Issues in Managing and Sequencing Financial Sector Reforms Lessons From Experiences in Five Developing Countries*

A review of the experience of five developing countries in reforming their financial systems illustrates the benefits and risks, and provides lessons on the factors which contribute to successful financial sector reforms. Financial sector reforms need to be supported by active monetary policy, and the adoption of new monetary control procedures early in the reform program; reforms should be sequenced consistently with the broader program of macroeconomic adjustment. The pace of liberalization of interest rates and credit should also take account of the solvency of financial and nonfinancial firms. A minimal system of prudential regulation is an essential element of successful financial sector reform.


A review of the experience of five developing countries in reforming their financial systems illustrates the benefits and risks, and provides lessons on the factors which contribute to successful financial sector reforms. Financial sector reforms need to be supported by active monetary policy, and the adoption of new monetary control procedures early in the reform program; reforms should be sequenced consistently with the broader program of macroeconomic adjustment. The pace of liberalization of interest rates and credit should also take account of the solvency of financial and nonfinancial firms. A minimal system of prudential regulation is an essential element of successful financial sector reform.

I. Introduction

1. Introduction

This paper reviews the experience of a sample of developing countries in liberalizing their financial systems to identify the factors which contribute to successful financial liberalizations. Two broad questions are addressed: (1) are there specific components of financial sector reforms that are best implemented at specific stages of a broader stabilization-cum-reform program, and (2) is there an appropriate sequencing of various detailed components of financial sector reforms?

The research reported in this paper should be viewed in the context of two other relevant areas of work. First, increasing emphasis has been placed on the role of financial market conditions—in contrast to the traditional emphasis on money—in influencing real economic activity. Many authors have argued that credit market conditions and balance sheet developments (such as debt-equity ratios, ratio of net worth to liabilities, etc.) can have important effects on output and investment. 1/ In addition, the information asymmetries and the resulting market failures (equilibrium credit rationing, credit market collapse, bank runs, weak secondary markets, etc.) imply the possibility that government can, through appropriate regulations, improve on the types of contractual arrangements that would arise in an unfettered private economy. 2/ This paper draws on this analysis to interpret the developments in the sample of countries under review.

The second relevant area of work is that on the sequencing of broad economic reforms. 3/ This literature has suggested broad propositions on the optimal sequencing of economic reforms including: (1) that macroeconomic stabilization is a prerequisite to successful structural adjustments; (2) that the liberalization of domestic financial markets should precede the removal of controls on international capital flows; and (3) that trade liberalization and real sector adjustments should precede capital account liberalization. The investigation in this paper complements this analysis by focusing on specific aspects of financial sector reform.

Several components of the financial sector are considered, namely: (1) reforms of the interest rate regime; (2) the development of money markets and market-based monetary control procedures; (3) reforms of prudential regulations and supervisory system; (4) recapitalization and restructuring of weak financial institutions; (5) measures to strengthen competition among banks; (6) reform of selective credit regulations; and (7) the development of long-term capital markets. Legislative reforms and organizational changes are also touched on briefly.

The study examines experiences with financial sector reform in five countries: Argentina (1976-81), Chile (1974-80), Indonesia (1983-88), Korea (1980-88), and the Philippines (1980-84). Conditions prior to embarking on economic and financial reforms ranged from severe financial repression, distortion in prices and economic imbalances (for example, in Argentina), to more progressive financial sectors and smaller economic and structural distortions (for example, in some Asian economies). In all the countries the activities of financial institutions were tightly controlled prior to financial reforms with a high degree of policy-induced segmentation between different types of financial institutions.

The paper is organized as follows: the rest of Section I provides an overview or the paper; Section II reviews the financial sector reform experiences of five countries; and Section III presents the main conclusions.

2. Overview 4/

a. Countries’ experiences with sequencing reforms

Reform followed no unique sequencing in the countries examined and the time frame for implementation varied substantially. A deregulation of interest rates and credit controls occurred early on in the reforms in Argentina, Chile, and the Philippines. These countries experienced significant financial deepening but also faced problems of a loss of control over domestic financial aggregates following their financial reforms. Indonesia and Korea liberalized administered controls over bank credit more gradually, and did not experience the same loss of control.

While policies to reduce segmentation between financial institutions and to lower barriers to entry, were initiated early in the reform process in most countries, the policies had mixed effectiveness in promoting competition. In Argentina and, initially, in Chile, there was increasing concentration of ownership. The liberal entry policies for new financial institutions in the Philippines and -Indonesia increased competition significantly but also created a vulnerable component of the banking system and were ultimately unsustainable.

As regards the liberalization of the capital account, exchange controls had been liberalized prior to the financial reforms in Indonesia and the Philippines. This increased competition and accelerated the reforms. However, larger capital flows may have added to instability in liquidity and made control over domestic monetary conditions somewhat more difficult. Argentina and Chile only gradually relaxed their exchange controls, but both countries faced substantial capital outflows because of uncertainty about their exchange rates, which became significantly overvalued. In these circumstances, capital controls were generally ineffective in preventing the outflows and thus in supporting domestic interest rate policies. Korea maintained tight exchange controls until relatively late in its financial reform.

