BANKING CRISES IN LATIN AMERICA AND THE POLITICAL ECONOMY OF FINANCIAL SECTOR POLICY Agustin Carstens International Monetary Fund March 28, 2004

2 Uruguay’s ex-President Sanguinetti summarized precisely a widely held view about banking in Latin America when he said: “The banking system will never take you to paradise, but it can bury you in hell in an afternoon.”

3 Countries of LAC Have Suffered Numerous Episodes of Financial Sector Difficulties Subjects of concern:  Frequency  Severity  Tendency to repeat

4  Frequency and Repetitiveness From 1980 onwards, 22 countries in LA have suffered either a financial sector crisis or financial system distress and averted crises Number of EpisodesNumber of Countries

5  Severity Crises have been extremely costly from the point of view of: ― Public debt ― Economic activity

6  Severity (cont’d) Fiscal costs Fiscal Costs of Banking Resolution, Type of Countries Number of Crises Average Nonperforming Loans (% of total loans) Fiscal Cost (% of GDP) LAC Developed71412 Source: Hoggarth and Sapporta (2003) and IMF staff estimates.

7  Severity (cont’d) Banking crises accelerates dramatically in short periods of time the accumulation of public debt: ― During the last ten years, six countries in LAC have seen their public debt increase by about 40 percentage points in terms of GDP within one year

8 Speed kills

9  Propensity to Crisis Repetitiveness “Short-termism” and low intermediation Bank Intermediation in Developing Countries, (in percent) Bank DepositsBank Credit Median Upper Quartile Lower Quartile Median Upper Quartile Lower Quartile LAC Other developing countries Sources: IFS, IMF staff estimates.

10  Propensity to Crisis Repetitiveness (cont’d) Poorly enforced property and creditor rights High interest rate spreads Cost of bank rescue might threaten fiscal sustainability

11 Institutional Factors that Exacerbate Banking Distress Deficiencies in prudential regulation and supervision FSAPS in Latin America: Summary of Main Findings Observance of Basel Core Principles for Effective Banking Supervision (Percentage of countries “materially non-compliant” or non-compliant”) Basel Core PrincipleAll Countries Other Developing Countries Latin American and Caribbean Countries Independence Legal Framework Legal Protection Capital Adequacy Loan Evaluation and Loan-Loss Provisioning Market Risks Internal Control and Audit Off-Site Supervision Consolidated Supervision535575

12 Main Policy Change  Supervisory and Regulatory Independence Analogy with approach to combat inflation It is essential that society express its outcry for financial stability by enshrining in the law their desire of having within the state an institution exclusively devoted to this objective. Key elements: a.Supervisory authority needs mandate to procure above all financial soundness; b.Autonomy in decision-making; c.Availability of resources; d.Accountability regime.

13 Urgent Need to Strengthen Institutions and Supervisory and Regulatory Framework  Some policy priorities Limits on exposure to government Stronger governance of state banks –Clear and well-defined objectives –Provision of the means to fulfill such mandate –Isolation of institutions as much as possible from political pressures –Strict supervision and regulation Adaptation of supervision and regulation to new challenges –Risk-based supervision –Off-balance sheet exposures –Conglomerates and cross-border financial institutions Effective crisis management

14 Causes and Triggers of Banking System Distress The key issues associated with crises in LAC are: –A boom in credit for the private sector, both for consumption and investment –Wholesale liberalization in the absence of an appropriate and effective prudential regulatory framework –Direct effect of fiscal difficulties on the banking system –Contagion and spill-overs –Terms of trade shocks and movements in RER –Political instability, unrest, and, in some cases, civil conflict

15 Output Losses Associated with Banking Crises ( ) Number of Crises Average Crises Length (in years) Average Cumulative Output Losses (in percent of GDP) All Single banking crises Twin banking and currency crises Developed Countries Emerging market countries Sources: Hoggarth and Sapporta, 2001.