Financial Integration in Latin America

Abstract

Financial Integration in Latin America

Introduction and Overview

1. Between 1982 and 2002, all major Latin American (LA) economies underwent—in many cases—repeated economic and financial crisis including the Mexican crisis of 1994 that the IMF Managing Director Camdessus called the first crisis of the 21st century. In nearly all cases, the countries undertook IMF adjustment programs (see table 1). The current financial systems of Latin America are to a large extent legacies of the manner in which the various countries responded. In most cases, responses involved the initial nationalization of a significant part of the banking system, followed by sales, in many cases to foreign banks, particularly to those from North America and Europe. Mexico was an extreme example of this, with only one large bank remaining in domestic hands. At the same time, many countries sought to reduce their vulnerability to loss of confidence: in some cases, including Brazil and Mexico, tight limits were put on residents’ holdings of foreign currencies and banks’ exposures to foreign currencies.

Table 1.

IMF Lending Arrangement with A-7 Since 1982

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Source: International Monetary Fund.

2. After the LA crises of the 1980s and 1990s many LA countries opened their economies to global financial institutions, reflecting a view that this strategy could bring protection from regional instability, provide much needed capital, and help import managerial and technical skills. This strategy worked well and, together with gains from the commodity boom and improvements in macro management, growth recovered strongly in most countries; no large LA country needed financial support during the global financial crisis (GFC), despite the exposure to global banks. Indeed, foreign bank subsidiaries in Latin America in some cases provided a source of strength for global balance sheets and in some cases provided liquidity to their overseas parents. This resilience was linked also to the banks’ reliance on domestic deposits. Overall, the period since 2002 has seen sustained LA growth: GDP in 2014 in the seven LA countries covered in this report (see below) is estimated to have been 52 percent higher in real terms than in 2002, compared with 25 percent for the United States and 16 percent for the countries of the European Union.

3. Nevertheless, although Latin America was relatively less impacted by the GFC than other regions, the crisis demonstrated that extreme volatility could also originate from outside the region, and that the region too would be significantly affected. Weakened in the GFC and facing the costs of additional regulatory demands, reduced profitability and increased funding costs, European and North American banks have been downsizing. In this process some global institutions have left countries in Latin America, and other emerging markets, or markedly reduced their exposures. No new bank from Europe or North America has established a significant presence to replace them. The withdrawal of global banks has led to increased consolidation among leading local banks, for instance in Brazil, potentially undermining the competitiveness of the banking systems and liquidity in the local markets. The pressure on global banks to withdraw may increase further as regulators implement a range of reforms, including the systemic banks’ capital surcharge requirements, the requirements of the Key Attributes of Effective Resolution Regimes of Financial Institutions, OTC reforms and ring-fencing requirements. Most recently, Deutsche Bank has announced its witrhdrawal from investment bank activities in ten LA countries.

4. The nonbank financial sector is also challenged. Volumes and liquidity in a number of exchanges are declining as US regulations for derivatives trading have increased the cost of doing business in emerging markets. For pension funds and insurance companies, regulatory restrictions constraining the bulk of their activities to their domestic markets are causing increasing friction, especially in smaller markets.

5. There are important ongoing initiatives mirroring private sector trends to complement the strategy o f openness to global institutions with increased financial integration within Latin America. Banks particularly from Brazil and Colombia are moving across the region, regarding themselves as regional institutions with the whole region essentially as their home base. Cross-border participation in stock exchanges is also apparent, with the Brazilian stock exchange purchasing 8% of the Santiago exchange. Non financial corporates are expanding across the region, particularly including retail institutions from Chile and conglomerates from Brazil and Mexico. On the official side, since 2011 the Presidents of Chile, Colombia, Mexico and Peru have been meeting regularly to take forward the Pacific Alliance (PA). Most recently, on July 2, 2015, they issued the Paracas Declaration, reaffirming their commitment to foster market integration between their countries. Mercosur has brought together six LA economies3 with the objective of integration; although the Mercosur process has stalled recently, conditions may be favorable for a revitalization of the financial integration process.

6. Regional initiatives are not substitutes for further integration with the rest of the global economy. LA c ountries are deeply involved in major ongoing global initiatives. However, the ongoing retrenchment of global institutions from the region could leave countries underfinanced, or with less competitive systems, unless they are able to attract new institutions. Moreover, global agreements, particularly as regards financial integration are not reached quickly, and substantial mileage may be achieved by going further and faster on a regional basis. Indeed, to the extent that regional integration would involve also raising financial standards across the region, it could facilitate wider integration in the future. And integration initiatives bring greater visibility to Latin American economies, and hence possibly greater investment into the region: in September 2015 the Presidents of the PA conducted a joint roadshow around major global financial markets, and the PA was invited as observer to the ASEAN meetings in the Philippines in November 2015.

7. Currently, LA has less regionally integrated financial markets than other parts of the world. Latin American financial markets are less integrated than a global average, after controlling for fundamentals. Various factors, including size, history of crises, and regulatory structures, may contribute to this. Integration can help foster depth, and deeper financial markets, at least up to a certain degree, have been shown to positively impact growth, so reducing the integration deficit in Latin America could serve to stimulate growth. As prospects for growth in a number of LA countries, for instance Peru, now hinge on large infrastructure investment projects, mainly financed through public-private partnerships (PPPs), the need for deep and strong financial markets has become even more important.

8. At least some of the lack of integration of financial markets in LA countries derives from prudential measures adopted after their economic/financial crises of the 1980s and 1990s. Several countries including Brazil and Mexico had adopted some restrictive measures even before the crises, many of which remain in place, including for example Brazil’s regulations that restrict Brazilians from holding foreign currency domestically, permit foreign banks to enter the country only upon Presidential approval, and allow only 10% of pension fund assets to be invested abroad. The Mexican regulatory framework also provides a schedule of restriction on investment by type of instrument, limiting foreign asset holdings to 20%. In many countries, pension and insurance funds remain heavily constrained in how much they can invest outside the home country.

9. Many LA economies are now under strain. In part, this is conjunctural. With the end of the commodity super-cycle boom and the slowdown in China, which had been the key impetus for much of the growth experienced in most of the region, largely countries in South America, meanwhile the effect on Mexico remains limited, there is recognition of the need to find new drivers of economic growth. Amongst possible drivers, financial liberalization and regional integration may help new growth sectors emerge. At a more fundamental level, the reasons for the strain at this point are structural. For instance, restrictions are hampering synergies between the rapidly growing pensions and insurance funds in the region and countries’ needs for long-term financing. Legislative and regulatory reforms in a number of LA countries, most significantly Chile, have generated rapid growth in these funds, but domestic capital markets are insufficient to provide efficient investment opportunities. Restricting funds to invest mostly domestically, and avoiding having foreign funds join them in the domestic market, means that financing large domestic initiatives would involve an over-concentration by the domestic funds, which would therefore be reluctant, or unable, to invest on a commensurate scale, putting such investments under threat.

10. Measures to foster regional financial integration could thus be an important response to Latin America’s economic challenges:

  • Growth for most of the LA has been closely related to the expansion of the Chinese economy, which drove both higher volumes of commodity exports, and the resultant higher prices at which they were sold. W ith the slowdown in China and the end of the commodity super-cycle, growth through commodity exports may no longer provide sufficiently strong export support to the region’s economies. The prospect of tighter global financial conditions further complicates the economic outlook. New industries will require financing, which in turn will require strong financial markets, both in terms of banking (which still dominates the financial sectors of all LA economies) and capital markets (where pension funds in particular are growing rapidly and could potentially supply much of the financing for the emerging needs of the region).

  • The global banks that have been major players in many LA economies have been withdrawing since the GFC, both because a number were weakened in their home countries and have had to retrench, and because the global regulatory agenda in response to the GFC has increased prudential requirements. Insofar as the departing banks are not replaced by cross-border institutions, this will imply increased concentration in domestic banking systems, with potential loss of competitive forces, which in turn could undermine the efficiency of the systems. For instance, the purchase of HSBC’s retail operations in Brazil, announced in July 2015, by Bradesco, Brazil’s second largest private bank, will add to the consolidation of the Brazilian banking sector. Most recently, Deutsche Bank has announced its withdrawal from investment banking activity in ten Latin American countries.

  • There are increasing links across Latin America in the non-financial sector, not primarily through trade between LA countries but through the cross-border establishment of LA corporates, including some of the major conglomerates. Companies from Brazil, Chile and Mexico have been particularly active in this regard.

  • The intent of the international regulatory agenda has been to reduce overall risks. At the same time, at least in its initial stages it appears to have inflicted a number of unintended consequences on emerging markets (EMs). The increasing cost of cross-border activities (for instance by requiring haircuts on cross-border collateral and centralizing business on exchanges) and of dealing in markets outside the financial centers has led to shifts in capital market activity towards exchanges in advanced economies. If global institutions and markets withdraw from LA, this may hinder the region from developing new products, which may in turn increase costs of, and reduce access to, finance particularly for second-tier institutions, in addition to potentially transferring intermediation fees outside the region.

  • Increasingly, size matters in building and maintaining financial infrastructures. IT and legal representation costs, for instance, in order to achieve competitive parity with the major financial centers, may be prohibitive on a national scale for all but the largest LA countries. Without the integration of regional markets, prospects for maintaining active markets in some LA countries may be limited.

  • In the nonbank arena, the ongoing rapid growth of pension and insurance funds in a number of LA economies threatens to overwhelm domestic capital markets. The limited pool of assets in these markets may be largely held by the funds to maturity, depressing liquidity, and limiting investment opportunities for smaller retail investors.

  • As a corollary, with the next phase of growth in Latin America likely to involve projects with large financing needs, for instance for infrastructure, it will be challenging to finance these solely through domestic markets. Countries’ domestic pension and insurance funds, which are generally subject to concentration limits, may provide an insufficient pool for financing on the required scale. Permitting increased cross border investments by pension funds and insurance companies will enable them to diversify their risks, and thus facilitate the financing of large indivisible projects. Such an increase in cross-border investment would of course need to be accompanied by appropriate risk management.

  • Also, while ensuring domestic protection from potential cross-border spillovers may have been the most prudent response to the LA crises, regulatory reforms since then provide a complementary route for protection. In addition to tighter bank capital, liquidity and disclosure requirements, regulators have increasingly recognized the need for consolidated supervision. Consolidated supervision, and conglomerate supervision, together with upgraded MOUs, and colleges of supervisors for all banks with significant cross-border activity, are designed to mitigate the risks of cross-border activity. Macroprudential measures too are increasingly being adopted and refined to address systemic risk concerns and to limit spillover risks from global market volatility.

  • Finally, differences across the region in the speed of application of the new global regulations, as well as continuing limitations on the range of permissible activities, generate their own costs, and lead to anomalies. In an environment of consolidated supervision, each institution has to follow both home and host regulations, putting banks from countries with more advanced regulations at a competitive disadvantage. And while banks from some countries are able to make cross-border investments, their home countries may not be very accessible to inward inflows. Brazilian Bank Itaú Bank for example takes an explicitly regional perspective for its operations; however, its expansion might be more welcomed in target countries if institutions in those countries found it easier to enter and to do business in Brazil.

11. In sum, regional integration of banking and capital markets could help counter the negative conjunctural and structural factors presently affecting the region. Integration creates a larger internal market, thus enhancing competition and potentially fostering economies of scale. It reduces the costs of the withdrawals of the global institutions, serves to diversify the risk exposures of LA economies and makes them less vulnerable to volatility in global markets. Capital market integration would enable pension and insurance funds to diversify their investments, and enable large projects to find a wider range of potential investors. Deeper markets would likely be more liquid, reducing costs and increasing access for participants more generally. Increasing access for regional banks to operate cross-border would enhance competition and enable the spread of best practices. Some form of “passporting” broker dealers recognized in one country would help the process of establishing a unified capital market, as long as the passported firm would be subject to full supervision in both home and host jurisdictions. Retaining financial intermediation within the region would help markets develop new products, facilitate access for second-tier companies, for whom intermediation on global markets may be difficult, and would serve to generate income from financial market activity. As a prelude, harmonizing tax, regulatory and accounting frameworks would help provide a level playing field, and would also likely stimulate investment from overseas into the region.

12. Increasing cross-border activity without robust risk management may be considered a potential threat to financial stability, but possible risks can be mitigated. Enhanced cross-border consolidated and conglomerate supervision across Latin America should enable supervisors to keep track of banks’ and financial conglomerates’ complex cross-border activities. Careful monitoring of intra-group transfers and ring-fencing capital should dampen spillovers from the home countries of parent institutions. Higher quantity and quality of capital and liquidity requirements should make banks safer. Supervisory and resolution colleges together with signing MoUs should provide early warnings of problems and assist in dealing with those that occur. With this expanded toolkit, countries may be more willing to accept the benefits of regional integration, notwithstanding the initial costs of enhancing the regulatory regime to protect financial systems from systemic risks.

13. Ongoing initiatives may provide a model for taking regional integration forward. The combination of political and market enthusiasm may make the PA a more successful initiative than earlier regional attempts. The diversity between Mexico on the one hand, as a large manufacturing country, and the other three, medium-sized commodity exporters (Chile, Colombia and Peru), suggests that their integration could bring particular synergies. Among the various PA plans for integration, the Latin American Integrated Market (MILA) initiative seeks to establish a unified capital market. Initial MILA measures have been limited, and activity disappointingly minimal, with the process coming under criticism for achieving few results. Impediments are interrelated, and may require a comprehensive rather than step-by-step removal in order to have an impact. Thus, especially in light of the strong political support, it would be timely to make a strong coordinated push for financial integration amongst these countries and more widely. A coordinated approach to remove the remaining barriers, particularly if based on reciprocity across the PA countries, and more widely in the region, could enable reforms to proceed more effectively, generating significant early results, which would help sustain momentum. Meanwhile Mercosur has been a vehicle for integration across Brazil, Argentina and Uruguay for many years. While it has recently been relatively dormant, factors including the recent changes in external economic policies in Argentina, suggest that this may be a propitious moment for the revival of Mercosur too.

