1

Surviving Financial Surviving Financial Turbulence: Tales from Turbulence: Tales from and for Latin Americaand for Latin America

Andrew PowellAndrew Powell

Inter American Development BankInter American Development Bank

Pontificia UniversidadPontificia Universidad

Católica del PerúCatólica del Perú

Lima, November 9Lima, November 9thth 2011 2011

Opinions are strictly those of the author and are not necessarily those of the IDB or any other

institution.

2

OutlineOutline A) Latin America has learned important lessons A) Latin America has learned important lessons

from its financial history, and escaped the worst of from its financial history, and escaped the worst of the crisisthe crisis

B) The G20 has set an ambitious agenda regarding B) The G20 has set an ambitious agenda regarding financial sector reform in response to the crisisfinancial sector reform in response to the crisis

C) Regulatory innovations in the North: (Dodd-C) Regulatory innovations in the North: (Dodd-Frank (US), ICB (UK) – Euroland overtaken by Frank (US), ICB (UK) – Euroland overtaken by events).events).

D) Given capital inflows and strong growth in D) Given capital inflows and strong growth in credit, LAC needs a strong financial sector!credit, LAC needs a strong financial sector!

E) What is LAC doing, what needs to be done?E) What is LAC doing, what needs to be done? F) A Proposal – Lima IF) A Proposal – Lima I

3

Lessons from LAC Financial Lessons from LAC Financial HistoryHistory

4

On LAC’ s (Recent) Financial On LAC’ s (Recent) Financial HistoryHistory

The debt crisis of the 1980’s – US interest rates, The debt crisis of the 1980’s – US interest rates, commodity prices, sovereign debt, banking crises.commodity prices, sovereign debt, banking crises.

Tequila in the 1990’s – liquidity, financial crisesTequila in the 1990’s – liquidity, financial crises The 1997 Asian crisis & 1998 Russian default – The 1997 Asian crisis & 1998 Russian default –

contagion!contagion! The Argentine crisis of 2002 – fixed money with not The Argentine crisis of 2002 – fixed money with not

so flexible prices/wages, sovereign debt & banks and so flexible prices/wages, sovereign debt & banks and “innovative” resolution: “asymmetric pessification”, “innovative” resolution: “asymmetric pessification”, “aggressive default”, deep recession but then “aggressive default”, deep recession but then growth...growth...

5

Financial vs. Other Financial vs. Other CrisesCrises

Financial crises are crises of stocks, Financial crises are crises of stocks, balance of payments crises are related to balance of payments crises are related to flowsflows

Rheinhart and Rogoff (“This time is Rheinhart and Rogoff (“This time is different: eight centuries of financial different: eight centuries of financial folly”), document that financial crises are folly”), document that financial crises are deeper and more persistentdeeper and more persistent

Financial crises: resolution frequently Financial crises: resolution frequently requires significant use of public money requires significant use of public money and may provoke redistributions of and may provoke redistributions of wealthwealth

6

LAC Has Strengthened Its LAC Has Strengthened Its DefensesDefenses

ReservesReserves Financial SystemsFinancial Systems Regulation and SupervisionRegulation and Supervision International InsuranceInternational Insurance

7

Reserves Pre-Crisis and End Reserves Pre-Crisis and End of 2010of 2010

0% 10% 20% 30% 40% 50% 60%

EcuadorDominican Rep

ColombiaPanamaMexico

BahamasVenezuelaCosta Rica

El SalvadorChile

BrazilArgentina

GuatemalaBelize

JamaicaHondurasBarbadosUruguay

SurinameParaguay

HaitiNicaragua

PeruGuyana

Trinidad and TobagoBolivia

Reserves 2010 Reserves 2007Source: LMW on National Sources

Reserves as % of GDP, end of period

8

Bank (Regulatory) CapitalBank (Regulatory) Capital

8 10 12 14 16 18 20

Argentina

Bolivia

Brazil

Chile

Colombia

Costa Rica

Dominican Republic

Ecuador

El Salvador

Guatemala

Mexico

Panama

Paraguay

Peru

Uruguay

Venezuela

Average requirements (exigencias) are around 11%, the average regulatory ratio (integracion) is around 16%. Source: IMF, GFSR.