Korea was the only country that actively promoted its capital market as part of its financial reform. Capital market development played little part in the reforms in Argentina and the Philippines, and Indonesia developed its capital market only in the later phase of reform. A capital market boom accompanied the Chilean reforms, but this was mainly related to temporary financial conditions, and the boom and subsequent stock market collapse accentuated financial instability following the reforms.

The critical need for effective prudential supervision was identified only late in the reform process in many countries, as was the need to reform deposit insurance as a means of increasing discipline on financial institutions. New prudential regulations were introduced in the initial stage of the reforms in Argentina and Chile, however, their effectiveness was weak.

In three countries—Argentina, Chile, and the Philippines—financial liberalization was followed by a financial crisis that disrupted the financial sector and was accompanied by a sharp contraction in gross domestic product (GDP) and a reversal of the financial deepening that initially followed the financial reforms. It is important to stress that there was no direct connection between financial liberalization and financial crisis and the countries’ experiences need to be seen in the broader context of the success of their stabilization policies. In Argentina, the fiscal deficit was not contained; the real exchange rate appreciated sharply; and the substantial capital outflows reflected a general lack of confidence in the economy. In Chile, the fiscal deficit was reduced but the real exchange rate appreciated to unsustainable levels, resulting in speculation against the peso and capital outflows resulting in very high real interest rates that impaired the value of the banks’ assets. The banking crisis in the Philippines was preceded by a crisis in the balance of payments and a moratorium on external debt payments that seriously damaged investor confidence.

In contrast, Korea had a successful real sector adjustment that included exchange rate depreciation and fiscal correction, resulting in a strengthening of the balance of payments and capital inflows. In addition, the authorities adjusted nominal interest rates actively in line with inflation in order to prevent sharp increases in real interest rates. In Indonesia, the fiscal deficit was reduced and the authorities were active in managing financial sector liquidity and avoiding sharp fluctuations in interest rates in the face of speculative flows of capital.

b. Lessons for managing and sequencing financial sector reforms

In all countries, except Korea, financial liberalization was followed by a period in which credit growth exceeded the growth of deposits, and in most of these countries, the gap between the growth of credit and the growth of deposits widened following the reforms. In other words, the financial reforms were immediately followed by a widening in the gap between private expenditure and income. Unless carefully managed this can add to inflation and put pressure on the balance of payments.

The initial tendency for credit to grow more rapidly than deposits is not perhaps surprising where credit growth was previously constrained by direct controls with an excess demand for credit. Once the direct controls are removed, financial institutions respond by meeting the excess demand and credit expands rapidly. In the pre-reform period, deposits were not limited by direct controls and so a similar excess demand did not exist. With reform, deposit growth, therefore, responds more slowly as a portfolio response to the new liberal financial situation.

The countries’ experiences also suggest, however, that the tendency for credit to grow more rapidly than deposits is only a temporary phenomenon when the authorities maintain positive real interest rates. Following the initial stock adjustment—reflecting the initial excess demand—credit growth slows down. Deposit growth continues in response to the ongoing financial deepening, and after some time, the growth of deposits and credit converge, allowing for balanced growth with a higher level of overall resource mobilization.

In order to manage the growth of credit and interest rates in the post reform period, the authorities need to have available effective indirect instruments of monetary control to replace the direct controls. Hence, a reform of monetary control procedures should occur very early in the reform process. The use of these instruments can also be catalysts in the development of money markets and can promote financial sector competition. 5/ However, it also has to be recognized that to the extent that the initial credit growth reflects a one-time adjustment to a new equilibrium position, an attempt to constrain credit demand solely through interest rates could result in very high real interest rates. This would carry attendant risks for real economic growth, the maintenance of an appropriate exchange rate, and thus external adjustment and stability of the financial sector.

The need to rely on tight monetary policy to maintain macroeconomic balance—which is why real interest rates are raised to a high level—would be reduced by a larger fiscal adjustment or an increase in foreign resources, or both. Although, the post-liberalization adjustment in credit probably cannot be avoided, it can be phased through a continued use of types of direct controls that would more closely align credit growth with the otherwise lagging growth of bank deposits. Credit ceilings that allow banks to increase credit only in response to increases in deposits might achieve the desired phasing, while reducing disincentives to deposit mobilization. These ceilings need to be supported by positive real interest rates and an adjustment in the indirect instruments of monetary policy. A phased approach was followed in Korea and Indonesia and succeeded in reducing private resource imbalances.

Not only did real interest rates rise with financial reform, but the reforms tended to widen initially banks’ gross lending margins. These margins reflected a number of influences. The removal of interest rate controls allowed banks to price credits and risks more appropriately, and this may have acted to raise margins, since controlled lending rates were usually set too low. Against this, reserve requirements were normally lowered as part of the reforms that reduced the cost wedge between deposit and lending rates. However, authorities generally should reduce rapidly the costs to financial institutions of reserve and liquid asset requirements, and increase reliance on indirect monetary controls.

