Regulatory and Supervisory Reform: Going back to Basics: The Latin American Perspective MÓNICA APARICIO SMITH Madrid, June 15, 2009

Table of contents 1. The origins of the financial crisis and its impact on LAC 2. Why LAC has been less vulnerable than in previous episodes? 3. Regulatory and supervisory changes. 4. The financial safety net and the deposit insurance. 2

After Mar/09 From sep/08 to feb/09 (After Lehman) In contrast to previous episodes, LAC countries have not been the origin of the crisis, nor have contributed to its deepening. Instead, the origin of this crisis has been the breakdown of the American economy, as a result of its monetary policy, its financial regulation and supervision, its subsidies policies which generated an asset price bubble, its inadequate risk measurement, its management incentive policies, etc. It is difficult to find a bigger package of errors. Facing the crisis, LAC countries have experimented three moments: 1. The origins of the financial crisis and its impact on LAC Before sep/08 Some Governments and experts argued that LAC would remain immune to the possible crisis effects (Decoupling). The crisis hit the region, fostering deep plunge in the stock market, depreciations of local currencies and sudden stop of capital flows. LAC markets “cooled down” due to the stabilization of world market indicators and to the relatively strengthen of LAC financial systems. 3

Due to the advances LAC countries have made during the last decade, the region is now better prepared to deal with a financial crisis: Macroeconomic factors Today, macroeconomic “fundamentals” of the majority of the LAC economies are more robust, as a result of the world economic “boom”: Fiscal Imbalances are improved and current account deficits almost disappeared. Macroeconomic reforms in many LAC countries on inflation-targeting regimes, floating exchange rates and counter cyclical monetary policies helped. 2. Why has LAC been less vulnerable than in previous episodes? 4

Source: IMF, WEO (2009) Current account balance in LAC % of GDP Overall balance in LAC-7* % of GDP External debt in LAC % of GDP Source: IMF, WEO (2009) n.a. * LAC-7 includes Argentina, Brazil, México, Chile, Colombia, Peru and Venezuela. Source: IADB In fact, LAC has strengthened its monetary, fiscal, and external fronts Exchange rate index (January 2006=100) Source: Bloomberg 5

LAC countries have been able to adopt counter-cyclical macroeconomic policies Monetary policyFiscal policy LAC countries that have adopted or announced expansive policies (% of the sample 1/ ) Source: CEPAL 1/ 33 countries in LAC Source: IADB 6

Governments, bankers and depositors of the region have learned from the financial crises lived in the last twenty years. 12 countries in Latinamerica lived a major financial crisis during the nineties. LAC´s financial systems have adjusted their prudential regulation to international standards (capital requirements and provisions). Current figures show solvency ratios above 13%. LAC financial institutions have reduced their exposure to US dollar assets and liabilities. Foreign bank branches in LAC countries, which hold an important portion of these financial markets, fund their positions mainly with local deposits instead of cross border operations. Microeconomic factors 7 2. Why has LAC been less vulnerable than in previous episodes?

The underdevelopment of LAC´s capital markets explained the low amount of toxic assets hold by the banks of the region. Many LAC countries established capital controls and limits on bank's exposure to financial innovations ( complex derivates and structured products). In most LAC countries, the share of state-owned banks in their financial systems has declined in an important way. Microeconomic Factors (continuation) 8 2. Why LAC has been less vulnerable than in previous episodes?

Source: Laeven y Valencia (2008). Colombia 99 estimation Fogafin. As a response to the financial crises the region lived in the nineties, LAC´s financial systems started a strengthening process 9 Capital adequacy ratio (Regulatory capital to risk weighted assets) Nonperfoming Loans ratio Fiscal Cost of financial crisis % of GDP Source: IMF, Regional economic outlook: Western Hemisphere. May 2009

The international debate on reforming the financial regulatory framework has just started. LAC countries should not rush to implement new measures without balancing their implications. In low developed financial markets, such as LAC, it is important to avoid the temptation of “over-regulate” and “over-intervene” the financial activity, under the premise that the financial integration is a threat to the economic growth. Risk assessment statistical models do not substitute: good management, business knowledge, adequate in-situ supervision, and prudential regulation. According to some important authors, the focus of the regulatory reform should not be only on capital requirements. The main problem of the actual crisis is the risk measurement Regulatory and supervisory changes.

3. Regulatory and supervisory changes Macro prudential policies: In order to face the asset price bubble and financial instability, central banks should make efforts to accelerate the transmission channel from the monetary policy to the credit and expense channel(Colombian case). Prudential regulation should increase capital requirements and provisions in “good times” as function of credit growth and asset price growth so financial institutions will have a “back-up” during recessions. 11

4. The Financial Safety Net and the Deposit Insurance Regulator Deposit Insurer Supervisor FINANCIAL SYSTEM Lender of last resort Coordination among safety net participants. Universal deposit insurance coverage vs. market discipline. Today we have an implicit and explicit deposit insurance. Too big to fail vs. Moral Hazard. Role of the financial safety net dealing with “non-bank financial intermediaries”. Main topics 12

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