9

Regulation and Regulation and SupervisionSupervision

LAC regulators have become more LAC regulators have become more professionalprofessional

Supervision has improvedSupervision has improved Monitoring has been usefulMonitoring has been useful

– – e.g.: IMF/WB FSAP programe.g.: IMF/WB FSAP program

10

International Insurance International Insurance

Source: Bloomberg and Staff estimations

A) LAC Countries with no access to ILOR during Lehman

B) Countries with access to ILOR in Lehman with same credit ratings as A

C) LAC Countries with access to ILOLR during Lehman

11

The Ambitious G20The Ambitious G20Reform Agenda and Reform Agenda and

Regulatory Innovations Regulatory Innovations from the Northfrom the North

12

Elements of the G20 AgendaElements of the G20 Agenda 1. Bank Capital 2. Bank Liquidity 3. Complexity and cross border issues3. Complexity and cross border issues

Other Issues:Other Issues: Systemic institutions Systemic institutions intensive supervision, additional capital, intensive supervision, additional capital,

liquidity, and other prudential requirementsliquidity, and other prudential requirements Derivatives: standardized OTC contracts should be traded Derivatives: standardized OTC contracts should be traded

on exchangeson exchanges or electronic trading platforms, where or electronic trading platforms, where appropriate, and cleared through central counterpartiesappropriate, and cleared through central counterparties

Rating Agencies, Rating Agencies, oversight of the ratings businessoversight of the ratings business CompensationCompensation packages packages A single set of A single set of global accounting standardsglobal accounting standards Countermeasures against Countermeasures against tax havenstax havens

Other LA issues I will Other LA issues I will notnot talk about today talk about today (dollarization, lending to public sector, related (dollarization, lending to public sector, related lending)lending)

Basel N (N=1,2,3)

13

Dodd-Frank (US)Dodd-Frank (US) Includes a serious attempt to limit the Executive’s powers Includes a serious attempt to limit the Executive’s powers

to bail-out financial institutionsto bail-out financial institutions A failing institution to be liquidated or resolved by “title 2” A failing institution to be liquidated or resolved by “title 2”

resolutionresolution Under “Title 2”, the State has the power to create a good Under “Title 2”, the State has the power to create a good

and bad bank and then sell the good bank (to some extent and bad bank and then sell the good bank (to some extent similar to some LAC bank resolution rules)similar to some LAC bank resolution rules)

But rules on market concentration may prevent selling the But rules on market concentration may prevent selling the “good bank” to another large existing entity.“good bank” to another large existing entity.

The idea is that limiting bail out powers ex ante will create The idea is that limiting bail out powers ex ante will create disciplinediscipline

Significant uncertainty as to how would be applied in Significant uncertainty as to how would be applied in practice, especially in a potentially systemic crisispractice, especially in a potentially systemic crisis

See a simulation of a major US bank failure under Dodd-See a simulation of a major US bank failure under Dodd-Frank at a recent Economist conference in NY. Frank at a recent Economist conference in NY. www.economist.com/blogs/freeexchange/2011/11/banking-regulationwww.economist.com/blogs/freeexchange/2011/11/banking-regulation

14

Independent Commission on Independent Commission on Banking, ICB – (Vickers Banking, ICB – (Vickers

Report, UK)Report, UK) Separation of Investment and Retail Banking with Chinese Separation of Investment and Retail Banking with Chinese wallswalls