14. The argument of this paper is that, in response to these ongoing developments, financial integration within LA, with appropriate management of the risks, could bring needed diversification to LA financial sectors, and set the stage for further integration into the global economy as conditions permit. The process of regional financial integration is more likely to be successful if pursued as a consolidated package, even if gradual, rather than through a continuation of the ad hoc measures that have characterized much of the liberalization process so far. Such integration would diversify the risks to which individual LA economies are exposed. It could also serve to offset the possible loss of competitive forces as domestic financial institutions consolidate their positions in local financial markets. Finally, integration could help foster financial deepening, and potentially attract capital from outside the region. This paper provides some recommendations to facilitate this process.

15. The aim of this paper is not to propose measures that artificially stimulate financial integration in LA if there is no underlying economic case. Rather it seeks to identify barriers to financial integration in the region that are a legacy of the past environment, or are the unintended consequences of measures introduced for other reasons, the removal of which could pave the way for regional financial integration, and thereby support growth.

16. Financial integration has a number of aspects: the cross-border establishment of financial institutions; cross-border investment and portfolio flows; and the integration and unification of financial markets. The regulatory environment needs to be permissive, with a supportive financial infrastructure, but markets will ultimately determine the extent to which integration actually takes place. Other regions have included financial integration as part of their overall unification objectives, for instance the European Union (EU), and the Association of South East Asian Nations (ASEAN). There have in the past also been attempts to foster economic integration in Latin America, for instance through Mercosur and the Andean Pact, but these did not focus primarily on the financial sector. These past attempts had some successes, but also generated lessons.

17. This study covers seven LA economies, Brazil, Chile, Colombia, Mexico, Panama, Peru and Uruguay (LA-7). All are at a relatively similar stage of economic development, and have taken steps to liberalize in recent years. Five are amongst the biggest LA economies; the other two are much smaller, but are closely related. One, Brazil, represents almost half of the entire LA economy, and is somewhat separated from the others, partly because of geography and language but also due to its regulatory regime. Four of the others—Chile, Colombia, Mexico and Peru—are actively engaged in an integration strategy, through the PA and its capital markets component (MILA); their efforts are now at a critical stage. Finally, the two smaller countries (Panama and Uruguay), also have large financial systems, are closely related to their regional neighbors, and have economic prospects that will be greatly influenced by their regional relationships.

18. The report first looks at possible benefits of regional integration. It then covers the various sectors of the financial markets: banking; pension funds; insurance; and capital markets in the seven countries. The following chapters look at regulatory and legal barriers to regional integration, and finally at possible measures to contain the risks. Recommendations are provided for each section, and are summarized at the end of this section. An accompanying background paper sets out some quantitative evidence on the benefits of integration, and also looks at some of the issues country-by-country.

Key Recommendations to Facilitate Regional Financial Integration

  • Take opportunities for regional integration, in the event of global bank withdrawal/downsizing, when identifying potential purchasers.

  • Develop an explicit, open, objective and non-discriminatory statutory and regulatory framework for entry of cross-border financial institutions.

  • Ensure level playing fields within countries for domestic and cross-border banks, including by ensuring all banks have access to credit bureaus and deposit insurance.

  • Develop stable and transparent tax rules for domestic and cross-border financial activities, where appropriate buttressed by agreements for avoidance of double taxation.

  • Harmonize accounting and regulatory frameworks, through consistent implementation of IFRS, timely adoption of a consistent capital definitions as articulated by Basel 3 and Solvency II-type regimes, and explore opportunities for mutual recognition of licensing.

  • Introduce and/or enhance consolidated supervision of all banking groups; expand supervisory and resolution colleges to cover all regional banks with significant cross-border activity.

  • Introduce and/or enhance conglomerate supervision, and establish regulatory limits for intra-group exposures within banking groups, and between bank and non-bank parts of conglomerates.

  • Harmonize legal frameworks for bank resolution and restructuring, as well as non-bank insolvency regimes.

  • Increase gradually (avoiding disruption to markets) the maximum ratio for pension funds and insurance companies to invest cross-border within the region up to 50% (or higher) when the present limit is below this. Ensure that this occurs when there are sufficient safeguards for management of risks of these investments abroad.

  • Examine scope for relaxation of limits for pension funds and insurance companies to invest in regional infrastructure projects.

  • Ensure infrastructure procurement bids are open to institutions from the region (if not wider).

  • Explore prospects for revitalizing regional currency settlement.

  • Assess the compliance of regulatory frameworks Central Counterperties (CCPs) using the CPSS-IOSCO Principles for Financial Market Infrastructures (PFMI), through peer reviews. Upon compliance, LA-7 countries may recognize each other’s CCPs and/or regulatory frameworks.

  • Work towards full compliance with FATF standards so as to avoid loss of correspondent banking relationships; integrate efforts, including on plans to mitigate corresponding banking issue, across the region.

  • Consider, where relevant, relaxation of exchange controls in a timed and sequenced manner taking into account other macroeconomic and financial sector prudential policies. This could include permitting individuals to hold foreign exchange accounts onshore.

Brazil

  • Permit sales of LA bonds in Brazil.

  • Reduce fragmentation of Brazilian public bond market by eliminating practice of separate legislation for each issuance.

  • Remove requirements for institutional investors to invest abroad only through Brazilian asset management vehicles.

  • Encourage revitalization of financial Mercosur.

  • Enhance cooperation with PA, bilaterally and through Mercosur, to examine possibilities for further integration, for instance through increasing cross-holdings of stock exchanges and harmonizing capital market practices.

Pacific Alliance countries (Chile, Colombia, Mexico, Peru)

  • Establish a small secretariat in one of the countries to prepare and disseminate a comprehensive framework for integration, including timelines and sequencing to maintain integration momentum, ensure consistency, and gain the benefits of proceeding through reciprocity.

  • Permit pension funds and insurance companies to count cross-border PA investment as domestic Once appropriate supervisory arrangements have been put in place.

  • Replace remaining ratings-based country limitations for pension fund investments across PA countries with specific foreign exchange and corporate limitations.

  • Complete MILA expansion beyond equities (primary and secondary markets) to include sovereign and corporate bonds.

  • Harmonize operational procedures, including all aspects of listing requirements, for capital markets.

  • Ensure all countries have signed IOSCO Multilateral MOUs.

  • “Passport” broker-dealers in MILA countries, while ensuring broker-dealers are subject to regulatory oversight in both home and host countries.

  • Seek to harmonize safety nets, for instance as regards bank deposit insurance and investor protection, and consider establishment of a common fund.

  • Enhance contacts amongst national regulators and supervisors, including through exchanges of staff and secondments to the secretariat.

  • Examine potential for expanding geographic scope.

Panama, Uruguay

  • Panama to refocus its efforts to be a regional hub including by ensuring that capital, disclosure and other requirements are at least as strong as those of other countries in the region.

  • Panama to examine the benefits of joining PA, and to adopt PA measures for regional integration.

  • Uruguay to consider raising its pension funds foreign asset cap, and to end the restriction that purchases be entirely with securities from multilateral institutions.

  • Uruguay to support revitalization of financial Mercosur, and to examine possibility of integration more broadly, including for instance to establish partnerships for the Uruguayan stock exchange.

Benefits of Regional Integration

A. Definition of Financial Integration

19. Financial integration is the process through which the financial markets of two or more countries or regions become more connected to each other. Financial integration can take many forms, including cross-border capital flows (e.g. firms raising funds on capital markets cross-border), foreign participation in domestic markets (e.g. a parent bank’s ability to set up a subsidiary abroad), sharing of information and practices among financial institutions, or unification of market infrastructures. Financial integration can have a regional or global dimension, depending on whether a country’s financial market is more closely connected to neighboring countries or to global financial centers/institutions.

20. Financial integration is a multi-faceted concept. There is no universally-accepted definition of financial integration. From a theoretical point of view, it may be signaled by the convergence of the prices of assets with the same characteristics (law of one price). Perfect integration exists if similar assets have the same price even if they are traded on different markets. To work with a more tractable indicator, this section defines financial integration by two main criteria:

  • The first criterion is the degree of cross-border financial activity. In this sense, the concept of integration is very close to that “financial globalization” defined by IMF (2007) as “the extent to which countries are linked through cross-border financial holdings, and proxied by the sum of countries’ gross external assets and liabilities relative to GDP.” According to this criterion, any barrier to exchange or market access impedes the free movement of capital and limits integration.

  • The second criterion is the degree of convergence and consolidation across markets. Financial openness and free access are not sufficient conditions for integration. Two markets can be perfectly open to each other and still be imperfectly integrated, because they keep very distinct market structures.4 In their definition of an integrated financial market, Baele and others (2004) include the feature that market participants “face a single set of rules when they decide to deal with financial instruments and/or services.” According to this second criterion, a single (common and fully harmonized) market is the ultimate form of financial integration. Moretti et al (2015) explain that in particular convergence and consolidation patterns have helped regional and global integration due to large increases in portfolio investments, syndicated loans, and M&A flows.

  • Importantly, these two criteria are interconnected. The convergence of market structures facilitates and creates incentives for cross-border capital flows, while financial openness offers opportunities to import financial institutions from abroad, paving the way for greater harmonization across markets.

21. In practice, financial integration is always imperfect. Segmentation stems from various sources, including capital flow restrictions (some of them having a prudential purpose), technical constraints hindering cross-border flows, insufficient harmonization of financial regulations, cultural barriers, and country-specific risks that deter foreign investors.

B. Is There a Deficit of Financial Integration in Latin America?5

22. Since the 1990s, most countries in Latin America have embarked on a process of financial liberalization. This process has been characterized by a reduction of impediments to cross-border financial transactions, increased participation of foreign banks in the local banking systems, and greater cross-border capital market activity. Today most LA countries have fewer de jure restrictions on capital flows than Asian economies (Galindo and others, 2010).

23. However, de facto integration of LA with the rest of the world remains low. To assess the degree of financial integration, figures 1 and 2 use three measures of cross-border capital flows. The first, and most common, indicator is international investment positions (IIP) presented here as the sum of foreign asset and liability stocks outstanding. While the dollar value of international assets and liabilities among all LA countries has grown over the last decade, the region has not increased its international exposure (assets plus liabilities in percent of regional GDP). Nor has its relative importance as a partner in international finance improved, unlike the allocation of foreign positions vis-à-vis emerging Asia, which doubled between 2004 and 2013 (figure 1). The second measure looks at cross-border claims held by BIS banks. These data include not only traditional loans (across-borders), but also portfolio equity and debt holdings of BIS banks. Here again, the broad group of all LA countries has garnered a relatively low 3-5 percent of BIS claims over the last 10 years (figure 2, left). The third dataset is bilateral portfolio and FDI stocks outstanding reported in the IMF’s Coordinated Portfolio Investment Survey (CPIS) and Coordinated Direct Investment Survey (CDIS). While technically these are components of the IIP data, their bilateral nature permits investigation of regional integration. This indicator re-iterates the relatively low (and potentially declining) participation of the LA region, while highlighting the importance of FDI flows over portfolio investments (figure 2, right). These results are further supported by the econometric analysis set out in the background paper, which shows that LA-7 countries are under-integrated even after controlling for macroeconomic fundamentals such as the level of development, trade openness, or the quality of the institutional framework.

Figure 1.
Figure 1.

Global Financial Integration in Latin America and the Caribbean: International Investment Positions1

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: IMF, Balance of Payments Statistics.1 Values are not consolidated for intra-regional trade.
Figure 2.
Figure 2.

Global Financial Integration Latin America and the Caribbean (LAC): International Bank Claims, Portfolio, and FDI1

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: IMF, Balance of Payments Statistics; BIS, Consolidated Banking Statistics; IMF, Coordinated Portfolio Investment Survey; and IMF, Coordinated Direct Investment Survey.1 Values are not consolidated for intra-regional trade.2 BIS bank lending, immediate borrower basis. Foreign claims includes cross-border lending, holdings of debt and equity securities, and local currency lending to residents.3 Aggregate assets plus liabilities of Latin America, in percent of aggregate assets plus liabilities of all reporting countries.

24. Regional integration in LA seems also less advanced than in other EM regions. Figure 3 shows that there is greater intra-regional investment, of both FDI and portfolio, amongst the ASEAN countries reflecting both the fruits of long trade and financial negotiations as well as the importance of a large, diversified trade and financial center (i.e. Singapore6). Regarding its evolution over time, the available indicators of financial regionalism depict differing trends depending on how it is measured. For portfolio assets, there is an apparent diversification away from regional assets in Latin America as the intra-regional share has fallen from over 10 to under 5 percent since 2008 (figure 4, left). For FDIs, the data, only available since 2009, also suggest a declining trend. However, indicators of cross-border bank lending do point to some momentum in LA. Table 3 highlights the expanding positions that Latin BIS banks are taking in their neighbors7. Although BIS bank lending data are only available for four LA countries, it is a striking trend that the share of claims on other LA-7 countries has risen dramatically since 2005.

Figure 3.
Figure 3.

Intra-Regional Component of Global Integration: Portfolio and FDI Investments, 2014

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: IMF, Coordinated Portfolio Investment Survey (CDIS); IMF, Coordinated Direct Investment Survey (CDIS).1 Numbers in parenthesis report the share of intra-regional assets or liabilities in total assets or liabilities of the region.2 LA7 Includes: Brazil, Chile, Colombia, Mexico, Panama, Peru, and Uruguay.3 Emerging Asia includes: Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam.4 Non-Euro Emerging Europe includes: Bulgaria, Hungary, Poland, Romania, and Russia.5 Euro Emerging Europe includes: Cyprus, Estonia, Greece, Latvia, Malta, Slovak Republic, and Slovenia.
Figure 4.
Figure 4.

Evolution of Intra-Regional Integration

(Stocks outstanding in percent of group GDP)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: IMF, Coordinated Direct Investment Survey (CDIS).1 LA-7 Includes: Brasil, Chile, Colombia, Mexcio, Panama, Peru, and Uruguay.2 Emerging Asia includes: Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam.3 Non-Euro Emerging Europe includes: Bulgaria, Hungary, Poland, Romania, and Russia.4 Euro Emerging Europe includes: Cyprus, Estonia, Greece, Latvia, Malta, Slovak Republic, and Slovenia.