The speed and nature of interest rate liberalization also has to take into account the financial structure of nonfinancial firms and the pace with which problem banks and their debtors can be restructured. If nonfinancial firms are highly leveraged, any sharp increase in real interest rates could further weaken the repayment capacity of these firms and the condition of banks. The preferable option would be to recapitalize the banks and restructure their portfolios. This may require budgetary transfers and, therefore, a larger fiscal adjustment in support of the financial reforms. Without such transfers, the ability to control interest rates may become a critical issue; and it may then be desirable to liberalize bank interest rates only gradually, while pushing ahead with industrial sector restructuring and the recapitalization of banks.

The major common elements of the financial crises were the unsound liability structures of nonfinancial firms prior to reform (reflecting, e.g., subsidized credit and insider loans); changes in relative prices that influence the viability of borrowers; and weaknesses in the institutional structure of banking that facilitated risk taking, including weak prudential regulation and banking supervision. Certain characteristics of the reform may have contributed to the crises. First, the very rapid growth of bank credit following the liberalization may have strained the credit approval process and resulted in an increase in lending to more risky projects. This was a particular problem because of extensive lending to interrelated entities, and the lack of regulation of loan classification, provisioning, and interest capitalization. Second, in some cases the abruptness of the financial liberalization did not give the private financial institutions time to develop the necessary internal monitoring and credit appraisal processes or for the public sector banks to develop a more commercial approach. Third, information systems—accounting, financial disclosure rules, company analysis, credit-rating systems, etc.—that are necessary for efficient allocation of resources were not developed. At the same time, public supervision was not developed, and, because of explicit or implicit deposit guarantees, depositors were largely indifferent to bank credit risks. Insolvent banks were able to attract deposits and to disguise their true financial positions by continuing to pay interest and dividends out of deposit receipts.

Early and timely attention to developing vigilant bank supervision and well-designed prudential regulations could have helped detect and contain the buildup of financial fragility. In some countries, financial reform was accompanied by a strengthening in prudential regulations; however, implementation of the regulations was weak and some critical regulations—for example, restrictions on lending to interrelated entities, on loan classification and provisions, and on accounting rules on interest accruals—did not exist and others were rescinded because of inability to implement them. This underlines the importance of not only having adequate regulations but also the capacity to implement them. Such a capacity is in part technical, but also requires the absence of political interference. The achievement of such a capacity takes time and often involves the strengthening of key public institutions, particularly the Central Bank, as part of the process of financial reform.

c. Summary of conclusions

In summary the main conclusions are:

First, a minimal system of prudential regulation is necessary before embarking on financial sector reforms in order to support efficient credit allocation and to safeguard against a financial crisis that could undermine monetary control and macroeconomic adjustment;

Second, key monetary control reforms and supporting reforms to develop money markets must be initiated early in the reform process. This reflects the critical importance of maintaining macroeconomic control during the reform period while simultaneously allowing for the removal of the various discriminatory controls on interest rates, credit, and financial institutions’ portfolios that is essential in the development of a market-oriented financial system; and

Third, the speed of the liberalization of interest rates and credit controls needs to take account of the extent to which fiscal and external policies are available to support monetary policy in achieving overall macroeconomic balance. Fiscal and external policies need to support the initial increases in resource pressure that can follow financial liberalization.

II. Five Developing Country Experiences with Financial Reform and Liberalization

1. Introduction

This chapter presents the experiences with financial sector reform and liberalization of five countries: Argentina, Chile, Indonesia, Korea, and the Philippines. In presenting the individual country experiences we have sought to standardize data presentation and to develop some key indicators. Inevitably, with data drawn from many different sources, series are not fully comparable across different countries. Appendix Table 31, provides a detailed description of the data.

The indicators of financial sector development include various measures of private financial assets: currency, M2, M3 and private financial assets. M2 is defined as currency in circulation plus deposit liabilities of the banking system. M3 is defined as M2 plus deposit liabilities with nonbank financial institutions (NBFIs). Private financial assets, the broadest measure of liquidity presented, is defined as M3 plus identified holdings of other financial assets by the private sector (such as treasury bills, and central bank bills where they exist). The relative movements in these aggregates are indicative of portfolio shifts within the financial sector, while their growth rates and the trends in their ratios to GDP are indicative of economic monetization and the development of financial markets.

Financial institutions credit to the private sector and central bank credit to financial institutions are also presented. The former is an indicator of the development of financial sector intermediation, while the latter is an indicator of the extent of official involvement in the operations of financial institutions. When the Central Bank provides a larger part of the funding for credit to the private sector, the credit allocation decisions of the Central Bank—through its refinancing and rediscount policies—necessarily have a strong influence on private credit allocation decisions regardless of whether there are explicit controls.

The growth of financial institution credit to the private sector relative to the growth of private deposits with financial institutions is an indicator of the change in the use and mobilization of domestic financial resources from the private sector. A more rapid growth of credit to the private sector than of private sector deposits could signify pressures on domestic resources which would worsen the balance of payments unless offset by a reduction in the fiscal deficit or larger capital inflows.

Other indicators include real interest rates, GDP growth rates, number and types of financial institutions, gross lending margins, international interest rate differentials, and excess bank reserves. For those countries that have faced a financial crisis selected indicators of these crises are also shown.