Prohibited Services in Retail include:Prohibited Services in Retail include: any service which would result in a trading book asset;any service which would result in a trading book asset; any service which would result in a requirement to hold regulatory any service which would result in a requirement to hold regulatory

capital against market riskcapital against market risk any service which results in an exposure to a non-ring-fenced bank any service which results in an exposure to a non-ring-fenced bank

or a non-bank financial organization, except those associated with or a non-bank financial organization, except those associated with the provision of payments services where the regulator has the provision of payments services where the regulator has deemed this appropriatedeemed this appropriate

the purchase or origination of derivatives or other contractsthe purchase or origination of derivatives or other contracts which would result in a requirement to hold regulatory capital which would result in a requirement to hold regulatory capital

against counterparty credit risk; and services relating to secondary against counterparty credit risk; and services relating to secondary markets activity including the purchase of loans or securities.markets activity including the purchase of loans or securities.

Authors note: “A ring-fence of this kind would also have the Authors note: “A ring-fence of this kind would also have the benefit that ring-fenced banks would be more straightforward benefit that ring-fenced banks would be more straightforward than some existing banking structures and thus easier to than some existing banking structures and thus easier to manage, monitor and regulate”.manage, monitor and regulate”.

See Chapter 3, Independent Commission on Banking (2011): See Chapter 3, Independent Commission on Banking (2011): Final Report: Recommendations, London: ICB.Final Report: Recommendations, London: ICB.

Commission also recommends UK following Switzerland’s lead Commission also recommends UK following Switzerland’s lead and introduce the use of Coco’sand introduce the use of Coco’s

15

The Latin American The Latin American Context:Context:

Now is the time to ActNow is the time to Act

16

Latin America: Capital Latin America: Capital InflowsInflows

-6%

-4%

-2%

0%

2%

4%

6%

8%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Inflows Outflows E&O (Net) Net Flows

% of GDP2008 was an interruption of the current episode

Inflows

Outlfows

Net Flows

For LAC 7 Economies

17

The Changing Composition of The Changing Composition of InflowsInflows

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

% o

f GD

P

FDI Portfolio Other

Now More Capital Inflows are Portfolio and Bank – in “Other”

In 2006, FDI was >2/3, now <1/3

18

Strong Growth in Domestic Strong Growth in Domestic CreditCredit

Source: National Sources-10.0 -5.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0

Trinidad and TobagoEl SalvadorNicaragua

JamaicaBelize

SurinameBahamasUruguay

Costa RicaHaiti

BarbadosHonduras

GuatemalaMexico

ChileColombia

PanamaGuyana

PeruEcuador

VenezuelaBolivia

BrazilDominican Rep

ArgentinaParaguay

Credit to the Private SectorCurrent Prices- annual average

% change

2009

2010

19

Strong Appreciation Strong Appreciation PressuresPressures

Source: Staff on National Sources

Multilateral Real Exchange Rates(a higher index implies depreciation)

60

70

80

90

100

110

120

130

Brazil Chile Colombia Costa Rica Mexico Peru Uruguay

Mexico: the only “depreciator” in this sample

Significant depreciations in the crisis, save Uruguay and Peru

Large appreciations post crisis

20

Current Accounts Now Mostly in Current Accounts Now Mostly in Negative Territory Negative Territory

Source: WEO, IMF

21

Fiscal Balances have Fiscal Balances have DeterioratedDeteriorated

Source: WEO, IMF

Fiscal Balance% of GDP

22

““Structural Balances” Structural Balances” Deteriorated Deteriorated

23

Ongoing analysis of Emerging Ongoing analysis of Emerging Economy Capital Inflow Economy Capital Inflow

Episodes Episodes

Of the 91 Capital Inflow Episodes:Of the 91 Capital Inflow Episodes: 29% Ended in a Banking Crisis29% Ended in a Banking Crisis 53% Ended in a Recession53% Ended in a Recession 59% Ended in a Banking Crisis or a 59% Ended in a Banking Crisis or a

RecessionRecession

24

      Banking CrisisBanking Crisis    RecessionRecession      Def 1Def 1    Def 2Def 2    Def 3Def 3    Def 1Def 1    Def 2Def 2    Def 3Def 3

