1 The Interactions between Macro and Micro Prudential Regulation: Some Reflections based on Latin America Miguel A. Kiguel Econviews and Universidad Torcuato Di Tella October 2009

2 Contents  Why didn’t Latam countries experience a banking crisis this time?  What is different about the Latin American banking systems?  What principles should guide financial regulation in LA countries?  Credit rating agencies, countercyclical policies, Regulation perimeters and other topics  Final reflections

3  LA countries entered the crisis without significant macroeconomic imbalances.  The policy response to the crisis did not destabilize the banks balance sheets, not even in the dollarized economies  The external accounts were in good shape, and the level of international reserves high.  As banks had been reducing their exposure to the public sector, the fall in government bond prices did not have a large impact on their balance sheet.  Good Luck, because the crisis was short. Why didn’t Latin American countries experience a crisis this time?

4  The micro-prudential regulations and supervision helped: Banks were well capitalized NPLs were low and well provisioned more than adequate levels of liquidity.  The fact that the banking systems were small helped to reduce the potential size of the problem.  There were no toxic assets, structured products or off-balance sheet itmes  Central banks were in a better position to provide liquidity and to successfully perform their roles as lender of last resort as inflation was low. Why didn’t Latin American countries experience a crisis this time?

5 What is different about the Latin American banking systems ?  Financial systems tend to be small and dominated by commercial banks.  No toxic assets, less off-balance sheet items and small derivatives transactions.  Capital markets play a smaller role and the markets for derivatives and structured products are still in the process of being developed.  The degree of dollarization in the financial sector is significant. Central Bank limited to act as lender of last resort, potential currency mismatches.

6 What is different about the Latin American banking systems ?

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9  Sovereign credit ratings below investment grade levels; governments could face difficulties and lack of credibility if they need to assist banks in a crisis.  In most countries the systems are highly concentrated and in several countries they are dominated by either foreign or publicly owned institutions.  Much more macroeconomic volatility regarding the intensity of the business cycles and the fluctuations in key financial variables. What is different about the Latin American banking systems ?

10 What is different about the Latin American banking systems ?

11 What is different about the Latin American banking systems?

12 What principles should guide financial regulations?  Basel guidelines to maintain the soundness of “individual” banks to address moral hazard and asymmetric information. Instruments are capital and liquidity requirements and provisions.  Systemic safety net to address externalities and contagion (deposit insurance system, lender of last resort, resolution mechanisms for failing banks).  Regulatory issues entail trade-offs between the two approaches. The pendulum is currently shifting towards the systemic problem issues.

13 More emphasis on systemic problems is needed in at least three ways 1. Redefining and enlarging the perimeter of regulation (investment banks and other institutions that operate in the capital markets). 2. Role of credit rating agencies and mono-line credit insures, among others, needs to be reconsidered. 3. In many cases neither the Basel agreements nor most regulatory frameworks have managed to address in a satisfactory way issues such as:  Treatment of liquidity  Cyclical aspects  Asset bubbles  Macro-financial risks  Too big too fail and too small to care

14 Large financial dollarization Regulatory responses:  Micro-prudential level: stricter capital requirements on foreign currency loans and higher reserve (or liquidity) requirements.  Macro-prudential level: enhance the ability of the Central Bank to act as lender of last resort and impose regulations to limit dollar loans within the country, imposing gates or circuit breakers as a way to stop a panic.

15 Low sovereign credit ratings  The banking systems already have high capital ratios

16  Brunnermeier et. al (2009), classify banks in four groups, depending on their systemic effects: 1. Individually Systemic 2. Systemic as part of a herd 3. Non-systemic large 4. Tinies  We need to think twice about the regulation of non-systemic institutions, as they could have contagion effects Macro-regulation required Less regulation required Size of financial institutions matters

17 Do ownership and the business model matter?  Are foreign banks a blessing or a curse? Do they behave in pro-cyclical or countercyclical way?  Are public sector banks fashionable again?  Is there a role for cooperatives, “mutuales” and other type of specialized banks (such as mortgage banks?)

18 Large macroeconomic and financial volatility has affected bank performance  Latin America is by far the most volatile Region Very unstable funding from deposits and capital markets large increases in NPLs during recessions, large fluctuations in the prices of the bonds and other liquid instruments.

19  Regulations need to be stricter than in more stable economies; the argument for countercyclical policies is stronger: Higher capital requirements, more conservative rules for provisioning and more attention to liquidity requirements, incorporating the point in the business cycle in which the economy is at a given point in time, using prudent rules that take into account large fluctuations in asset prices. Valuation methods matters (book values, market values, fair values, mark to funding) Large macroeconomic and financial volatility

20 Credit Rating Agencies  Redefining and reducing their role within regulatory frameworks.  Making a more comprehensive rating that: not only includes individual rating of the financial instrument, considers some additional features (i.e: its liquidity and the macroeconomic risk).  The solution does not seem to be a government agency that takes over the CRAs role as: A government agency is unlikely to do a better job than a private one, there is a big risk of ratings becoming “politicized”.

21 The Regulation Perimeter  Institutions that need to be regulated are those that: Can be subjected to runs, Their failure can have an effect on systemic liquidity or solvency, Liabilities are set in nominal terms while its assets can experience variations when valued at mark to market prices (i.e. money market funds), Financial institutions that are interconnected with the banking system.

22 Final Reflections  This crisis indicates that the interconnection among different players of the financial is significant  The run was on capital market instruments and not on deposits  It raises questions about Narrow banking Universal banks and financial groups Who is potentially a candidate to receive liquidity assistance? Whether bank regulation should be inside or outside of the Central Bank (as it is the lender of last resort) Whether different regulatory criteria is acceptable for different financial intermediaries