The presentations for each country describe the pre-reform financial structure and the broad economic circumstances that were associated with the financial reforms. The financial sector reform measures and their sequencing are then presented. This is followed by an examination of the consequences of reforms using the indicators that have been developed. Finally, a number of broad conclusions are drawn from each country’s experience. Comparative indicators from the five countries and the lessons from their different liberalization experiences are further examined in Section III.

2. Argentina

a. Pre-reform, 1974-76

The Argentinean economy of the mid-1970s was characterized by distortions in relative prices, a highly disorganized and repressed financial system, multiple exchange rates and restricted international capital flows. GDP growth was negative in 1975 and 1976; inflation was increasing (to 443 percent in 1976); the fiscal deficit reached 12.5 percent of GDP in 1976; and there were increasing balance of payments pressures. 6/

Argentina’s financial sector was severely repressed and dominated by commercial banks (see Tables 1 and 2). The numerous NBFIs were mostly very small. Government ownership (Federal, state, and municipal) of banks and other financial institutions was substantial (as measured by the number of branches of government-owned financial institutions) and the financial structure was constrained by strict central bank approval requirements for new banks and for the opening and closing of branches.

Table 1.

Argentina: Structure of Financial System; 1976-83

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Sources: World Bank (1984); IFC. Emerging Stock Market Fact Book, 1989; Central Bank of Argentina, “Memoria Annual”.

Between 1978-80, includes variable interest rate and fund mobilization bonds. Between 1981-83, includes monetary absorption and consolidation bonds.

Table 2.

Argentina: Selected Financial Indicators, 1974-86

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Sources: Central Bank of Argentina; IMF International Financial Statistics; and staff estimates.

The Deposit Nationalization Law of 1973 forced banks to deposit all financial savings with the Central Bank (a de facto 100 percent reserve requirement). Banks could only lend from their capital and reserves, and from access to central bank funds, mainly in the form of selective and subsidized credit to priority sectors. Interest rates on bank deposits and loans were set by the monetary authorities, as were their fees and commissions.

As a result of the controls, real interest rates became increasingly negative between 1974 and 1976 (see Table 3), and financial savings through banks and financial institutions declined in real terms, and as a percentage of total financial sector liabilities. An informal money market, based mostly on enterprise promissory notes expanded rapidly; the size of this market in 1976 was estimated at 40 percent of the interest-bearing deposits of the banking system (Fernandez, 1985). The ratio of currency to deposits was very high and the ratios of M2 and M3 to GDP fell sharply. Only about half of the private savings were monetized by commercial banks (see Table 2), 7/ and credit extended by financial institutions to the private sector fell in real terms (on average by 17 percent per annum during 1974-76) reflecting the decline in central bank credit to financial institutions, and declines in the real value of financial institutions’ capital. Central bank resources were increasingly directed to finance public deficits and between 1974-76 an average of 68 percent of the fiscal deficit was financed by the Central Bank.

b. Financial sector reform. 1977-80

In the context of an economic adjustment program aimed at curbing inflation, limiting the economic role of the Government and promoting the international integration of the economy (through the reduction of tariffs and exchange controls), the Argentinean authorities introduced a range of measures to reform the financial system. Figure 1 summarizes the main measures and the sequencing of the financial reforms.

Figure 1.
Figure 1.

Argentina: Sequence of Financial Reform

Citation: IMF Working Papers 1992, 082; 10.5089/9781451954661.001.A001

The liberalization of interest rates commenced in 1976 when interest rates on certificates of deposit (CDs) were freed. This was followed in 1977 by a major financial sector liberalization and reform of monetary control instruments. In 1977, all bank deposit and loan rates were liberalized, the controls on bank credit were removed, the 100 percent reserve requirement was reduced (initially to 45 percent and then lowered progressively to 10 percent by 1980), and interest was paid on required reserves held against time deposits through a newly established Interest Equalization Fund. Selective credit practices were abandoned (except for export-oriented loans), and selective rediscounts were replaced with a single discount window with the discount rate set at a penal level compared with market rates. 8/ Treasury bills, which had been available on tap at predetermined interest rates, were auctioned with the aim of managing financial sector liquidity. Because of the effects on liquidity distribution of the change in the reserve requirement and rediscount policy, transitional arrangements included special temporary rediscount lines for some banks and special deposit requirements with the Central Bank for some other banks.

Concurrent with the financial liberalization, new prudential regulations were instituted. These included: changes in the definition of minimum capital requirements; maximum ratios of assets and liabilities to total capital and reserves; and limits on loans to any single borrower in terms of both the borrower’s and the lender’s capital and reserves. 9/ The minimum requirements for opening new bank branches were eased and the need for prior central bank approval was eliminated. Also, new regulations facilitated the establishment of new financial institutions and the restructuring of old ones. Later, in 1979, the deposit insurance scheme was reformed. Full insurance coverage was removed from all but the smallest deposits, the maximum amount of insured deposits was indexed, insurance premiums were set (previously the Central Bank bore all the cost), and foreign exchange deposit insurance was completely eliminated. 10/ In 1981, financial institution supervision was reorganized through the introduction of new accounting, auditing and reporting standards, and the responsible department of the Central Bank was reorganized.

c. Effects of the financial sector reforms, 1977-80

First, the reforms did not have a major effect in improving the structure of the financial sector. Although, the reforms were associated with some restructuring, this was not associated with a significant improvement in financial sector competition or efficiency, and banks’ administrative costs remained high (averaging about 8 percent of total loans). The differential between deposit and lending rates widened following the liberalization, and although it narrowed subsequently—partly in response to the progressive reduction in required reserve ratios—the differential generally remained above its pre-reform level (Table 3). This reflected increasing concentration in the financial sector. 11/ Also the capital markets were not developed and the number of companies traded and their capitalization on the Buenos Aires stock exchange fell after the reforms (Table 2). Also the Government continued to resort to the banking system for finance (see Tables 1 and 4) so that the real stock of government securities outstanding did not increase.

