This paper deals with key issues in Latin American financial markets. After examining a sample of countries dealing with severe banking difficulties, the paper analyzes remaining fragilities and current challenges faced by policymakers who have the complementary objectives of maintaining long-run macroeconomic stability and a healthy financial system.
The experiences of five Latin American countries--Argentina, Chile, Colombia, Mexico, and Peru--over the last decade are reviewed to derive lessons regarding the most effective ways to deal with banking difficulties in developing countries. It is shown that the strength of banks at the onset of the banking crises and the quality of central bank leadership were important determinants in how quickly public confidence was restored in each of the financial systems. Where the banking system was relatively strong, bank supervisors and bankers were able to implement credible programs to restore confidence in the banking system; the soundness of the rescue programs prevented the eruption of inflation, even though substantial increases in credit were involved. 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. In those cases, credit expansion was associated with episodes of high inflation.
Having just resolved the financial difficulties of the 1980s, however, Latin American policymakers faced new challenges to the stability of banking systems in the early 1990s. This paper analyzes two of the issues involved: (a) financial market risks associated with the recent large capital inflows; and (b) the potential threat to the profitability of banks in the form of increased competition from recently developed domestic capital markets.
Regarding financial market risks associated with the capital inflows, the paper concludes that the quality of the inflows invested outside the banking system--say, in the equity markets--is strongly related to the strength of the domestic banking system. It is also shown that the policy response to the inflows may have an important impact on the soundness of banks. Conclusions regarding both the desirability and the method of sterilization are linked to the strength of the central bank relative to that of the commercial banks. As for bank competition from domestic capital markets, the paper argues that such developments are still years away from seriously threatening bank soundness. Even in those countries where fixed income markets 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.
Finally, the paper deals with the key macroeconomic issue of the capacity of central banks to withstand speculative attacks on the exchange rate. It argues that the degree to which a Latin American central bank succeeds in this task is influenced by the strength of the banking sector. The paper also addresses the issue of the appropriate holdings of foreign exchange reserves by central banks and the role of dollarization.