25. Cross-border mergers and acquisitions provide anecdotal evidence of global fragmentation and regional integration after the GFC crisis. Although the trend seems less pronounced than in Emerging Europe or Emerging Asia, several global banks have withdrawn from LA to refocus on their core markets and activities, while regional or domestic banks have taken over their activities (see following section). In 2013, Grupo Aval, the largest conglomerate in Colombia, acquired BBVA activities in Panama, while the largest bank in Colombia, Bancolombia, purchased HSBC’s holdings. The same year, BBVA sold its Chilean, Colombian, Mexican and Peruvian pension funds to regional and local buyers. Santander issued IPOs in Mexico and Brazil. More recently, the Ficohsa group from Panama has nearly completed the purchase of Citibank’s operations in Honduras and Nicaragua, while HSBC has announced its intention to sell its Brazilian holdings to Bradesco, the second largest Brazilian private bank. Another dimension of regional integration is the gradual merger of the MILA stock exchanges (Chile, Colombia, Mexico, and Peru) that began in 2011. Once complete domestic investors will more easily be able to buy and sell equities from other MILA countries (see section V).

C. Benefits of Further Integration in Latin America

26. By expanding possible financing options and vehicles for savings in a country, financial integration can enhance financial development, which in turn has been linked to higher economic growth (Sahay and others, 2015). First, integration may stimulate capital accumulation. There are indeed general advantages related to financial deepening in the host country. If capital is brought from outside, competition among financial institutions can be enhanced, particularly when the domestic financial sector contains few institutions, and maintains high spreads between borrowing and lending rates; and economies of scale can be exploited by pooling larger amounts of savings. The monetary transmission mechanism can also be enhanced if the banking sector becomes more competitive. All these factors are likely to lower funding costs, and stimulate investment. Second, better resource allocation and importation of technology and knowledge may create opportunities for efficiency gains and boost productivity, which is another source of growth. Third, financial integration can also promote growth indirectly by exposing policy maker decisions and corporate actions to greater financial market scrutiny. The background paper shows a quantitative assessment of the macroeconomic effects from further integration in LA-7 countries. It shows substantial gains from closing the “integration gap,” with a growth dividend estimated in the 0.25–0.75 percent range.

27. In addition to raising the growth trend, financial integration may also foster economic resilience and reduce volatility around the trend. Output volatility can be mitigated through two main channels. First, financial integration is likely to increase the depth of financial markets leading to greater market liquidity: possibilities to sell and buy securities will increase with the emergence of new players and new instruments. Second, financial integration offers new opportunities for risk-sharing and inter-temporal consumption smoothing through the diversification of portfolios across asset classes, sectors and countries. Overall, this stabilization effect should be particularly beneficial in LA countries where production bases are concentrated and that depend heavily on agricultural activities or extraction of natural resources (IMF, 2015). Of course, the flip-side of this must also be acknowledged: increased integration could, in certain situations, serve to transmit shocks from one country to another.

28. Regional integration can bring a number of additional benefits for both the home and host countries:

  • Cross-border financial activity (bank and nonbank) both follows and can be followed by cross border trade, and thus could help foster wider regional economic integration. A larger common market creates new growth opportunities, which may be influential in LA in a context of lower commodity prices and tighter global financial conditions. The potential for increasing intraregional trade in LA may be limited by factors such as geography and foreign exchange risk, but is aided by the heterogeneity of economic activity across the region, with for instance Mexico exporting manufactured goods, Chile copper and Uruguay food.

  • Regional banks (robustly supervised with sufficient high quality capital to support their cross border operations) and regional markets may have a better understanding of the needs of the region than global institutions. They may be able to provide expertise particularly suited to the host country, such as improving financial inclusion. The homogeneous importance of specific commodity exports across some countries in the region may also be fertile ground for transplanting expertise in trade and industrial credit.

  • At the regional level, capital market integration creates scope for economies of scale, especially when individual markets are relatively small. In many LA countries, the small size of national markets, in some cases due partly to domestic regulatory factors, constrains financial sector growth and efficiency, contributing to higher costs, a narrower range of financial products and the exclusion of many from formal financial services. Addressing regulatory limitations and facilitating regional integration could contribute to loosen these constraints by allowing governments, financial intermediaries, and corporations to access a regional market with greater depth and liquidity. In addition, larger inflows of foreign capital to the region may follow, as a larger and more liquid regional market may be more attractive to international investors.

  • Regional banks can fill the hole left by retrenching global banks. Since the GFC, financial pressures together with increased regulatory oversight, have led some global institutions to reduce their cross-border activities and pull back into their core markets (IMF GFSR April 2015). Responding to the withdrawal of these banks, regional activity has been growing rapidly in a number of emerging markets, particularly in Asia and Emerging Europe (BIS, 2014). This trend has so far been less pronounced in much of LA, although global banks continue to downsize and withdraw. Regional integration could help avoid increased consolidation of domestic financial sector activity and mitigate a possible credit squeeze if North-American and European banks continue to reduce their presence in the region without onselling their business to another institution. While this could lead to the emergence of large regional banks, and bring the risk of concentration at a regional level, it would nonetheless foster greater competition and diversification of risks within domestic markets.

  • Diversifying exposure to external financial markets through regional integration could mitigate the impact of foreign spillovers. While regional integration may enhance risks if a region were to be hit by a common shock, the presence of regional banks could also serve to diversify the overall risks facing a country’s financial sector: although the GFS showed that global banks were more-or-less all subject to similar risks, the performance of banks from regions other than the US and Europe was substantially less affected. An internationally exposed, but geographically diversified financial system could more nimbly replace borrowing and saving vehicles regardless of the origin of foreign shocks. Regional banks could thus provide a buffer against global volatility, while giving countries the possibility to develop financial capacity beyond the limitations of their national boundaries.

29. Such advantages are not assured though unless accompanying measures are in place, including enhanced supervision. Cross-border financial activity also brings risks, including adverse spillovers if there is insufficient official capacity to exercise necessary oversight. Critics of financial integration point to financial crises following capital account liberalizations in Mexico (1994), East Asia (1997) and Russia (1998). Work to identify positive results from financial integration often struggles to generalize results and often must narrow the findings to selected forms of integration (FDI and equity are statistically favored over debt instruments) or acknowledge necessary conditions such as high levels of economic development, institutional quality, or financial development. However, Rancière and others (2006, 2008) show that the direct effects of financial liberalization on growth outweigh the negative indirect effect of higher propensity to crisis. In their review of the benefits and costs of financial globalization, Kose and others (2006) also recognize the existence of conflicting results but conclude that the empirical literature “lends some qualified support to the view that developing countries can benefit from financial globalization, but with many nuances. On the other hand, there is little systematic evidence to support widely-cited claims that financial globalization by itself leads to deeper and more costly developing country growth crises.”

Can Regional Financial Integration Facilitate Infrastructure Project Financing?

The infrastructure gap in Latin America remains large and will require significant financing resources. Infrastructure gaps exist in energy, transportation, telecommunications, and water/sanitation across Latin America. Traditionally these projects are sponsored and financed by governments. However, with shrinking fiscal space, governments are finding it more difficult to balance competing demands and still fund infrastructure on their own balance sheets. Hence many countries are making wide use of PPPs to deliver more public investments with more freedom to choose where to commit long term resources.

Pension funds and insurance companies are natural investors in funding infrastructure projects, but concentration limits preclude large investments in individual projects. As prudential caps limit their capacity to attract cross-border financing, large projects may find it hard to generate the financing they need. Pension fund and insurance companies have substantial resources to invest, and need long-term local currency assets to match their liabilities. While institutional investment managers express great interest, project risks remain high, and prudential caps1 for “alternate” investments—which include infrastructure—continue to be low. Given that the alternate asset class includes many competing products like real estate, energy, and private equity, funds available for infrastructure may be limited. Moreover, when pension and insurance funds help finance projects cross-border, they have to mind both foreign currency and alternative asset caps. In such cases, flexibility on the part of project sponsors to absorb currency risk in their liabilities, or hedging as financial markets deepen, could help draw in foreign institutional financing.

Expertise in risk assessment for regional projects can facilitate the flow of investment funds; however developing such expertise is expensive. Arranging infrastructure loans can be difficult because the projects can be expensive and subject to risks that are difficult to quantify. Syndication of bank loans has been useful in distributing the risks across multiple banks. One of the contributions of PPPs has been developing risk frameworks and project financing that looks to pair risks with participants best able to manage those risks. For example, a project may seek equity financing from participating engineering, procurement and construction firms or firms that will provide operational services after construction. These firms may have better access to capital, while the equity stake helps align incentives for timely, cost effective delivery of obligations. Collaboration among banks, equity funds, insurance companies and pension funds to jointly develop risk assessment teams among regional lenders that specialize in infrastructure projects can help them amass their intellectual capital quickly and at lower cost. And as risk mitigation strategies become more widely employed, regional sponsors will begin tailoring the financial structure of their projects to more easily attract financing.

uA01fig01

Private Sector Deals for Infrastructure Projects

(number of deals)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Source: Preqin deals database.1 Includes China, India, Indonesia, Malyasia, Myanmar, Pakistan, Philippines, and Thailand.2 Includes Czech Republic, Hungary, Poland, Russia, and Turkey.3 Includes Argentina, Brazil, Chile, Colombia, Mexico, and Peru.4 Includes Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

References

OECD, 2014, “Private Financing and Government Support to Promote Long-Term Investments in Infrastructure.”

Brown, C., Davis, K., 2009, “Is Pension Fund Collaboration Possible and Sustainable? Insights from Australian Experience,” SSRN Electronic Journal.

CEPAL, 2014, “The Economic Infrastructure Gap and Investment in Latin America.”

1Typically 5–10% of assets under management for pension funds.

The Financial Sector in Latin America and Barriers to Integration

A. Banking in the LA-7

Banking systems are the largest financial intermediaries in the LA-7, amounting to about 100 percent of LA-7 GDP. Brazil has the largest, closely followed by Chile’s banking system, and only surpassed by Panama as a share of GDP. With liberalization of financial systems in the 1990s, most assets in the LA-7 are now with private banks (about 60 percent of LA-7 GDP), while assets in public banks remain high only in Brazil and Uruguay as a share of GDP; meanwhile foreign banks hold important market shares in some of the LA-7 (27 percent of LA-7 GDP). However, the integration of regional banking systems remains low. Despite liberalization, most banking systems are characterized by high concentration and in some cases by high bank interest rate spreads.

Figure 5.
Figure 5.

LA-7 Indicators of Banking Sector Growth, Size and Concentration

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: National authorities; Bureau van Dijk; IMF, International Financial Statistics; and IMF staff calculations.
Figure 6.
Figure 6.

Credit Growth, 2010–15

(percent, annual average)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Source: IMF, International Financial Statistics.

Background - Financial Intermediation:

30. Financial intermediation in the LA-7 remains limited compared to advanced economies and other emerging economies. However, important heterogenity exists. Chile has the highest credit ratio to the private sector among the LA-7, while financial deepening in Mexico, Peru and Uruguay remains relatively low. Chile’s credit to the private sector more than doubled since 1995 (from 50 to over 100 percent of GDP in 2014), while it is only about 35 percent of GDP in Mexico, Peru and Uruguay, not having risen in the past two decades. Chile is the only LA country whose credit to the private sector is comparable to that of Emerging Asia and G7 economies. Even Brazil’s credit to GDP ratio remains relatively low compared to Emerging Asia and G7. In terms of deposits, Brazil and Panamalead (with ratios of 60 percent of GDP), though even these ratios are much lower than in Emerging Asia, while Peru’s ratio is the lowest. While Mexico has a low ratio, it has access to other financial funding through corporate bond issuance and capital markets. Financial access in terms of number of branches per 100,000 adults is lowest in Uruguay and Mexico.

31. Economic growth, stable macroeconomic policies, and reforms to deepen financial markets have supported credit expansion in recent years. Credit growth in Uruguay has been high, albeit from low levels, driven by economic growth as well as official attempts to increase financial access. Credit growth in Brazil has decelerated to 11 percent y/y in 2014 from the high rates of 30 percent y/y in 20108, driven by a slowdown in credit expansion by public banks, while private bank credit continued to expand at a moderate pace. The slower credit growth likely also reflects lower demand, given weaker economic activity. Since 2011, credit in Peru has been slowing gradually on the back of macro prudential measures but monthly growth rates still average around 15 percent (y/y). Credit growth in Mexico moderated to below 10 percent y/y in 2014 (from 17 percent y/y in 2011), driven in part by a deceleration in construction after financial difficulties of the three largest builders surfaced. At the same time, lending by the publicly-owned development banks is growing rapidly, given a new mandate of promoting micro-finance and lending to underserved sectors. Credit growth in Colombia was also buoyant over the period, and will likely continue to outpace nominal GDP growth, in line with the government’s financial inclusion policy.

Figure 7.
Figure 7.

Foreign Currency Loans and Liabilities

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Source: IMF, Financial Soundness Indicators.

32. Dollarization in some of the LA-7 has slowed in recent years. High dollarization was a response to past crises and hyperinflation episodes and consequent loss of purchasing power of bank deposits. Dollarization slowed—and even reversed—following policy initiatives that included adopting inflation-targeting frameworks; macroprudential measures, including differential reserve requirements on local currency versus foreign currency deposits and capital requirements on FX loans; and the development of local currency capital markets. In Peru, FX corporate loans have decelerated sharply following de-dollarization measures introduced at the end of 2014: new repos in domestic currency to support the growth of credit in local currency and to encourage the substitution of foreign currency loans with local currency loans; also, higher reserve requirements on foreign currency deposits, as well as reserve requirements for banks that do not meet certain de-dollarization targets for credits. Uruguay, on the other hand, still has a highly dollarized financial sector, possibly associated with inflation persistently above the target range, with FX loans accounting for 60 percent of total loans, and FX liabilities at close to 80 percent of total liabilities. At the other end of the range, Brazil, Chile, and Colombia have much lower FX lending and liabilities ratios, even though dollarization in Brazil has been increasing in the last year.