Table 3.

Argentina: Interest Rate Structure, 1974-88

(Percent per annum) 1/

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Source: IMF, International Financial Statistics; Central Bank of Argentina.

For 1974-82, quarterly average. For 1983-88. monthly average.

Data for 1974-76 are form Gaba (1981) as reported by Baliño (1987).

Quarterly average of second half of 1977.

From July 1982-November 1987, rates reported are the regulated rates.

Loan rates: monthly average of January-October 1987.

From November 1987-December 1988, deposit rates are the average paid on interest free deposits of various maturities.

Deflated by average annual CPI inflation. Real=(1+nominal)/ (1+inflation)-1

Adjustment formula used: (1+LIBOR)*(1-t-actual devaluation)-1.

Table 4.

Argentina: Summary of Financial Sector’s Operations, 1974-86

(In millions of australes valued at 1985 prices) 1/

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Sources: IMF, International Financial Statistics; and staff estimates.

For the pre-1985 period, pesos were transferred to australes at the rate of 10 million pesos to the austral.

From 1984, includes private sector holdings of central bank paper.

For 1981, data for time deposits include savings deposits. After 1982 includes accrued interest payments.

Includes net credit to Central Government and to the rest of the public sector. For commercial banks (after 1979), includes foreign exchange loans to official sector.

Second, real deposit and lending rates rose sharply from the highly negative pre-reform levels, and real loan rates became temporarily positive in 1977 (Table 3).

Domestic deposit and loan rates also rose substantially above U.S. dollar interest rates, after adjusting for the ex-post devaluation of the exchange rate. Although capital movements into and out of Argentina were gradually liberalized, 12/ remaining restrictions constrained the scope for international interest rate arbitrage and allowed the domestic/international interest differentials to persist. 13/ The remaining exchange controls also protected the inefficient domestic financial system.

Beginning in 1978, the authorities had sought to reduce inflation by posting a devaluation schedule (tablita) for the exchange rate that lagged behind the general price increases. The success of such a policy required credibility and monetary and fiscal discipline. However, these were ambiguities surrounding the tablita which weakened its credibility. 14/ Fiscal deficits were large and growing, and averaged 12.8 percent of GDP between 1978-82, and monetary financing of the deficits was inconsistent with the pre-announced rates of devaluation. The ensuing inflation (that averaged 153 percent in 1977-80) appreciated the real exchange rate by 64 percent between 1977 and 1980, and fueled expectations of a breakdown of the tablita and contributed to the sharp rise in real interest rates in 1981, prior to abandoning the tablita in 1982. The real sector’s health was damaged by the appreciation in the exchange rate and the sharp increase in real interest rates.

Third, there was a shift in monetary and credit aggregates. The liberalization of bank deposit rates.encouraged a shift out of currency into bank deposits, and the currency to deposit ratio fell sharply and the ratio of broad money to GDP increased (Table 2). The growth of bank credit to the private sector increased and was considerably higher than the growth of private sector bank deposits. This was reflected in a fall in the ratio of private savings to GDP. To control the credit expansion and increase deposit mobilization, monetary policy should have been tightened by raising interest rates; however, by 1978, real interest rates had again become negative. 15/

Fourth, the rapid expansion in bank loan portfolios exposed banks to increasing risks, and combined with the rise in nominal interest rates resulted in a sharp increase in problem loans (Table 5). Enterprises’ debt to equity ratios also rose with the freer access to bank credit, which increased their vulnerability to a rise in real interest rates. When real interest rates rose in 1981, the result was a sharp increase in distress borrowing.

Table 5.

Argentina: Manifestations of the Financial Crisis, 1977-81

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Sources: IMF International Financial Statistics; Fernandez (1985); The World Bank (1984); and Baliño (1987).

d. Financial sector crisis

In March 1980 a major bank failed. The ensuing reshuffling of bank deposits (to banks perceived as relatively safer), and the drying up of the interbank market placed serious strains on the financial system. By May 1980, the Government was forced to intervene in three further institutions, and by March 1981 a total of 62 financial institutions, holding approximately 20 percent of total deposits, were intervened and liquidated.

The financial sector crisis reflected a number of factors. While the prudential regulations instituted in 1977 were fairly comprehensive, the implementation of the regulations and bank supervision was inadequate. 16/ Only in 1981, four years after the financial reforms were initiated, was the supervisory system strengthened. In the interim, bank supervision had weakened—for example, the number of institutions inspected each year by the Central Bank had fallen to only 10 percent from 23 percent before the financial reforms—and the share of problem loans in bank portfolios had increased fivefold.

