argentina—were severely challenged when a reversal of international capital flows led to sharp increases in domestic interest rates and a general weakening of the quality of financial assets. Section IV discusses the strengths and weaknesses of the banking systems in these two economies on the eve of the 1994 crisis and assesses the options available to policymakers in restructuring their financial systems.

The last two sections of the paper deal with the long-run challenges policymakers face in dealing with the performance of the banking sector. Section V discusses the impact of stabilization policies and structural developments in capital markets on the strength of the banking system, and Section VI turns the question around and analyzes the contribution of a sound banking system in dealing with an adverse shock that leads to a speculative attack on the exchange rate.

Section V focuses on two factors that affect the strength of the banking system: sterilization policies and the securitization of many financial instruments that heretofore appeared mostly on bank balance sheets. Regarding the first factor, the impact of sterilization policies on the soundness of banks is emphasized. Conclusions regarding both the desirability and the method of sterilization are linked to the strength of the central bank relative to that of commercial banks. The message is straightforward: as the decision to sterilize or not implies a decision to concentrate resources in the central bank rather than in the commercial banks or other financial institutions, it follows that resources should be channeled to the institutions that can manage those funds better. This section concludes that the stability of investments made in the domestic equity markets is closely related to the strength of the banking systems: stock market volatility is lower in those countries with relatively strong banking systems.

The analysis also shows that the second risk to the strength of banks, namely, the recent development of capital markets, is still years away from becoming a serious threat to bank soundness. Even in those countries where fixed-income markets—such as commercial paper or the corporate bond market—have developed, open market interest rates are still high relative to bank interest expenses and the instruments are still held by only a few investors. The discussion shows that a strong banking system complements, rather than competes with, the development of healthy markets for equity issues. The development of equity markets, however, may pose some dangers for policymakers worried about unstable capital inflows. In this connection, the analysis shows that these dangers can be minimized by strengthening the domestic banking sector.

Finally, Section VI deals with a key macroeconomic issue: the ability of central banks to withstand speculative attacks on the exchange rate, with an emphasis on the role of banks’ performance in facilitating the policy objective. The main argument is that the degree to which a Latin American central bank may be able to withstand a speculative attack on its domestic currency is influenced by two aspects of the financial markets: the first one, which is a natural extension of the well-known literature on speculative attacks, is the extent of the commitment of the central bank to the stabilization of prices in the financial sector. The second one, and the one emphasized in this paper, is the strength of the banking sector. In this connection, the paper also deals with the role of dollarization. A conclusion from the analysis is that, when the banking system is sound, dollarization may be an ally for governments pursuing exchange-rate-based stabilization programs. In an insolvent, bank-dominated financial system, however, dollarization imposes an additional constraint on policymakers facing a speculative attack. In dealing with these topics, this section addresses the issue of the appropriate holdings of foreign exchange reserves by central banks.

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