33. Most banking systems in the LA-7 are characterized by high concentration, which may have a significant impact on loan rates and spreads (see the panel on bank concentration below). In Peru and Uruguay, the three largest banks account for about 70 percent of banking system assets, and in Uruguay, 40 percent of banking system assets are controlled by one government-owned bank. In Brazil, Chile, Colombia and Mexico the three largest banks hold 50 percent of banking system assets, and Brazil stands out with 45 percent of banking system assets controlled by public banks, with a high degree of earmarked and subsidized lending.

34. Bank spreads in several LA-7 are high compared to other regions. Brazil has the highest spreads at over 15 percent,9 and ROE is reported to be around 20 percent for the largest banks. At the same time, Brazilian banks exhibit high operating expenses due to entrenched inefficiencies,10 especially in state-owned banks which have a high share of directed lending and social projects. In addition, high costs of doing business, as Brazil ranks poorly in terms of ease of doing business and investor protection, may increase costs for private banks. Uruguay too has high interest rate spreads and operating expenses. While Peru has high spreads, it has one of the lowest operating expenses. Spreads in Colombia, Chile, Mexico Panama, are lower than in Brazil and Peru and they have been coming down in Colombia, Mexico, and Panama, hinting at increased competition in those markets.

Figure 8.
Figure 8.

Interest Rate Spread, 2014

(lending minus deposit rate, percent)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Source: IMF, International Fiancial statistics.

State of Play of Regional Financial Integration:

35. Banking systems in the LA-7 have been liberalized since the 1990s. This liberalization process involved deregulation, openness to foreign bank entry and privatization. While the market share of foreign banks is high in some of the LA-7, the cross-border share of regional banks remains minute. Panama is the only exception: regional banks hold 33 percent of bank assets in Panama, of which 22 percent are held by Colombian banks. Foreign ownership of banks is highest in Mexico, with most bank assets held by North American and European banks (of the 70 percent of banks assets which are foreign-owned, 18 percent are owned by U.S. banks and 37 percent by Spanish banks). At the same time, Mexican banks (i.e. Banco Azteca) have a very small cross-border regional presence. Brazil and Colombia lie at the other end of the range, where bank assets are predominantly held by domestic banks, either in large part government-owned banks in Brazil, or private banks in Colombia.

Figure 9.
Figure 9.

Commercial Bank Ownership1

(bank assets in percent of GDP)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: National authorities; Bureau van Dijk; and IMF staff calculations.1 Year-end 2014 or latest available.

36. Foreign claims of some Latin American BIS reporting banks on the region provide some evidence of increasing regional integration since 2005.11 Foreign claims by Chilean banks on the region are 50 percent of total claims, the highest among the BIS reporting banks from Latin America, while Panama’s are 30 percent of total claims (Table 2). Foreign claims by Brazilian banks on the other LA-7, while significantly increasing since 2005, are still only about 13 percent of total claims—US$18 billion (of which 12 percent are on Chile), with most foreign claims being on the U.S. and the U.K. Foreign claims by Mexican banks on other LA-7 are tiny, at 3 percent of total claims.

Table 2.

Size of the Regional Market, 20141

article image
Source : National authorities, and IMF staff calculations.

Year-end 2014 or latest a vailable.

Table 3.

Consolidated Foreign Claims on the World by BIS Banks in 4 Latin American Countries

(Percent of GDP)

article image
Source: BIS, Consolidated Banking Statistics.

37. Mergers and acquisitions (M&A) by LA banks of international banks withdrawing from the region (see table 5) suggest a trend towards greater regional integration. Regional banks, especially Colombian banks, acquired businesses of HSBC, Santander, BBVA and Citibank, which were withdrawing particularly from Central America, but Paraguay and Peru too. The assets of Colombian banks’ subsidiaries abroad reached US$50 billion, accounting for 24 percent of the total assets of the Colombian banking system (table 4). Colombian banks have attained a significant market position in Central America (22 percent of assets on average), with the share of Colombian bank assets in Panama reaching 23 percent (and over 50 percent in El Salvador). These regional integration trends can be a spur to enhancements to supervisory, resolution and tax system frameworks.

Table 4.

Assets of Colombian Banks in the Region

(Percent of parent bank’s assets)

article image
Sources: National authorities and IMF staff calculations.
Table 5.

Financial Sector Divestments Following the Global Financial Crisis

article image
Source: Bloomberg, LLP.

Prospects for Further Regional Financial Integration:

38. Two Brazilian banks (of which one is an investment bank) have a regional perspective and have established a significant presence across Latin America. Bank Itaú, based in São Paulo, has the strength and the ambition to become the major regional player. The size of the bank is close to that of the entire Mexican banking system (US$420 billion in assets). It has expanded regionally mainly via M&A, but through a few greenfield investments in Colombia and Mexico as well. With its most recent acquisition of Chilean Corpbanca12 (and merger with Corpbanca Colombia), the share of Itaú’s cross-border business will now reach 13 percent, from 7 percent in 2011. Similarly, investment bank BTG Pactual, based in São Paulo, aspires to be the investment bank of the region. Investment banks are likely more able to establish operations abroad compared to retail banking, owing to the lower cost structure and initial investment involved in their operations. BTG Pactual started expanding throughout much of Latin America following the GFC when global banks were seen to be withdrawing.13 However, other Brazilian banks mostly focus on their domestic market. They view the potential to expand domestically, and appear to be consolidating their positions at home

39. Conditions in other countries too have so far precluded much regional integration. The large presence of foreign banks from the U.S. and Spain in Mexico mean that any decisions on expansion to the region from Mexico are taken at headquarters, rather than in the Mexican subsidiaries; among domestic banks, only Bank Azteca has decided to expand regionally, having a small presence in Brazil, Guatemala, Panama and Peru among others. Also, the more important real economy ties with North America and Europe have so far dampened pressures for regional financial integration. Furthermore, from a financial stability perspective, at least until the GFC, global banks were considered by most countries to have advantages that made them preferable to regional Latin American banks: they were considered easier to “discipline”, less politically connected, and more accountable.

40. While the Mexican, Chilean, and Peruvian banking systems are very open, equity prices appear to be a deterrent for acquisitions. Chile, Mexico, and Peru liberalized their banking systems in the 1990s, and they all attracted foreign capital, especially from North America and Europe. Only a few large LA banks are able to afford entry to these markets, given high equity prices compared to valuations. Large Colombian banks find markets in Chile and attractive, but prices of assets can be prohibitive, and concentrated markets represent a barrier to entry. Of the Colombian banks, GNB Sudameris acquired HSBC’s operations in Peru, whilst Brazil’s Bank Itaú and BTG Pactual entered the market as investment banks. In addition, Bank Itaú acquires Corpbanca in Chile (and merge with Corpbanca Colombia).

41. In some countries, such as Brazil, high bank concentration and size of the market, are potential barriers to regional bank entry. High bank concentration is likely due to the role played by family and publicly owned banks. The power of incumbents, including of financial conglomerates with linkages to the real sector, could act as strong deterrent to entry. The Brazilian banking system has been consolidating, and Bradesco, the second largest private bank, is now closing acquiring the retail business of HSBC (increasing its market share from 11 to 14 percent). In addition, the three large government-owned banks have grown significantly since the GFC. BNDES, the development bank, lends to large conglomerates at subsidized rates. The legal regime for entry by foreign banks in Brazil is relatively opaque, and entry requires presidential approval, which may have a “chilling effect” for potential entrants (see below). In Uruguay, BROU has had a legal monopoly on public employee accounts, which has given the public bank a majority share of the peso deposit market. The only regional bank in the Uruguayan market is Bank Itaú, following Banco do Brasil’s exit in 2005 after 20 years. Banking fees and rates in Uruguay are high compared to the region because banks’ operating costs are very high, while profits are relatively low. Uruguayan banks have consolidated in an attempt to gain scale economies: in 2002, there were 20 private banks; today, there are only nine.

Figure 10.
Figure 10.

Ease of Doing Business

(Rank, 1 (high) to 189 (low))

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Source: World Bank, Doing Business, 2015

42. Ease of doing business (i.e. getting credit, protecting investors, and enforcing contracts) is hampered by institutional and regulatory factors and lack of competition. For example in Brazil, there is no full depth of, and access to, credit information, especially distribution of both positive data (repayment of loans and loans due performance) to build positive credit files for borrowers to benefit from lower interest rates, compared for example to Mexico, which has achieved the highest rating in terms of full depth of credit information (see Doing Business Report, 2015). Colombia also has a high rating in terms of depth of credit information, given that all financial institutions supervised by the Financial Superintendency of Colombia (SFC), including small banks, have access from, and report data to, the credit bureau, and must have well-defined credit-granting criteria (e.g. take into account information on the debtor’s current and past payment performance; pay timely attention to their liabilities; and consider the financial and credit history from credit bureaus or rating agencies). While supervised entities provide credit information to determine asset quality in monthly and quarterly financial statements, some credit exposures are currently not covered, such as off-balance sheet exposures, letters of credit and bank collateral and sureties.

43. High concentration and lack of competition likely explain high loan spreads in some of the LA-7. Competition, low taxation and reserve requirements, strong creditor rights and legal framework, availability of information on borrowers, and a stable macro environment would be expected to reduce bank spreads. While some of the LA-7 banking systems have similar levels of concentration, they have diverging interest rate spreads, explained in part by institutional and regulatory factors,14 competition, and level of foreign bank participation (and the technological spillovers from foreign banks which lower costs and improve efficiency in the market). This combined with a more stable macro environment could help explain lower spreads in Mexico.

44. Another impediment to safer cross-border regional banking integration is the fact that countries are moving at different speeds in adopting the new regulatory agendas. There are big differences in the speed of adoption of enhanced supervisory and regulatory frameworks, such as a consistent capital definition (Basel III), as well as adoption of the International Financial Reporting Standards (IFRS), which makes it hard to establish a level playing field across countries during the (possibly protracted) transition period. Brazil and Mexico lead the region in the implementation of Basel III, following closely the international timeline, followed by Peru, while Chile and Colombia have taken a more gradual approach. Colombia has enhanced its capital measure, bringing it closer to the Basel III definition.

45. A bank’s ownership structure could also be an impediment for regional acquisitions. When HSBC tried to sell its operations to GNB Sudameris (Colombian) in Uruguay, the deal fell apart reportedly because the banks owned by the owner of GNB Sudameris do not have the same holding structure in different jurisdictions, a situation that was considered inappropriate by the Uruguayan supervisor. The SFC affirmed to the Uruguayan supervisor that it performs supervision on a consolidated basis over its supervised entities, and therefore requires GNB Sudameris to fulfill prudential regulations such as capital requirements, but this was deemed not sufficient.

Global Financial De-Integration:

46. Regulations in home countries of global banks aimed at strengthening banks’ resilience have reduced the profitability of subsidiaries. These measures have discouraged bank subsidiaries from playing an active role in markets as intermediaries or liquidity providers. Liquidity in sovereign debt markets has fallen as certain big banks (mainly from the U.S. and U.K.) have substantially reduced their presence in regional markets. Consolidation rules applied globally by parent banks on their subsidiaries appear in some cases to have come into conflict with the legal regulations in LA host countries, and raised the costs of doing business in those countries, not only vis-à-vis prior requirements but also relative to local banks. Vigorous application of these regulations could further the “de-globalization” trend. In the new regulatory environment, the costs and benefits of subsidiaries operating in emerging markets are likely to shift, possibly initiating further downsizing or withdrawal from these markets.15

47. Bilateral and multilateral initiatives to increase the transparency of the international financial system have also contributed to a loss of correspondent banks in LA. U.S. agencies’ enforcement actions against breaches of compliance with domestic regulations on trade and economic sanctions, tax evasion and AML/CFT, as well as other port-GFC developments, lead international banks operating under U.S. regulations to withdraw from activities seen as “high risk”. This has had a particular impact on correspondent banking relationships. A small number of large international banks dominate the provision of correspondent banking services for banks in the region. Some of these have been ending, or reducing, the provision of these services for local banks. For example, in Mexico, JPMorgan is maintaining its wholesale business, but is withdrawing from providing correspondent bank services to small and medium sized banks. Bank of America is for some local banks the only major U.S. bank still offering correspondent banking facilities. This evolution overall is intended to increase transparency in financial transactions and financial institutions’ risk management policies. However, authorities in the region have raised their concerns about these developments in various forms. They report the withdrawal of lines to medium-sized banks, which cater to SMEs, raising the cost of finance for these enterprises, and in some cases causing firms loss of access to credit from US exporters, who fear for the safety of their payment in the future.

Recommendations:

  • Move forward in harmonizing regulatory frameworks across the region, as well as the legal framework for bank restructuring and resolution, towards international standards and best practices, with a view to promoting financial stability and establishing a level playing field across countries as well as across banks operating cross-border in the region.

  • Strengthen consolidated supervision. Supervisory agencies should have adequate powers over non-bank holding companies of banks, both domestically and cross-border.

  • Increase transparency regarding entry of foreign banks. To increase competition and lower the cost of financing, foreign banks should be allowed to enter the banking system through an explicit, open, objective and non-discriminatory statutory and regulatory framework (see also below).16 At this point regional banks seem to be more likely than global banks to respond to such opening.

  • In dollarized economies, strengthen prudential requirements on dollar lending and encourage the private sector to hedge its foreign currency exposures, and further support the de-dollarization process whilst deepening financial and capital markets. Indeed, deepening financial markets has proven to be an effective way to achieve de-dollarization, including through an active policy of de-dollarizing public debt, deepening local-currency bond markets, and promoting the development of markets for FX derivatives along with FX flexibility. In Brazil and Colombia, when market conditions and financial stability considerations permit, relaxing the constraints on foreign exchange activities and adjusting net open FX position limits for settlements in other currencies, where present limits are low could be considered.