The weaknesses in prudential supervision were aggravated by the comprehensive official deposit guarantees and the associated moral hazard problems; 17/ in 1979 the comprehensive deposit guarantees were replaced with partial guarantees. The moral hazard problem became more acute in the early 1980s, as the financial institutions that eventually failed began offering the highest deposit rates in order to mobilize resources to meet their customers’ distressed borrowing and to meet interest payments on deposits.

In the aftermath of the financial crisis, the authorities completely reversed the liberalization measures in 1982, with the aim of redistributing wealth from depositors to borrowers through sharply negative interest rates. Interest rates on most deposits were re-regulated, the 100 percent reserve requirement was reintroduced on most deposits, and the Central Bank became the major source of funds to the financial sector through its rediscount policy. 18/ As a result, there was a complete reversal of the financial deepening trends established during financial liberalization, 19/ real interest rates became highly negative and gross margins between deposit and lending rates widened.

e. Conclusions

The financial reforms in Argentina, 1977-80, illustrate the risks of a financial sector liberalization when other structural and macroeconomic policies are inadequate to support the liberalization. At the structural level, the competitiveness and depth of the financial system were not promoted significantly by the reforms, which largely resulted in a reshuffling of existing institutions and ownerships rather than a fundamental reorganization. New instruments and markets in securities were not part of the reform. Consequently, the financial system remained uncompetitive and underdeveloped, and borrowers continued to rely mainly on bank borrowing. Also, prudential controls were not developed, while deposits were guaranteed by the state. As a result, the efficiency of credit allocation was weak and the portfolios of bad loans increased among the banks.

Macroeconomic policy contributed to the failure of the liberalization. The liberalization of direct credit controls allowed for a rapid expansion of bank credit, as interest rates were not raised sufficiently to restrain private credit expansion. Concurrently, the government deficit was increasing, and gross domestic savings declined as a percent of GDP. The overvaluation of the exchange rate under the policy of following the tablita aggravated the external position and weakened the financial position of enterprises. Monetary policy was eventually tightened in 1981, but resulted in a financial crisis because of the weak position of banks and enterprises.

3. Chile

a. Pre-reform

The Chilean economy of the early 1970s was characterized by weak GDP growth, domestic and external imbalances, and extensive controls on trade, capital flows, and enterprises. In 1973, GDP fell by 5.6 percent, the fiscal deficit reached 21 percent of GDP, and the inflation rate was approximately 500 percent.

The pre-reform financial sector consisted of 20 government-owned domestic commercial banks, one foreign-owned commercial bank, and a limited number of NBFIs. The financial sector was highly regulated through interest rate ceilings, quantitative controls on banks, substantial directed credit and restrictions on operations of financial institutions. Real interest rates were negative.

b. Reform and stabilization

The Chilean authorities followed programs of stabilization between 1974 and 1981. An initial effort at stabilization through reducing the fiscal deficit and restricting money supply growth, coincided with major international shocks (particularly, the decline in copper prices) and resulted in GDP contracting by 12.9 percent in 1975. Subsequently, the foreign exchange rate became the main anti-inflationary instrument, 20/ the fiscal deficit was gradually reduced until it showed a surplus in 1979, and monetary operations were used mainly for smoothing liquidity. Inflation declined from 212 percent in 1976 to 20 percent in 1981, and real GDP growth recovered; however, the real exchange rate appreciated which made the policy unsustainable. 21/

Concurrent with the stabilization program, sweeping liberalization measures were enacted covering the spectrum of economic activities, including an opening of the current account and a gradual liberalization of the capital account between 1976 and 1982. 22/ These reforms had as objectives the international integration of the Chilean economy and improving the price mechanism.

The main elements of the financial sector reform and their sequencing are summarized in Figure 2. First, the measures included financial sector restructuring. In 1974, all but one of the 20 domestically owned commercial banks were privatized; in 1975, new regulations were introduced allowing the creation of new financial institutions; in 1976, the distinction between banks and NBFIs was removed and foreign banks could liberally open branches and purchase Chilean banks; and in 1981 the distinction between commercial and development banks was abolished. Between 1977-80, banks became generally freer to borrow abroad. 23/

Figure 2.
Figure 2.

Chile: Sequence of Financial Reform

Citation: IMF Working Papers 1992, 082; 10.5089/9781451954661.001.A001

1/ Measure rescinded.

Second, several measures were introduced relatively early to strengthen banking supervision and regulation as part of the financial reform. In 1974, minimum capital requirements were raised and penalties imposed for noncompliance, restrictions were placed on the concentration of bank owner-ship and banks’ disclosure, and reporting requirements were strengthened. Between 1974 and 1976 the jurisdiction of the supervisory authorities was widened to include all financial institutions. However, important weaknesses in the supervisory and regulatory framework remained. The restrictions on concentration of bank ownership were difficult to enforce and were removed in 1978. Only in 1980-81, after the financial crisis had developed (see below), were limits imposed on banks’ lending to interrelated and individual entities (including purchases of shares), and loan classification and provisioning rules established. Further measures to tighten bank supervision were subsequently approved in 1982 and in 1986 (see below).