Inflow Inflow CharacteristicsCharacteristics                                                                          

Total InflowsTotal Inflows                                    

                                      

Portfolio InflowsPortfolio Inflows                                    

                                      

Debt SecuritiesDebt Securities                                    

                                      

Banking FlowsBanking Flows                                                                          

Banking Banking CharacteristicsCharacteristics                                                                          

Directed CreditDirected Credit                                    

                                      

Banking SupervisionBanking Supervision                                    

                                      

Increase in CreditIncrease in Credit                                                                                                                

Inflows and their Inflows and their ImpactsImpacts                                    

                                      

Outflows/GDPOutflows/GDP                                    

                                      

Real AppreciationReal Appreciation                                    

                                      

Change in Reserves +Change in Reserves +                                    

Key: Red implies greater risk of a crisis higher is variableE.g.: Higher

portfolio inflows imply greater risks, as does faster increase in credit and appreciation

25

On LAC Financial Reform:On LAC Financial Reform:Capital, Liquidity, Complexity, Capital, Liquidity, Complexity,

DisciplineDiscipline

26

1. Bank Capital1. Bank Capital

Level and QualityLevel and Quality Cyclical BehaviourCyclical Behaviour Basel II “Approaches”Basel II “Approaches” ProvisionsProvisions

27

Bank Capital: where was the Bank Capital: where was the crisis?…crisis?…

8

10

12

14

16

18

20

2005 2006 2007 2008 2009

Germany

Japan

Spain

Switzerland

United Kingdom

United States

Regulatory Capital to Assets at Risk. Source: IMF GFSR

28

Quality Not Quantity:Quality Not Quantity:Capital Increases by Type Capital Increases by Type

2000-20082000-2008

Source: Archyra et al (2009) for a sample of major banks in each regionSource: Archyra et al (2009) for a sample of major banks in each region

-200

0

200

400

600

800

1000

1200

1400

US$bn

US UK Euro

Subordinated Debt

Preferential Shares

Ordinary Shares

29

Basel II vs. Basel III:Basel II vs. Basel III:Schematic Representation of Schematic Representation of

RequirementsRequirements

0

2

4

6

8

10

12

14

Basel II Basel III

Tier 1

Core Tier 1

Tier 2

Capital Conservation Buffer (0-2.5%)

National and Individual Cyclical Buffer (0-2.5%) ea.

Minimum Total Requirement 8%

Additional Tier 1

4.5%

6%

30

Quality of Capital in Brazil and Quality of Capital in Brazil and MexicoMexico

Tier 1 Capital Levels: Top 10 Brazilian and Mexican Banks

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Excess Tier 1 over Basel III

% o

f F

ina

nci

al S

yste

m (

by

asse

ts)

Mexico Brazil

50% of these Financial Systems operate with Tier 1 Buffer of about 5% (i.e.: 13.5% of assets at risk = 6 + 2.5 + 5)

31

What Should LAC do?What Should LAC do?

LAC should publish core tier 1 and LAC should publish core tier 1 and tier 1 ratiostier 1 ratios

And adopt Basel III perhaps with And adopt Basel III perhaps with stricter rules (as LAC has adopted stricter rules (as LAC has adopted Basel I and II with stricter ratios)Basel I and II with stricter ratios)

Analytical work required to consider Analytical work required to consider what those stricter ratios should what those stricter ratios should be…be…

32

On Anti-Cyclical Capital On Anti-Cyclical Capital RulesRules

Basel III’s cyclical buffers force banks to hold more Basel III’s cyclical buffers force banks to hold more capital in the good times, with an expectation it will be capital in the good times, with an expectation it will be used in the badused in the bad

But LAC banks already hold significant capital But LAC banks already hold significant capital cushions, perhaps to avoid hitting the requirement cushions, perhaps to avoid hitting the requirement levels.levels.