  • Continue to promote best efforts to ensure strong direct home and cross-border supervision, including measures to ensure that effective customer due diligence measures are in place. Countries should work with key international financial centers’ regulators and international bodies, such as the FSB and the FATF, to ensure a clear understanding of regulations and policies relevant for their financial institutions. They should also be encouraged to assess the need of adapting their financial system to the new regulatory environment and to consider public sector support in case of market failure.

Figure 11.
Figure 11.

Profitability, Concentration, and Competition, 2014

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Source: National authorities, Central Bank of Brazil, IFS, and IMF FSIs and staff calculations.
Figure 12.
Figure 12.

Indicators of Financial Deepening, 2013

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Source: National authorities, World Bank, and staff calculations.

B. Pension Funds

Pension funds are increasingly important in LA-7 financial markets, as their size has surpassed 17 percent of GDP in assets under management, largely driven by growing participation following legal changes in most of the region. Brazil dominates the LA-7 pension fund assets in value terms, while the Chilean pension fund industry—whose framework has often been used as a model in the region—remains the largest in relation to the country size. Despite the rapid growth, total assets and participation rates within the LA-7 remain below advanced country averages, thus, strengthening expectations that LA-7 pension funds growth will continue to outstrip that of regional GDP. Most pension funds are restricted to largely investing domestically, although in many cases LA pension funds have outgrown domestic capital markets.

Figure 13.
Figure 13.

Indicators Pension Asset Growth, Size, and Manager Concentration

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

48. For over a decade, domestic pension funds have been among the largest institutional investors in many LA countries, increasingly expanding their importance in the capital markets (GFSR April 2014). Pension fund participation in government securities markets increased significantly over the last decade. Pension funds’ share of the sovereign debt market in Peru, for example trippled, while in Colombia their share of the market almost doubled. Brazilian Previ, Chilean AFP Provida, and Mexican Afore XXI Banorte are now ranked among the largest 100 pension funds in the world17.

Figure 14.
Figure 14.

LA-7: Size of Pension Funds

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: National authorities; Bureau van Dijk; and IMF staff calculations.1 Year-end 2014 or latest available.

49. Overall, assets under management of the LA-7 pension funds have reached US$700 billion through the combination of healthy returns and rising contributions that reflect higher incomes and a growing participation base as younger, more urban population segments enter the formal workforce. Authorities have also promoted private pension participation as a means to build domestic savings and stem the growth of public pensions. As a result, pension funds asset accumulation has well outpaced regional economic growth, significantly increasing their importance in the regional financial systems and domestic capital markets. Between 2008 and 2014 LA-7 pension assets have experienced growth rates that ranged between 50 and 100 percent18. Pension fund assets in many LA-7 countries now rank second largest among financial intermediaries, trailing only the banking system.

Figure 15.
Figure 15.

Pension Fund Assets

(Index, 2008=100, in percent of GDP in USD1

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: AIOS; ABRAPP; PREVIC; IMF, WEO and staff estimates and calculations.1 Estimates may be based on partial data for some countries.2 Estimates for BRA reflect ativo total das Entidades Fechadas de Previdência Complementar, segundo patrocínio predominante.

50. Given their relatively recent establishment, however, LA-7 pension funds have ample room for further growth, as their size remains well below developed country averages. LA-7 pension fund assets amounted to about 17% of LA-7 GDP at end-2014, well below the OECD average of 37% of GDP19, for every country, except Chile. The majority of the current pension fund systems in LA-7 trace their origin to the introduction of mandatory participation in defined contribution pension systems in the 1990s, following that of Chile in 1981. Brazil has an organization-sponsored pension system that is largely of defined benefit nature, but transitioning to an increasing number of defined contribution. The public sector pension plan is transitioning from defined benefit to defined contribution. Chile, Colombia, Mexico, Peru and Uruguay have implemented various forms of a multi-fund system, where younger participants are steered toward more aggressive funds while older contributors deposit into safer portfolios. Panama has retained its single-fund system. Another distinguishing characteristic of LA pension funds is the highly elevated levels of industry concentration; the largest two pension funds in Colombia, Peru, and Uruguay manage more than 70 percent of the industry assets, pension administrators. While the total number of pension fund administrators in each country is no more than four. In Chile and Mexico, by contrast, the two largest pension funds manage about 50 and 40 percent of total assets, respectively. While there is significant variation between the countries, pension fund performance in LA-7 largely remains on par with other financial intermediaries.

Figure 16.
Figure 16.

LA-7 Pension Size and Concentration

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

State of play

51. Regional integration of pension fund markets is quite limited. Financial integration of pension funds—regional and with the rest of the world—has historically occurred through two main channels: the internationalization of pension fund management firms and cross-border investments of pension funds’ assets. While the recent years have witnessed some activity of the former, the latter continues to be held back by the low regulatory investment limits.

52. Cross-border management of pension funds’ asset has experienced a pick-up in recent years, in light of consolidation trends and the withdrawal of a number of global institutions, while regional asset managers are beginning to assert themselves. Throughout the region, the largest pension funds and the majority of assets are controlled by domestic asset managers, except in Chile. However foreign asset managers have sizeable market shares in Chile, Mexico, Peru and Uruguay. In recent years, many LA-7 countries have seen a number of M&As, involving either domestic or foreign asset management firms. The sector has seen a withdrawal of several foreign institutional investment groups from the pension fund industry in the region, such as BBVA, ING, and HSBC, among others, which have been partially replaced by others, including Principal Financial Group and MetLife. At the same time, Latin American financial g roups, such as Grupo Suramericana de Inversiones (Colombia) and its affiliates have acquired interests of controlling positions in Chile, Mexico, Colombia, Peru, and Uruguay. This trend, largely accomplished through M&A, has resulted in higher industry concentrations, with Colombia and Mexico being the more prominent examples. The number of pension fund administrators dropped in Mexico from 21 at end-2007 to 11 at end-2014, while the number of pension fund administrators in Colombia fell from 6 in 2012 to 4 in 2014.

Figure 17.
Figure 17.

LA-7: Pension Fund Assets Under Management, 20141

(Billions of US dollars)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: National authorities; Bureau van Dijk; and IMF staff calculations.1 Year-end 2014 or latest available.2 Data for some countries may include partial estimates due to availability.

53. International investments are an important asset class for regional pension funds, but regional exposure is small. The overwhelming share of foreign holdings is invested in advanced economies, such as the Euro Area, United States, and Japan, with a somewh at smaller share attributed to EMs. Investments in other LA countries are relatively low, Peruvian pension managers for example reported LA-7 investments of just 3.7% of assets (9.3% of foreign allocations), although this share increases marginally if indirect investments through ADRs and LA focused ETFs and mutual funds are taken into account. Foreign securities investments are often allocated to debt securities, given that many countries also place a regulatory limit on equities, both for foreign and domestic markets. Pension funds have greatly contributed to the development of domestic debt securities markets, but their role in the expansion of equity markets has been rather limited. (Figure 19)

Figure 18.
Figure 18.

Pension Funds Investment

(Percent of Total, Mar. 2015)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: AIOS; ABRAPP; PREVIC;and IMF staff estimates and calculations.1/ ABRAPP and PREVIC estimates for Brazil. Classification may vary from other countires. Government debt includes only public bonds; other includes private loans and deposits, SPE, structure investments, real estate, operations with participants, and others.
Figure 19.
Figure 19.

Pension Funds Investment Flows

(Percent of total, 2005-141)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

54. In addition to explicit caps on foreign asset holdings, many countries in the region have regulations that indirectly discourage financial integration. For example, Uruguay’s low foreign asset cap of just 15% is further hindered by rules that limit external investments to securities from multilateral institutions. In Chile, while the regulatory limit does not appear to be binding in aggregate, foreign asset holdings are effectively constrained by additional caps on risk tolerance, as measured by sovereign ratings.20 Brazilian pension funds are required to collaborate with at least three other asset managers through a dedicated fund if they wish to invest abroad.

Analysis

55. Consolidation in the pension management industry has reduced the scope for regional firms to enter neighboring markets, restraining competition and prompting higher pension fund fees. Regulatory treatment of foreign and domestic companies in most cases is largely equivalent21. However de facto barriers arising from high market concentrations with incumbent power present significant impediments to new entrants. The competitive advantages22 held by dominant, established asset managers are deemed too great for institutional investors to set up greenfield operations and grow organically. And as with the banking industry, consolidation has also pushed up corporate valuations beyond what foreigners are willing to pay to enter a market.

56. As assets under management continue to grow, pension systems in most countries of the region will have to increase their international exposures. Asset allocation strategies are likely to come under more strain as fund inflows continue to grow faster than net government borrowing, while excess allocations into bank deposits threaten to drag down returns. Issuance of corporate debt and equity can meet some of the pension fund demand for local currency investments, but in many countries there can be volume, liquidity, and maturity concerns in addition to corporate risks with these instruments. Alternative assets like private equity and infrastructure have garnered more attention in recent years especially in Brazil, Peru and Uruguay, but prudential limits are low and the class is generally considered too risky to expect caps to rise quickly. In the last two decades, regulators have been keener to raise caps on foreign asset holdings. While this asset class introduces foreign exchange risk, most funds have invested in highly liquid segments of advanced country markets for which currency hedging is less expensive.

57. The internationalization of pension assets is restrained by limits on some asset classes. Regulatory limits and restrictions on investments vary by country (Table 5), and generally span multiple categories, such as foreign securities, equity, foreign currency, commodities, derivatives, single issuance holdings, and debt securities of lower ratings among others. On average, limits on variable rate instruments tend to be more restrictive. Countries with a multi-fund system—which allows risk profile differentiation—over time have been able to ease their regulatory restrictions allowing larger shares of investments in variable rate instruments (Chile, Colombia, Mexico, and Peru).

58. Pension funds in the region have outpaced the growth of domestic capital markets, complicating the task of optimal portfolio diversification, and making a case for the expansion of investment opportunities through financial integration. In addition to providing retirement funding, the development of the pension fund sector has generated a number of benefits. Pension funds have contributed to higher savings rates, broadening the domestic investor base, and deepening of the local securities markets. However, their asset growth has long outpaced the supply of domestic securities, triggering an array of challenges. First, pension funds now find it more difficult to achieve optimal portfolio diversification. Second, equity markets may have become more prone to asset price bubbles—as pension funds pursue a limited number of securities—which is further magnified by herd behavior as asset managers chase the same type of securities. Third, the large size and established investment behavior of pension funds, which is based largely on a buy-and-hold strategy, combine to further diminish financial market liquidity. Trading volumes in the financial markets have declined substantially as pension funds absorb significant portions of new and existing products. And, finally, pension funds’ appetite for domestic instruments crowds out other financial intermediaries, such as insurance companies from the domestic financial markets. Stronger regional integration could enable greater diversification by pension funds and enhance competition, and hence development, in financial markets.

59. While the minimum return requirements enforced in some countries inspire confidence in the systems, they can incentivize a herd mentality among asset managers and reduce diversification efforts into new foreign markets. The minimum returns requirement compels pension funds to disclose their asset composition and portfolio returns, and requires asset managers to top up returns by injecting their own cash into the fund when the return deviates significantly—generally more than 2-4 percentage points—below the minimum required threshold over an extended period, usually about 36 months. Typically, the industry average serves as the minimum required rate. To avoid underperforming their peer group, pension fund asset managers to mimic the portfolio allocation schemes of the largest pension funds, which tend to drive the reference rate. While this mechanism has successfully inspired some level of confidence in the systems, it also encourages herd behavior among asset managers. Strong homogeneity of returns across funds in a system shifts competitive pressures to management fees and marketing savvy. In such an environment, where risk taking by asset managers can be substantially hemmed, as negative consequences of poor returns outweigh perceived rewards of stronger performance, initial cross-border activity by market leaders would likely be followed quickly by the other market participants, if sufficient cross-border opportunities are available.

60. It is easier for regulators in countries with age/risk differentiated funds to introduce new limits on asset classes with higher risk/return profiles. Softer caps on foreign assets, corporate paper, or alternative assets can be introduced in funds with the highest risk tolerances (those designed for the youngest contributors). If over time the changes meet regulator expectations, similar reforms can be introduced into less aggressive funds.

Figure 20.
Figure 20.

Pension Fund Asset Allocations, 20141

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: National authorities; Bureau van Dijk; and IMF staff calculations.1 Year-end 2014 or latest available.2 Statutory limits on holdings of foreign assets (in percent of total pension fund assets) are: Brazil (10%); Mexico (20%); Colombia (40-70%); Chile (80%); Peru (50%); Uruguay (15%); and Panama (45%).

61. In an effort to diversify investments, pension funds have turned their attention to infrastructure products. So far, investments in infrastructure are in the range of 3-5 percent of pension fund investments, well below regulatory limits. A number of barriers prevent higher infrastructure investments, including lack of expertise in the infrastructure sector, problems of scale of pension funds, lack of transparency in the infrastructure sector, shortage of data on the performance of the infrastructure projects, and lack of a benchmark. Given the unique nature of each investment, investments in infrastructure, either directly or through a fund, also require significant time to complete due diligence and establish the appropriate framework for investment and risk management.23 LA-7 pension funds see infrastructure vehicles as a promising instrument for diversification, particularly as they align with the authorities’ strategies for public investment and structural reform implementation. In Mexico, for example, the recent energy reform is expected to provide a boost for the development of energy products. The long-term investment horizon of pension funds makes them natural investors in less-liquid and long-term infrastructure products. While prudential limits may have contributed to preventing pension funds from investing much in such infrastructure, own risk appetite also had a part to play. Such risk appetite and internal risk controls would also help to ensure pension funds do not hold too high a share of highly illiquid infrastructure assets.