Third, there were major reforms to monetary and interest rate policy. Initially, in 1974, interest rates on short-term capital market transactions outside the commercial banking sector were liberalized, followed a year later by the liberalization of commercial bank interest rates. 24/ In 1975, quantitative controls on bank credit were abolished and selective credits to priority sectors were greatly reduced. An indirect system of monetary control was implemented, based on auctions of central bank credits and treasury bills, and a reform of the Central Bank’s discount window. In 1976, interest was paid on required reserves. Subsequently, with the lowering of reserve requirements, 25/ and their unification across different financial institutions, the payment of interest on reserve requirements was phased out between 1977-80.

c. Results of the reforms 1975-81

The financial reforms resulted in an increase in the number of financial institutions (Table 6). The number of commercial banks rose from 21 in 1974 to 41 in 1981; 17 of the new banks were foreign owned. The number of bank branches also increased substantially. The liberalization of short-term capital market interest rates in 1974 also resulted in an initial increase in NBFIs—financieras.

Table 6.

Chile: Structure of the Financial Sector, 1974-84

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Sources: Velasco (1988); Superintendencia de Valores y Segures, Revista de Valores; and IMF, International Financial Statistics.

Only one domestic bank was state owned after 1975.

However, the financial restructuring raised a number of problems. First, the privatization of the domestic banks was controversial. The regulations on the concentration on ownership were not enforced and were abandoned in 1978. As a result banks were purchased by large conglomerates. The high concentration of ownership, together with the lack of regulation on bank loans to interrelated entities, and the absence of loan classification and provisioning requirements were, major factors in the subsequent insolvency of financial institutions. Second, the financieras were less stringently supervised and regulated than commercial banks and in 1976, financieras faced increasing difficulties and eight failed. Only thereafter did the supervisory authorities institute a formal approval procedure for financial institutions or individuals receiving deposits from the public. 26/

Following the liberalization of bank interest rates in 1975 real interest rates increased sharply (Table 7). The gross differential between bank deposit and lending rates fell substantially but remained wide reflecting. A subsequent fall in the differential reflected the reduction in reserve requirements, and an increase in financial sector competition associated with the entry of foreign banks and the opening of the capital account. 27/

Table 7.

Chile: Interest Rate structure, 1975-87

(In percent per annum: monthly average 1/)

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Sources: Central Bank of Chile; IMF, International Financial Statistics.

Interest rates ere those on short-term credit transactions and time deposits of commercial banks.

Real = (1 - nominal)/(l - inflation) - 1.

Difference between the devaluation-adjusted U.S. prime rate and the domestic loan rate. Adjustment formula: (1 + prime rate)*(1 + devaluation) - 1.

The private sector’s holdings of financial assets initially contracted in real terms following the reforms (Table 8). The slow response to the liberalization measures may have reflected the adverse effects on confidence of the severe economic recession in 1975, and the continuing high inflation rate and negative real deposit rates in the immediate post-reform period. Once interest rates became positive after 1977, holdings of financial assets increased rapidly (in real terms) and money and financial asset to GDP ratios rose. The currency to deposit ratio fell steadily following the financial liberalization.

Table 8.

Chile: Selected Financial Indicators, 1974-86

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Sources: Central Bank of Chile, and International Monetary Fund, International Financial Statistics.

Reserve requirement on 1-to-3-month time deposits applicable at December of year.

Applicable since March 1977.

After the removal of controls on credit and interest rates, the growth of private credit was considerably faster than the growth of private bank deposits and financial assets. In particular, the growth of peso-denominated bank credit was much faster than the growth of peso-denominated bank liabilities, and by 1980 domestic currency credit of financial institutions exceeded domestic currency deposits compared to only 40 percent prior to the reforms (Table 9). 28/ The rapid growth of bank credit was not prevented initially by loan rates which were highly positive in real terms in the post-reform period, but the growth of credit declined subsequently, suggesting a lagged adjustment.

Table 9.

Chile: Summary of Financial Sector’s Operations, 1974-86

(In billions of 1985 pesos)

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Sources: Central Bank Of Chile; IMF, International Financial Statistics; and staff estimates.

For 1983 and 1984, includes savings deposits.

Includes forward sales of foreign exchange, Liabilities held by CEPAC, and private capital and surplus. For 1979-87. also includes central bank and mortgage bonds. After 1985, also includes deposits.

Staff estimates.

A number of explanations have been provided for the growth in private credit. Initially, the credit growth was associated with borrowing by Chilean conglomerates (grupos) which were active in takeovers and in asset price speculation. Facilitated by the ownership structure of the banking sector, and inadequate bank supervision, enterprise shares were used as collateral for bank credit and share and property prices experienced a speculative boom. Later, as the business sector started facing difficulties (resulting from the overvalued currency and the high financing costs) there was distressed borrowing by enterprises, and the capitalization of interest payments became common.