Anti-cyclical rules may have less effect than may be Anti-cyclical rules may have less effect than may be imagined, depending on why we think banks hold these imagined, depending on why we think banks hold these buffers, as banks may reduce the optimal buffers heldbuffers, as banks may reduce the optimal buffers held

Aliaga-Diaz, Olivero and Powell (2011) show this Aliaga-Diaz, Olivero and Powell (2011) show this formally in a SDGE model calibrated to LAC countries.formally in a SDGE model calibrated to LAC countries.

Bottom Line: If Basel III rules are applied on total Bottom Line: If Basel III rules are applied on total capital, they will have little effect. Assuming they are capital, they will have little effect. Assuming they are applied to Tier 1 Capital (as they should), and banks applied to Tier 1 Capital (as they should), and banks are expected to increase tier 1 capital by 2.5% in the are expected to increase tier 1 capital by 2.5% in the best simulations, we find consumption volatility may be best simulations, we find consumption volatility may be reduced by 4-5%.reduced by 4-5%.

33

What Should LAC do?What Should LAC do?

Adopt anti-cyclical capital rulesAdopt anti-cyclical capital rules These should be specified on core tier 1These should be specified on core tier 1 Given the amplitude of cycles in LA, Given the amplitude of cycles in LA,

these rules should be more aggressive these rules should be more aggressive than Basel IIIthan Basel III

Work needs to be done to calibrate the Work needs to be done to calibrate the rules appropriately rules appropriately

34

On the Basel II On the Basel II ApproachesApproaches

LAC countries have taken LAC countries have taken different viewsdifferent views

IDB Project on Basel II IDB Project on Basel II Implementation in the Region:Implementation in the Region: Brazil: Simplified Standardized and Brazil: Simplified Standardized and

IRB for qualifying banks (no Credit IRB for qualifying banks (no Credit Ratings)Ratings)

Chile: Standardized Approach (i.e.: Chile: Standardized Approach (i.e.: Using External Ratings)Using External Ratings)

Colombia: Initially IRB, now more SAColombia: Initially IRB, now more SA Uruguay (and others): Softly-Softly, Uruguay (and others): Softly-Softly,

gradually adopting measures gradually adopting measures consistent with Basel IIconsistent with Basel II

Are the Basel II approaches a Are the Basel II approaches a good fit for Emerging Economies? good fit for Emerging Economies?

Basel II Pillar 1 Approaches

Simplified Standardized Approach (SSA) – Basel 1+

Standardized Approach (SA) – Use of Credit Ratings and a table to map to requirements

Internal Rating Based Approach (IRB)

- Banks’ rating methodologies and estimated PD’s and a standard curve

35

Sailing through the Sea of Sailing through the Sea of StandardsStandards

Powell (2002, 2004) and Majnoni and Powell Powell (2002, 2004) and Majnoni and Powell (2005)(2005)11 made the following arguments: made the following arguments: A lack of rated claims reduces the value of A lack of rated claims reduces the value of

Standardized ApproachStandardized Approach Arguably, the Internal Rating Based Approach:Arguably, the Internal Rating Based Approach:

gives too much autonomy to banksgives too much autonomy to banks requires very significant supervisory resources beyond many requires very significant supervisory resources beyond many

countriescountries is too much of a black box and the calibration is suspect for is too much of a black box and the calibration is suspect for

LAC (correlation assumptions and 99.9% tolerance) LAC (correlation assumptions and 99.9% tolerance) At the same time, many countries have centralized At the same time, many countries have centralized

“rating systems” to determine provisions…“rating systems” to determine provisions… Majnoni and Powell’s proposal: Majnoni and Powell’s proposal:

A Centralized Rating Based (CRB) approach would have A Centralized Rating Based (CRB) approach would have banks rate claims according to a standard scale, this has a banks rate claims according to a standard scale, this has a cost as banks must use a common scale but a huge benefit in cost as banks must use a common scale but a huge benefit in terms of ease of supervisionterms of ease of supervision

Should be calibrated appropriatelyShould be calibrated appropriately1 Majnoni, G. and A. Powell (2005). “Reforming Bank Capital Requirements” Economia, Spring 2005. See also Powell (2002) and Powell (2004).