LA-7 Pension Funds: Operating Costs and Pension Fees1

Pension fund fees levied on contributors directly affect the size of their retirement income. In a pension fund system with defined contribution arrangements, the size of retirement benefits depends not only on the contributions and the investment returns earned by such contributions, but also on the amount of fees levied by the pension fund providers. This implies that, while the size of the mandatory pension fund contribution is often determined by legislation, accruing sufficient retirement benefits requires the combination of high returns and low fees2.

uA01fig02

Pension Fund Fees

(In percent of assets under management, 2015 or latest available 1/)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: AIOS; IOPS; OECD, World Bank; National Authorities; and IMF staff estimates and calculations.1/ Occupational category for Spain; 2nd pillar for Slovak Republic; and voluntary plan for FYR of Macedonia.2/ Includes selected OECD (non-LAC) countries for which data available. Data may not be comparable due to differences in definitions.

Comparison to other countries indicates that LA-7 pension funds fees are higher than the level suggested by their operating costs3. LA-7 pension funds on average charge higher fees than OECD country average, when taken in percent of total assets under management. Fee size is largely driven by the structure of operating costs, as pension providers charge fees to cover operating expenses, which largely include fund administration expenses, marketing costs, and commission of sales agents, among others. However, the size of operational expenses in relation to total assets under management of LA-7 pension funds largely remains comparable to the OECD-country average. This implies that, based on international comparison, for a given level of operating costs, average pension fund fees in LA-7 exceed those levied by their OECD counterparts.

uA01fig03

Pension Funds’ Operating Expenses

(In percent of assets under management)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: OECD; AIOS; and IMF staff estimates and calculations.1/ For Latin and Caribbean: annual data include July, 2013 to June, 2014. Data for LAC may not be fully comparable to other economies. 2/ Includes selected OECD (non-LAC) countries for which data are available. Data may not be comparable due to differences in definitions.

Fees levied on contributors by pension funds in LA-7 are almost double the size that is needed to cover operating expenses. In Panamá and México, for example, while the operating costs constitute less than half of income collected from fees, the structure of operating costs differs; as Panamanian pension funds spend the bulk of their operating expenses toward the administration purposes, meanwhile more than half of the operating costs of their Mexican counterparts goes towards the commission of sales agents.

uA01fig04

Pension Funds: Operating Costs and Fees

(In percent, 2015)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: AIOS; OECD; and IMF staff estimates and calculations.1/Ratio of operating costs to total income from fees, implied estimate for some countries based on available data. 2/ Commission of sales agents costs for Peru may include promosion costs. Data for LA-7 cover July-June period.

LA-7 pension fund fees are also influenced by the industry characteristics and regulatory frameworks, largely exhibiting preference for fees levied on contributions rather than on asset balances. Pension fund fees collected from individual contributors depend on a number of factors, including the size and maturity of the system, market structure, competition, as well as the investment strategy and regulatory frameworks, among others. Fairly recent and less mature pension fund systems – which is the case for LA-7 – tend to have relatively higher fees. Asset allocation decisions and investment regulations also tend to influence fees, as investments in interest bearing assets, such as debt instruments, are usually cheaper than active investments, such as equities. Thus, the higher fees in nominal terms in Peru could potentially be partially explained by the relatively larger share of asset allocations toward equities. The structure of pension funds’ fees in general tends to be fairly complex. Unlike Central and Eastern Europe where preference is often given to fees levied on asset balances, Latin American pension funds mainly emphasize fees on contributions. Colombia, for example, levies a fee on contributions of 16 percent, while Peru and Chile have a 10 percent fee on contributions in place. LA-7 pension funds also impose a fee on salary, which vary from about 1.2 percent in Peru to 3 percent in Uruguay. Mexican pension funds, on the other hand, rely instead on fees imposed on asset balances.

uA01fig05

Pension Funds: Income from Fees per Contributor

(In percent of average salary)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: AIOS; and IMF staff estimates and calculations.1/ Annual data cover July-June period.

Selected LA–7: Pension Fund Fee Structure (As of June, 2015)

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Source: AIOS.

Fees on balance are taken as average. For Uruguay, data refer to custody fees.

More optimal fee structure in Latin America would instigate a decline in pension fund fees without jeopardizing optimal returns and their corresponding alignment with the managers’ cost strategies. Both types of fees, contribution fees and those levied on asset balances, have a number of disadvantages. While contribution fees generate revenues at the start, they may not be completely aligned with the continuously changing nature of the fund managers’ cost structure. Asset management fees on balances (levied as a percentage), on the other hand, while responding quickly to the funds’ costs, do not generate revenues initially. Meanwhile performance fees tend to distort the funds’ long term goals and objectives. Against this backdrop, it is often more advisable to implement annual flat fees—to cover transactions carried out during each period—combined with the asset management fees, which are aimed to absorb the portfolio management costs. Such a strategy may be more aligned with the cost structure of the manager and have fewer distortions on the long term investment strategies of the pension providers.

Greater regional financial integration in Latin America would prompt higher competition within the pension fund industry, while simultaneously relieving the burden of high pension fund fees levied on customers’ contributors. In some instances, such as Mexico for example, lower pension fund concentration may have been accompanied with higher fees. This could possibly be explained by higher operating expenses – incurred as a result of the increased efforts of the marketing and sales agents to encouraged pension fund members to switch providers, which drive up fees, given that some contributors may be more responsive to marketing rather than to the size and structure of the fees. In response to this, increased regional integration, in combination with continued efforts to promote financial education among contributors, would allow greater access of regional companies to domestic markets and increase competition within the pension fund industry, thus, forcing managers to reduce the size of fees they levy on their customers. This, in turn, would reinforce contributors’ efforts to accumulate sufficient funds for retirement.

1 Data references based on data by OECD, AIOS, and IMF staff estimates and calculations.2 Tapia, W. and J. Yermo (2008), “Fees in Individual Account Pension Systems: A Cross-Country Comparison”, OECD WP No. 27.3 OCED country averages may not be fully comparable due to variations in country and time period samples.

Recommendations

62. Higher regulatory limits on foreign security investments would ease demand pressures in domestic financial markets. The fact that Latin American pension funds have outgrown domestic securities markets provides a strong argument for an increase in regulatory limits on foreign securities, perhaps to about 50% percent in countries where they are currently set lower. Low limits not only may have led to suboptimal portfolio holdings and asset bubble developments in the domestic markets, but also may provide a source of instability as they fail to accommodate portfolio reallocations in response to changes in domestic financial conditions. Relaxing limits on foreign, particularly regional, investments, subject to risk safeguards around such investments abroad and availability of hedging instruments, plus enhancements to transparency and improvements in data, would allow pension funds to invest more cross-border, hence easing their demand for domestic securities and allowing other financial intermediaries, such as insurance companies, greater access to financial instruments.

63. Given regional labor mobility among the LA-7 countries, authorities should seek to institute pension fund portability across the region. Currently, Chile and Peru have a signed bilateral agreement that allows citizens of both countries to transfer the balances accumulated in their individual accounts voluntarily from one country to another. Not only does this action facilitate the transfer of savings, but it also encourages countries to adopt best standards and practices and harmonize asset management processes.

64. Authorities should simplify the process of creating infrastructure products and allow pension funds to access these instruments in other LA countries. Unrestricted access to regional infrastructure projects would provide a boost to the development of regional infrastructure products and further contribute to the development of securities markets. This would be beneficial to pension funds, as it would allow them to ensure better diversification of portfolios, given that infrastructure projects are long-term investments which could match the long-term duration of their liabilities. The benefit would also extend to the regional economy, as this would facilitate infrastructure financing overall.

Table 6.

Pension Funds in Latin America - Limits on Foreign Investments

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Note: In addition to the global investment limits specified above, some countries also set limits per issuer and per issuance. Colombia, for example, sets a limit of 10% of the value of each fund per issuer, and a 30% limit per issuance. Mexico also adds a 5% limit of the total assets of the fund per issuer and a 35% per issuance.

65. Countries of the region should demonstrate their commitment to integration with an understanding that in the future their pension regulators will agree to treat each other’s securities as domestic. Critically, such an agreement would be preconditioned on countries’ adoption of the highest standards in pension and financial system regulation and regulatory collaboration. Additionally, countries would have to have harmonized their accounting standards through adopting the IFRS, and have signed the multilateral memorandum of observance of international principles and practices relating to governance, monitoring, mitigating financial and operational risk. A token of this commitment could be the establishment of a special category for the holding of bonds issued in the region that would not count against foreign asset limits. While initially this category can be set at lower levels of about 5%, relaxation of these limits could be envisaged, should asset holdings reach them and they become binding.

C. Insurance Firms

Insurance penetration in LA-7 markets remains low, ranging from 1 to 4 percentage points of GDP, although the sector has expanded at a significant rate over the past decade, reaching almost 10 percent of the regional GDP in 2014, often influenced by changes in the domestic regulatory frameworks. While economic formalization, and possible increased occurrences of natural disasters are likely to fuel the non-life segment, purchases of life and retirement products are already quickly increasing the life portion of the insurance sector. Its growth is partly stymied by the limited availability of long-term financial instruments denominated in the domestic currency, given that their demand for financial vehicles is often crowded out by pension funds.

Figure 21.
Figure 21.

Indicators Insurance Asset Growth, Size, and Industry Concentration

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

66. The insurance sector in Latin America has achieved significant growth over the last decade (GFSR, April 2014). Insurance premia of the Latin American market quadrupled between 2003 and 2013, reaching almost 160 billion of USD by 2013, in large part on the back of resilient economic performance and strong employment growth, also supported by vigorous foreign direct investment, regulatory reform implementation, and improvements to the business environment in the region. Robust vehicle sales have contributed to the non-life insurance sector expansion, while pension-related products have fueled life insurance segments in many countries. Market maturity varies greatly by country, with Chile and Brazil having the longest maturities, as indicated by larger contributions of life premia. In Latin America compulsory insurance has played a number of roles: life insurance in Chile, for example, is strongly driven by mandatory products, while the absence of compulsory federal auto insurance in Mexico24 has reduced the non-life insurance sector penetration.

Figure 22.
Figure 22.

Selected Insurance Market Indicators

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

67. Both the size and the rate of market growth are influenced by the regulatory environment, which remains at different stages of development across the region. Some countries are currently setting the stage for risk-based capital model implementation, with Brazil and Mexico being at the forefront meeting Solvency II equivalent standards. Chile is also expected to adopt frameworks similar to Solvency II in the coming years. Other countries, however, continue to operate under regimes similar to Solvency I, with Colombia and Peru considering comprehensive regulatory reforms, as they continue to implement risk capital requirements (see box 3).

68. The main insurance distribution channels include agents, brokers, and banks, which vary by type of insurance sold. Many companies specializing in life insurance, for example, create their own networks of agents, which only sell the home company’s products. This distribution channel can be very costly due to the large resource requirements for agents’ management, remuneration, training, and supervision.

69. Market concentration across the LA-7 region varies by country but on average remains elevated. In Uruguay, for example, the large state-owned insurance company controls 80% of the market, while the two largest companies in Peru manage about 60% of total premia. Colombia’s ten largest companies account for almost 80% of the market share; meanwhile in Brazil, while there are over 110 companies, the largest 10 companies account for around 65% of the sector premia. Chile’s market concentration too appears to be somewhat lower, since the largest 10 companies account for about 60% of the market share.

70. Prospects for future growth of the insurance sector remain promising. The low insurance penetration of the LA-7 market, when compared to advanced and other Ems, testifies to the sizable unrealized potential. The relatively young population across the region provides expectation of future purchases of life and retirement products, while rising income levels are likely to stimulate automobile sales and drive non-life insurance growth. Regional susceptibility to natural disasters is likely to feed property and casualty market expansion, while the authorities’ efforts to increase the level of formalization of LA-7 countries are also likely to contribute to future growth.

Figure 23.
Figure 23.

Insurance Penetration

(Premium, in percent of GDP)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Source: Swiss Re 2011

State of play

71. Cross-border financial integration—regional and foreign—has been largely observed in the form of cross-border company ownership and reinsurance growth, rather than investments in foreign assets. While the former is largely a direct result of the growing importance of the sector, the latter is an effect of the product structure of many insurance companies in the region. Reinsurance has become particularly important in the property and casualty segment of non-life insurance, particularly given the region’s high exposure to natural disasters and the need to reinsure such risks. Nonetheless, reinsurance in LA remains relatively small, as the proportion of ceded premia is low, while the majority of the reinsurance activity is carried out by foreign, primarily European, companies.

Figure 24.
Figure 24.

LA-7: Insurance Firm Ownership, 20141

(Insurance sector assets in percent of GDP)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: National authorities; Bureau vanDijk; and IMF staff calculations.1 Year-end 2014 or latest available.

72. Growth in the Brazilian and Colombian companies has shifted the ownership structure and revised the rankings of the largest insurance groups operating in the region. LA has seen a notable shift in the ownership structure of the largest 10 insurance groups, which account for almost half of the market share. Among these ten groups, the market share of regional companies increased from 32 to 54 percent since 2003.25 This upsurge is mainly due to the life insurance segment, as the share of regional companies within the life segment more than doubled over the last decade, rising from 32 to 68 percent of the market (see table 7). This reordering was brought on by the fast expansion of such regional companies as Bradesco, Itau/Unibanco, and Brasilprev (all Brazil), and to a lesser degree Suramericana (Colombia). Bradesco has been the leading insurance group in the region since 2004, largely fueled by domestic market growth. But the region has also witnessed a number of mergers and acquisitions, which have pushed up the size and the ranking of the largest regional companies. In the non-life segment, the growth of regional insurance groups, while still exceeding that of foreign, has been less pronounced, with both, regional and foreign companies doubling in size.

Table 7.

Ranking of Top 10 Insurance Groups in Latin America (2003 and 2012)

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Sources: Fundacion MAPFRE; and IMF staff estimates and calculations.

In percent of top 10 premia.

Figure 25.
Figure 25.