Despite the rapid growth of the private credit, the ratio of savings to GDP gradually increased between 1977-80, as the growth of private credit was partly offset by a reduction in the government fiscal deficit. Part of the increase in private credit was used for the purchase of publicly owned enterprises that were privatized.

d. Financial crisis

In the early 1980s, the Chilean authorities faced a financial crisis. By 1981, two years after fixing the exchange rate, the degree of overvaluation of the real exchange rate had become significant and ultimately unsustainable, There was massive speculation against the peso, and interest rates rose sharply as the authorities did not sterilize the capital outflows. The increase in interest rates combined with the exchange rate overvaluation led to widespread business bankruptcies. This was accompanied by a run on a major bank and government intervention in several smaller financial institutions. The situation was sharply aggravated in 1982 when the stock market crashed, leaving many corporations insolvent, as they had borrowed using shares as collateral. Also in 1982, the peso was devalued damaging further the solvency of the business sector which was heavily indebted with foreign loans.

Table 10 provides a number of indications of the extent of the financial crisis. In 1982 about 20 percent of total bank loans were judged to be nonperforming; by 1986, this proportion had increased to about 60 percent by 1986. Six commercial banks and eleven financieras failed during 1981-83, and the authorities had to intervene in another seven banks and one financiera.

Table 10.

Chile: Indicators of Financial Crisis, 1974-86

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Sources: Velasco (1988); World Bank Data; Central Bank of Chile; IMF, International Financial Statistics.

For 1981-83, loans defaulted include “risky portfolio” portfolio loans sold to Central Bank.

Calculated as: the ratio of the sum of loans sold to the Central Bank, reprogrammed loans and overdue loans to total Commercial bank loans less loan provisions.

Two features of the post-reform Chilean financial system facilitated excessive risk-taking and unsound lending practices. First, as noted, the supervisory framework was weak until 1980. Second, banks were not subject to discipline by depositors. Although explicit peso deposit guarantees did not exist in Chile until January 1983, there appears to have been a widespread perception that the Government would rescue depositors in the event of a bank crash. 29/ It has also been argued that firms borrowed excessively because they expected a government bailout. 30/

The authorities reaction to the crisis is summarized in Table 11. 31/ The crisis resulted in a temporary reversal of some of the liberalization measures, and a strengthening of regulations and supervisory arrangements. With the transfer of problem loans to the Central Bank, the Central Bank became a major provider of liquidity to the banking system. 32/ In December 1982 the Central Bank initiated a policy of guiding interest rates through posting “suggested” deposit rates (set on the basis of expected inflation plus a premium).

Table 11.

Chile: Major Elements of the Financial Sector Rescue Program, 1982-87

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Source: World Bank

The strengthening of bank supervisory arrangements in 1982 included a more precise definition of the limit on loans to a single enterprise that took into account the interlocking ownership of firms. Commercial banks were prohibited from investing in equity capital, agricultural land, merchandise, or livestock, and from accepting equity stock as loan collateral.

The Superintendency of Banks also began to develop a formal system of rating financial institutions. 33/ In 1986, a new banking law further strengthened banking supervision, while permitting banks to establish subsidiaries to engage in new lines of financial business (mutual funds, leasing companies, and credit cards), and related nonfinancial businesses. 34/

e. Conclusions

The financial liberalization in Chile illustrates the risks in financial reform even with fiscal adjustments and a restrictive monetary policy. In spite of the highly positive real interest rates after the financial reforms, private credit growth was very rapid and faster than the growth of private sector deposits. This partly reflected the weak prudential regulations that permitted a rapid credit expansion to nonviable projects and subsequent distress borrowing on account of the persistence of high real lending rates. The impact of the faster growth of credit than deposits on the investment-savings balance was reduced by the cut in the fiscal deficit. However, the rapid credit growth associated with a high concentration of bank ownership and inadequate supervision resulted in a perpetuation of high real interest rates and a serious banking crisis.

Although the authorities in Chile initially revised their prudential regulations, prudential controls were poorly designed, and poorly implemented, particularly with respect to the concentration of ownership, restrictions on bank loans to interrelated entities, and loan classification and provisioning requirements. There was also little market discipline on the banks, because of implicit deposit guarantees. Also, weak prudential controls’ and rapid growth of credit allowed banks and borrowers to become overexposed, and when financial conditions tightened in 1981, this resulted in a financial crisis.

4. Indonesia

a. Pre-reform. 1978-82

Indonesia achieved high rates of growth during the seventies based largely on oil exports. For the period 1978-82, real GDP growth averaged 7 percent, and gross domestic savings and investment 28 percent and 27 percent of GDP, respectively. Savings were generated largely through the oil revenues accruing to the Government and were redistributed to the economy via government policies affecting resource allocation, production, price setting, and financial sector decisions. However, the efficiency of investment was declining and private savings were low. 35/ In 1982, as a result of the decline in the prices of oil, real GDP growth slowed to 2.2 percent and the current account registered a deficit.

The structure of the Indonesian financial sector is summarized in Table 12. The five state commercial banks dominated the financial sector accounting for an average of 76 percent of total financial sector assets, followed by private and foreign banks, accounting for 7-9 percent each; NBFIs accounted for only about 4 percent of the total. Activity on the Indonesian stock market, established in 197/, was limited. 36/ Indonesia had a convertible currency (Rupiah), followed a managed float indexed to a basket of currencies, with free capital mobility.

Table 12.

Indonesia: Structure of Financial Sector, 1979-88

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Source: Bank Indonesia. Report for the Financial Year. several issues.

Figure for 1981.

Figure for 1984.

Figure for 1986.