Insurance Market Premia

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Analysis

73. M&As are viewed by many as the preferred method of growth, which is largely shaped by the characteristics of the LA-7 insurance market, rather than by regulatory regimes. Sizable growth potential and market stability make LA-7 countries appealing for new entrants. Most companies prefer brownfield investment to organic growth. In the absence of major regulatory barriers to cross-border expansions, high market concentration is considered by companies as the largest barrier to entry. Among the companies specializing in life insurance, the distribution channel is a potential barrier to greenfield investment, given that setting up a network of agents can translate into a sizable up-front fixed cost, and developing a sound agent base can take several years. Relative product complexity in many markets—usually in the form of bundled products to attract a larger customer base—also serves as a barrier to entry. The general lack of trust in insurance companies and their products, and limited product awareness, also depress market deepening. Insurance products remain unaffordable for a large fraction of the population of the region, and the lack of products for these segments contributes to low insurance penetration.

Figure 26.
Figure 26.

Private Pension Plan Premia, 2013

(percent of life premia)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: MAPFRE; and IMF staff estimates and calculations.1 Includes VGBL (Vida Gerador de Beneficio Livre) prducts.

74. Shortages of domestic securities have forced some companies to face maturity and currency mismatches. Investment portfolio allocation decisions are largely directed by regulatory limits and insurance product specialization. Portfolio allocations of life and non-life insurance companies differ based on the currency and maturity composition of their liabilities. The composition of country portfolios continues to shift toward life insurance, driven largely by the flow of funds from those retiring and converting their pensions into annuities. Within the LA-7, Chile, Peru, and Uruguay have the largest contributions of private pensions to life insurance growth26, some of which is driven by legal and regulatory frameworks. In Chile, for example, life annuities grow at low double-digit rates due to the participation of life insurance companies in the social security system. Accordingly, an insurance company selling annuities generally must be able to begin paying out a stream of payments denominated in domestic currency soon after the annuities are purchased and over an extended period of time, thus requiring currency and maturity hedging of its assets and liabilities. Some insurance companies have difficulties in matching the currency and maturity of their assets and liabilities, largely due to the weak supply of domestic securities, scarcity of foreign exchange derivatives of sufficiently long duration, and the shortage of long-term assets in the domestic markets. These result in up to 3- to 5-year maturity mismatches. Chilean life insurers with annuity liabilities, for example, show a systematic maturity mismatch of assets and liabilities due to the shortage of assets with similar durations as liabilities.

75. Due to the growing need for domestic instruments, holdings of foreign securities are reported to remain well below the regulatory limits in many countries. In Mexico, for example, the share of foreign securities remains below 3%, while the regulatory limit is currently 10%. Mexican companies which offer insurance products in foreign currency tend to have slightly higher shares of foreign securities holdings. In general, LA-7 insurers largely choose to invest in debt securities, more so in Colombia, Mexico, Peru, and Uruguay, where about ¾ of investment portfolio allocations of life insurers are held in bonds. In Panama, on the other hand, only about a quarter of portfolio is allocated toward bonds. While companies in Mexico and Uruguay tend to hold mostly government bonds, in Chile, Colombia, Panama and Peru companies appear to favor private debt securities. The rest of the portfolio usually includes equity shares, real estate investments, and other instruments. Real estate investments are typically small, with the largest share around 10%, observed for Chile. Equity shares are also relatively low, except in the case of Panama, where the majority of portfolio is invested in equities.

Insurance Regulation in Latin America

The LA insurance industry has been undergoing significant regulatory reforms designed to strengthen stability, improve transparency, generate efficiency, and align with the worldwide trend of more rigorous rules. While most countries continue to strive to improve insurance industry regulation, the pace and the degree of development varies across the region. Mexico, Brazil, and Chile are leading the way in the introduction of Solvency II-type frameworks in Latin America, as regulations are set to be implemented in the next three years.

Regulatory changes are expected to tighten prudential requirements, encourage product diversification, promote transparency, and strengthen linkages with foreign countries through higher reinsurance. The impact of the regulatory changes is expected to vary by country, but some general effects are likely to exist. More advanced regulatory frameworks that incorporate risk-based charges will likely generate higher overall capital requirements, in particular under Solvency II-type regimes. This may encourage insurers to diversify their business and product portfolios. Efforts to decrease capital requirements may also translate into higher demand for reinsurance, essentially strengthening linkages with other countries, including the EU, given that a large portion of reinsurance is done through European companies. New regulations will also impose tougher rules governing the process of risk identification and monitoring, and will set strict disclosure standards.

Stricter regulatory frameworks may generate M&A in the region, as smaller companies may face difficulties complying with tougher guidelines. Smaller single-line insurers may encounter difficulties operating under the new guidelines as they may be unable to face the expected changes in governance, risk management, capital requirements and reporting—potentially leading to M&A and higher industry concentration. In Chile Colombia and Mexico, more stringent regulatory frameworks increasing transparency and efficiency, meanwhile making the insurance companies more streamlined.

Further convergence of Latin American and European regulation via the implementation of Solvency II-type regimes will even the playing field for foreign subsidiaries and empower Latin American insurers to access EU markets. For large multinational insurance groups, such as Mapfre for example, which have their home offices in the EU, Solvency II-type regulation largely extends to their subsidiaries in Latin America and Asia-Pacific. While the subsidiary structure of foreign companies operating in Latin America compels them to comply with the host country regulation, they may also be required to conform to the tougher Solvency II regulations of the parent country in the EU, including higher capital reserves. Thus, domestic insurers in Latin America—those without operations in the EU, but who compete against EU rivals in their home markets—could retain some competitive advantage as long as the Solvency II-type rules continue to be implemented. Once implemented, the introduction of Solvency II—type regulatory frameworks in Latin America will even the playing field for domestic and foreign insurance market players, thus making some Latin American markets—particularly in Brazil, Mexico, and Chile—more attractive to foreign entities.

Recommendations

76. Harmonize financial infrastructure and operational practices across the countries. This may require legal changes in a number of countries.

77. Relaxing regulatory foreign asset limits for pension funds would also ease the burden of optimal portfolio allocation for insurance companies. Limited domestic investment opportunities have led to a number of challenges for the insurance companies in the region. The shortage of supply of domestic securities is magnified by the overwhelming presence of pension funds, which increasingly hold securities to maturity and crowd out investment opportunities for the insurance sector. Insurance companies thus are in need of better domestic options in local currency and of long-term maturity. Relaxing foreign investment limits for pension funds, would not only ease the difficulty of optimal pension fund portfolio allocation, but would also provide additional investment opportunities for the insurance sector.

78. Simplifying new product development policies would foster capital market expansion and increase investment opportunities. Authorities should also review regulatory requirements to ease the process of creating new products in the domestic capital markets. Infrastructure product development, for example, could provide a valuable instrument for portfolio diversification for pension funds and insurance companies alike.

79. Data quality and provisions need further improvements to support industry monitoring and diagnosis of vulnerabilities. Data quality and availability on insurance companies vary by country, while the heterogeneity of publicly available information on insurance companies in many cases prevents proper comparison of the industry performance across countries. As such, data harmonization, improved quality, and availability would not only support monitoring by the authorities, but also increase transparency of the sector.

D. Capital Market Integration in the LA-7

Capital markets in the LA-7 are moderately sized by emerging market standards, but are facing competitive pressure from large exchanges in advanced economies. As of the end of 2014, capitalization of LA-7 equity markets was 47% of regional GDP while the value of domestically traded bonds outstanding was about 61% of GDP. In dollar terms the largest bond and equity markets are found in Brazil and Mexico, while the Chilean markets stand out for their relation to the size of the economy (91.6% stock and 51.0% for bonds). Despite solid market capitalization, low trading volumes are an emerging concern. Declining liquidity is frequently evident, attributed to high transaction costs, as well as the significant “buy and hold” positions of institutional investors.

Figure 27.
Figure 27.

LA-7 Indicators of Capital Market Growth and Size

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: Bank for International Settlements; Federation of Iberoamerican Exchanges; and Haver analytics.

80. Debt and equity markets in Latin America are generally smaller and less liquid than those found in advanced countries as well as emerging Asia and Europe. Even though most LA-7 exchanges are well established institutions that predate the great depression of the 1930s, their size and importance have tracked the cycles of macroeconomic prospects in the region. Since liberalization in the mid-1990s, Latin American stock markets have been characterized by a relatively low number of listed firms, limited sectoral diversity and a general reluctance among firms to raise capital in equity markets.

Figure 28.
Figure 28.

Average Closely Held Shares Ratio, 2011–141

(Percent of shares outstanding)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Source: Thomson Reuters Worldscope.Note: Advaned economies includes AUS, AUT, BEL, CAN, DEN, FRA, GER, HKG, IRL, ITA, JPN, KOR, NLD, NOR, SGP, ESP, SWE, GBR, and USA; emerging Asia includes CHN, IND, IDN, MYS, PAK, PHL, THA, and VNM; Emerging Europe includes BLG, CZE, HUN, POL, ROM, RUS, SLK, and TUR; LA-7 includes BRA, CHL, COL, MEX, PAN, PER, and URY.1 Closely held shares can include cross holding shares, related companies, holding companies, Governments, employees, principal indivduals or other insiders.

81. Equity market depth has been hampered by a number of factors. A significant hindrance is the ambivalence towards equity financing thought to be rooted in the tendency for family and conglomerate owners of Latin corporates to maintain strong controlling interests in their firms, thus preferring debt to equity financing. Furthermore, this creates perceptions that Latin markets have more limited “free floats” of tradable shares in the market and have corporate governances that are less responsive to minority shareholder interests.

82. Domestic bond markets are generally livelier, especially for sovereign paper, but are often considered second best options after international bond markets. Sovereigns and highly rated corporates generally find better terms (lower rates, longer maturities and larger borrowing amounts) on international markets. For most of the commodity boom period, currency risks were low and could be hedged cheaply given broad EM appreciation. Borrowers that come to domestic bond markets typically face higher (and often variable) interest rates, shorter maturities, and smaller volumes to borrow. Consequently, corporates obtains significant shares of their financing from bank loans and supplier credit, especially small and medium enterprises.

Figure 29.
Figure 29.

Equity and Bond Market Indicators

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: Bank for International Settlements; World Bank, Financial Development and Structure Database; World Federation of Exchanges and IMF staff calculations.Note: Advaned economies includes AUS, CAN, FRA, GER, HKG, ITA JPN, KOR, NOR, SGP, ESP, SWE, TWN, GBR, and USA; emerging Asia includes CHN, IND, IDN, MYS, PHL, and THA; Emerging Europe includes HUN, POL, RUS, and TUR; LA-7 includes BRA, CHL, COL, MEX, PAN, PER, and URY.

State of Play

83. One measure of capital market integration is the stock and flow of cross-border transactions in portfolio securities that are conducted through the financial networks that comprise capital markets. Financial integration literature has used both International Investment Positions (IIP) and balance of payments capital flow measures of integration into global capital markets to test theories that greater integration can help financial systems more efficiently meet domestic financing needs of governments, corporates and households in capital-scarce countries or to deliver higher financial returns in those with excess savings. The Coordinated Portfolio Investment Survey (CPIS), which reports bilateral, international portfolio asset positions (stocks) for about 80 countries with data since 2001, can be used to measure the degree of cross-holdings of portfolio securities among a subset of countries or within a region.

Figure 30.
Figure 30.

Global Integration of LA-7 Securities Markets

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Source: IMF, Coordinated Portfolio Investment Survey.1 Liability data derived from partner asset positions.2 Asset data not available.

84. Regional cross-holdings of securities have increased in most of the LA-7 economies in the last decade. Over the period 2003-2013 only Chile and Uruguay witnessed declines of regional assets as a share of total assets. However, as Uruguay comprises over half the region’s cross-border assets, rebalancing translated in a decline in the share of LA-7 asset cross-holdings. On the liability side, Chile, Mexico, Panama and Peru all increased their share of regional financing. While regionalism may have grown over the last decade, linkages with advanced country markets grew even more, such that now 91.4% of external assets and 93.9% of liabilities are held vis-à-vis advanced economies.

85. There are several impediments to regional capital market integration including:

  • Operating in the cross-currency markets add costs to transactions. Brokers, bankers, and institutional investors that do not have internal access to foreign currency and look to buy a foreign security must first sell local currency for dollars (usually through New York), then buy the foreign currency (again through New York) before buying the asset. Both F/X transactions incur charges and then incur charges again when the position is sold and receipts repatriated. Additionally, capital controls in Brazil further raise costs when investors look to enter the largest capital market in the region.

  • Higher costs to operate in local markets. In so far as there are higher transaction costs and larger bid/ask spreads in the region, smaller less liquid markets, this is likely to dampen regional investor appetites for securities in the region.

  • Poor sector diversity across some markets. The largest and most liquid debt and equity issuers in Chilean, Colombian and Peruvian markets tend to be natural resource/mining firms which over the last decade have experienced highly correlated business cycles. This is less of an issue as regards Brazil and Mexico.

  • The variance in tax rates/rules and administrative procedures. There is particular scope for standardizing and coordinating clearing and depository practices across the region.

Analysis

86. Regional capital markets are tentatively moving towards more operational integration to increase scale and address structural issues. Operational integration can take many forms such as when securities exchanges reach collaborative agreements on mutual access, post-trade clearing procedures and adopting the same electronic trading platform. Capital markets also become more synergistic when they harmonize trading hours, tax treatments and supervisory practices. Operational integration can increase when broker/dealers purchase or establish new operations abroad, facilitating the foreign trading activity of clients in both countries. Integration can also occur through enhanced infrastructure for payment and settlement across borders. LA countries could assess the compliance of regulatory frameworks of CCPs, as well as the safety and soundness of individual CCPs, using the CPSS-IOSCO PFMI through peer reviews. Upon compliance, LA-7 countries may recognize each other’s CCPs and/or regulatory frameworks.

87. LA-7 exchanges are modernizing their organizational structures, trading and settlement systems. In the last decade both BMF&Bovespa and Bolsa Mexicana stock exchanges have fully demutualized. The Chilean stock exchange is developing plans to demutualize as well. Other exchanges remain mutualized, though Bolsa de Lima and Bolsa de Colombia have publically traded floats and as such must comply with financial reporting requirements that provide greater transparency of operations. The major exchanges have adopted electronic trading platforms which facilitate more cost effective back-office support in brokerages than when OTC negotiations dominated trading. Exchanges in Brazil, Chile and Mexico, have instituted independent central counterparty (CCP) entities that settle and clear trades in all markets (stocks, bonds, foreign exchange and derivatives) as well as maintaining broker collateral against default. On the Colombian, Peruvian, Panamanian, and Uruguayan bolsas, stock and bond trades clear through the exchange itself. Bolsa de Colombia also operates a CCP for derivative and foreign exchange trades.

88. The trend for stock exchanges to build strategic alliances through ownership stakes in each other is also occurring in Latin America. Increasingly, exchanges are building international alliances with hopes of facilitating cross-border trades that may then mobilize larger pools of savings to increase market size, trading activity and cut costs through scales of operation and back-office synergies. Many global banks and exchanges have stakes in Latin American bourses, but regional cross-ownership is also on the uptick. In early 2015, BM&FBovespa purchased an 8% stake in the Santiago exchange and is working with it to set up an electronic derivatives market in Chile. BM&FBovespa was also said to be interested in acquiring stakes in the other MILA exchanges as well as the Bolsa de Buenos Aires. The acquisition in 2013 that earned the Bolsa Mexicana an 8% stake in the Lima exchange was significant, not only because it thereby became the largest independent share holder of the Peruvian Bolsa, but it signaled Mexico’s growing interest in the MILA initiative (see box 7).

89. Successfully expanding networks of internationally affiliated brokerages reduces the cost of cross-border trades and promotes greater integration. Several international brokerages have obtained seats or licenses to be broker/dealers in many LA-7 markets. While their motivations could vary substantially, likely benefits would include reducing transaction costs for regional trades (compared to similar trades with correspondent brokers); broadening client bases and hopefully transaction volumes which in turn could drive down average costs of back-office support. The larger regional players too have set up shops across borders, and thus are facilitating regional cohesion. BTG Pactual has brokerages on the most dynamic regional exchanges including those in Brazil, Chile, Colombia, Mexico, and Peru. Other investment bank/brokerages with intra-regional operations include Itau (Brazil), Sura (Colombia), Credicorp (Peru), GNB Sudameris (Colombia) and LarrainVial (Chile).

90. Greater integration of regional capital markets could potentially increase market depth, liquidity, and scale of operations for both exchanges and market participants. LA capital markets need to increase the scale of their operations to be competitive with financial markets in the United States and Europe and to overcome the emerging regulatory bias in those countries which are drawing more transactions onto their domestic exchanges. Regional integration can foster a higher volume of transactions conducted on LA exchanges, which in turn can support the engineering of LA specific financial products; preserve financial expertise and innovation in the region; and preserve regulatory expertise and surveillance of regional players. Moreover, larger regional markets are likely to attract greater extra-regional flows, thus promoting both regional and global integration.

Recommendations

  • Harmonize financial infrastructure, including through adoption of IFRS; those countries that have not yet done so should adopt the multilateral memorandum of observance of principles and practices as set out by the BIS and IOSCO related to governance, monitoring, mitigating financial and operational risk, and to exchanging information; also, where not yet done, to sign double taxation avoidance treaties; and over time to seek convergence in tax rates.

  • Encourage inter-operability of trading and settlement platforms across the region that will lower trading costs by reducing reliance on correspondent brokerage services.

  • Harmonize trading and extended trading hours.

  • Broker-dealers to be permitted to operate cross-country, while subject to supervision from both home and host supervisors, and receive the same regulatory treatment as domestic firms.

Mexico: Interest Rate Derivatives Market

The bulk of the interest rate derivatives denominated in Mexican peso continue to be traded predominantly in the offshore markets, mainly in the US. Mexico’s vibrant interest rate derivatives market is largely comprised of TIIE (Tasa de Interes Interbancaria de Equilibio, the equilibrium interbank interest rate) interest rate swaps, with an overwhelming share of trading taking place outside of platforms via the OTC market. OTC turnover of single currency interest rate derivatives denominated in the Mexican peso stood at USD 12.3 bn in April 20131, representing about 0.4% of the global OTC single currency interest rate derivatives market, trailing only the OTC interest rate market denominated in the Brazilian real and as the second largest in Latin America2. However, less than a fifth (USD 2.4 billion) of the Mexican peso turnover is cleared in Mexico, while the remaining 82 percent clear through offshore markets, mainly in the US.

A number of factors have accounted for the burgeoning offshore OTC market, including close ties with the US, delay in establishing a well-functioning trading platform, and lower costs of OTC transactions. Despite its establishment in the late 90’s, MexDer—Mexican derivatives platform (Mercado Mexicano de derivados)—became an important financial player only a few years ago. Thus, until recently, in the absence of a well-functioning platform, interest rate hedging needs were predominantly met through the OTC market. Higher fees, associated largely with the technological and technical costs of the trading platform, continue to contribute to the general preference for the OTC market.

The GFC prompted regulatory changes aimed to provide transparency and reduce counterparty risks in the global derivatives markets. Recent regulatory adjustments in the EU and US call for the trading of standardized OTC derivative contracts on exchanges or electronic platforms, and for their clearance through a recognized CCP, while non-centrally cleared contracts would be subject to higher capital requirements. In the spirit of alignment with the global standards, the Mexican authorities introduced a new regulation, scheduled for gradual implementation, which will require OTC derivative trades to take place on exchanges or through inter-dealer brokers, and calls for a mandatory clearing of standardized derivatives through a CCP – Mexican (established in Mexico and authorized by the SHCP) or foreign (if recognized by Banco de Mexico). In April 2016, compliance with the new regulation will be required for transactions between Mexican entities, while November 2016 is the start date for transactions involving foreign financial institutions.

In addition to making derivatives markets safer, the regulation is expected to improve competition between the domestic and foreign clearing houses. Over the medium term, the new Mexican regulation is broadly expected to increase the volume of contracts traded through MexDer and cleared through Asigna – the Mexican central clearing counterparty house for derivatives. However, given the large presence of foreign institutions, going forward, Asigna is likely to continue facing strong competition from offshore CCPs, such as CME (Chicago Mercantile Exchange) and LHC. Clearnet Ltd (European clearing house), for example, as foreign institutions are expected to continue clearing their derivatives offshore. By clearing through a CCP in the parent country, multinational entities can consolidate their operations through netting their derivative positions vis-à-vis the positions of the parent and other subsidiaries, thereby decreasing capital requirements. Operations of MexDer and Asigna, are likely to continue expanding largely through the derivative trading businesses of Mexican institutional investors, such as pension funds. While the new regulatory changes constitute a welcome step to market transparency and lower risk, further technical and technological improvements are required to boost Asigna’s and MexDer’s competitiveness.

1Based on Triennial Central Bank Survey, BIS.2Database covers following Latin American countries: Argentina, Brazil, Chile, Colombia, Mexico, and Peru.

Latin American OTC Interest Rate Derivatives1

Interest rate derivatives in LA-62 currencies represent about 1.2% of the global derivative turnover, with Brazilian real and Mexican peso constituting 60% of the market, largely in swaps.

uA01fig06

OTC Interest Rate Derivative Turnover

(In USD bn, single currency, by instrument and currency, April 2013)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: BIS Triennial Survey (2013); and IMF staff estimates and calculations.1/ TOT = all currencies, ARS=Argentine peso, BRL=Brazilian real, CLP=Chilean peso, COP=Colomnian peso, MXN=Mexican peso, PEN= Peruvian New Sol.

Interest rate swaps represent the larger portion of instruments in LAC-6 currencies, with a larger portion of cross-border activity.

uA01fig07

OTC Interest Rate Derivative Turnover: Swaps

(In USD bn, single currency, by currency, April 2013)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: BIS Triennial Survey (2013); and IMF staff estimates and calculations.1/ Total = total, ARS=Argentine peso, BRL=Brazilian real, CLP=Chilean peso, COP=Colomnian peso, MXN=Mexican peso, PEN= Peruvian New Sol.

Most of the interest rate derivatives in LA-6 currencies are traded in the US, while only about 16% is traded domestically.

uA01fig08

OTC Interest Rate Derivative Turnover

(In percent, single currency, by country and currency, April 20131)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: BIS Triennial Survey (2013); and IMF staff estimates and calculations.1 Total = total, ARS=Argentine peso, BRL=Brazilian real, CLP=Chilean peso, COP=Colomnian peso, MXN=Mexican peso, PEN= Peruvian New Sol. Forward rate agreements, swaps, options and other products. Adjusted for local inter-dealer double-counting (ie “net-gross” basis). 2 All Latin American currencies in the sample.

Majority of interest rate derivative transactions in Latin American are conducted with other financial institutions, in instruments denominated in Mexican and Colombian currencies, however, reporting dealers play a larger role.

uA01fig09

OTC Interest Rate Derivative Turnover

(In pernce of total, single currency, by counterparty and currency, April 2013)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: BIS Triennial Survey (2013); and IMF staff estimates and calculations.1/ Total = total, ARS=Argentine peso, BRL=Brazilian real, CLP=Chilean peso, COP=Colomnian peso, MXN=Mexican peso, PEN= Peruvian New Sol.

Offshore trading is mostly done with other financial institutions as the main counterparties.

uA01fig10

OTC Interest Rate Derivative Turnover: Swaps

(In pernce of total, single currency, by counterparty and currency, April 2013)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: BIS Triennial Survey (2013); and IMF staff estimates and calculations.1/ Total = total, ARS=Argentine peso, BRL=Brazilian real, CLP=Chilean peso, COP=Colomnian peso, MXN=Mexican peso, PEN= Peruvian New Sol.

There is a lot of heterogeneity in the domestic IRS markets, as USD is the primary currency used in CHL and PER, while Brazil, Mexico, Argentina, and Colombia have IRS markets primarily dominated by domestic currencies.

uA01fig11

OTC Interest Rate Derivative Turnover

(In percent, single currency, by country and currency, April 20131)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: BIS Triennial Survey (2013); and IMF staff estimates and calculations.Adjusted for local inter-dealer double-counting (ie “net-gross” basis).
1For definitions of categories refer to the source: BIS Triennial Survey (2013).2LA-6 refers to Argentina, Brazil, Chile, Colombia, Mexico, Peru.

Foreign Exchange Turnover of Latin American Currencies

Offshore trading continues to dominate turnover rates of LA currencies, with the majority of transactions taking place in the US and the UK1. Foreign exchange turnover of emerging market currencies has been predominantly driven by the offshore component in many regions, which testifies to the growing currency internationalization, particularly as foreign exchange turnover expansion outpaces trade growth. Latin America continues to have the largest share of offshore currency trading among emerging markets, closely followed by Central and Eastern Europe (CEE), and well above the Emerging Asian economies. Market patterns of offshore turnover of the currencies of Latin America, Emerging Asia, and CEE, however, appear to vary in response to geographic proximity, as well as trade and financial linkages with offshore jurisdictions. Emerging Asian currencies, for example, have the lowest share of offshore trading and nearly half of their offshore transactions occur in the regional financial centers—Hong Kong SAR and Singapore. Offshore trades of LA and CEE currencies, however, are largely concentrated in extra-regional financial centers, given the absence of sufficiently large financial centers in the region. While the majority of offshore turnover of CEE currencies occurs in the UK, financial centers in the US constitute the largest markets for trading LA currencies, accounting for more than half of the offshore turnover.

uA01fig12

Offshore Trading of Emerging Market Currencies

(In percent of total onshore and offshore OTC FX market turnover1)

Citation: Policy Papers 2016, 023; 10.5089/9781498345897.007.A001

Sources: BIS Triennial Central Bank Survey and BIS calculations; and IMF staff calculations.1 Dailyaverage in April 2013. Adjusted for local and cross-border inter-dealer double-counting (ie net-net basis). Latin American currencies (LA) = Argentine peso, Brazilian real, Chilean peso, Colombian peso, Mexican peso and Peruvian new sol. Weighted averages based on FX turnover. Central and eastern European currencies = Bulgarian lev, Czech koruna, Hungarian forint, Lithuanian litas, Latvian lats, Polish zloty, Romanian leu, Russian rouble and Turkish lira. Emerging Asian currencies = Chinese renminbi, New Taiwan dollar, Hong Kong dollar, Indian rupee, Indonesian rupiah, Korean won, Malaysian ringgit, Philippine peso, Singapore dollar and Thai baht. All emerging market currencies = Asia, CEE, LA, Bahrain dinar, Israeli new shekel, South African rand and Saudi riyal. 2 Intraregional is defined as all offshore trades within the respective EM region. 3 Regional centers: Hong Kong SAR and Singapore for EM Asia, Brazil and Mexico for Latim America, adn Turkey and Russkia for CEE.

Global turnover of LA currencies is dominated by the Mexican peso, and followed by the Brazilian real. The Mexican peso accounts for about 65 percent of offshore turnover of LA currencies. In 2013, the Mexican peso joined the ranks of the ten most traded currencies, largely against the US dollar and in the form of foreign exchange swaps and spot transactions. In terms of turnover ranking, the Mexican peso is only trailing the national currencies of the United States, European Union, Japan, United Kingdom, Australia, Switzerland, and Canada. The Mexican peso is fully convertible, free-floating, without any exchange controls, and widely accepted across the world. It saw one of the biggest increases in market share up to 2013 among the major emerging market currencies, when its turnover reached US$135 billion, raising its market share in global FX trading to 2.5%, from 1.3% in 20102, and significantly lifting Mexican peso turnover in the domestic market and in offshore jurisdictions. At 80 percent, the share of offshore trading of Mexican peso is among the highest among emerging markets, only trailing the Polish Zloty and the Turkish lira.

Turnover in the Mexican peso increased largely on account of strengthening investor confidence and growing market liquidity. Unrestricted access, given that the Mexican peso trades globally 24 hours a day, plays a fundamental role in its rising popularity. The high liquidity of Mexican assets also stimulates turnover of the domestic currency. Its popularity received a boost after the size of the Mexican bond market led Citigroup to add Mexican peso-denominated debt to its World Government Bond Index in late 2010, making Mexico the first Latin American country in the benchmark.

In 2013 the Mexican peso joined the ranks of the most traded currencies…

uA01fig13