36

On ProvisionsOn Provisions

Many countries in Latin America maintain Many countries in Latin America maintain provisions on the basis of losses incurred provisions on the basis of losses incurred

Basel III now calls explicitly for forward Basel III now calls explicitly for forward looking (expected loss) provisions and looking (expected loss) provisions and negotiations are underway with the negotiations are underway with the accountancy standard setters.accountancy standard setters.

Some countries have made progress on Some countries have made progress on Anti-Cyclical provisions (e.g.: Bolivia, Anti-Cyclical provisions (e.g.: Bolivia, Colombia, Peru, Uruguay)Colombia, Peru, Uruguay)

37

Galindo and Rojas-Suarez propose an Galindo and Rojas-Suarez propose an index of theindex of the

Quality of the Provisioning RegulationQuality of the Provisioning Regulation

Micro-prudential questionsMicro-prudential questions Does it reflect expected loss (and if so Does it reflect expected loss (and if so

over which categories of loans)?over which categories of loans)? Does it specify provisions over other Does it specify provisions over other

assets or only loans (investments, assets or only loans (investments, contingent claims, other assets)?contingent claims, other assets)?

Macro-prudential questionsMacro-prudential questions Does it have an anti-cyclical component?Does it have an anti-cyclical component? Are provisions counted as capital?Are provisions counted as capital?

38

Survey ResultsSurvey Results

Source: Galindo and Rojas-Suarez (IDB, forthcoming)

39

2. Liquidity2. Liquidity

Heralded as part of Basel III’s macro-prudential Heralded as part of Basel III’s macro-prudential tools….tools….

Suggested characteristics of liquidity rules to be Suggested characteristics of liquidity rules to be macro-prudential:macro-prudential: Should be held in assets that remain liquid even Should be held in assets that remain liquid even

if there is macro (systemic) stress.if there is macro (systemic) stress. Should be held and used for systemic purposesShould be held and used for systemic purposes

This indicates a system of requirements in a central This indicates a system of requirements in a central bank or centralized custodian with tough rules on bank or centralized custodian with tough rules on their compositiontheir composition

Basel III liquidity rules do not appear to satisfy Basel III liquidity rules do not appear to satisfy these characteristicsthese characteristics

40

Liquidity vs. CapitalLiquidity vs. CapitalAlternative ViewsAlternative Views

1) Two Risks: Solvency Risk vs. Liquidity Risk1) Two Risks: Solvency Risk vs. Liquidity Risk 2) Size Matters: capital requirements limit 2) Size Matters: capital requirements limit

size, liquidity rules are a restriction on asset size, liquidity rules are a restriction on asset compositioncomposition

3) Capital (the difference between of assets 3) Capital (the difference between of assets and liabilities) may be volatile and may and liabilities) may be volatile and may disappear, if liquidity is cash in the central disappear, if liquidity is cash in the central bank, its actually more realbank, its actually more real

Appropriate liquidity policy depends on what Appropriate liquidity policy depends on what you think is the problem and the role of you think is the problem and the role of liquidity …liquidity …

41

And what does/should LA And what does/should LA do?do?

Several countries have liquidity requirements Several countries have liquidity requirements (remunerated, so less of a tax) and banks must (remunerated, so less of a tax) and banks must satisfy in the central bank and in some more satisfy in the central bank and in some more sophisticated cases may satisfy in other sophisticated cases may satisfy in other centralized custodianscentralized custodians

Flexible tools: can be adjusted over the cycle, Flexible tools: can be adjusted over the cycle, remuneration rates can penalize anti-social remuneration rates can penalize anti-social behaviours such as lending in dollars or riskier behaviours such as lending in dollars or riskier (more flighty) types of liabilities(more flighty) types of liabilities

Work needed to determine the appropriate level Work needed to determine the appropriate level (Charlie Calomiris advocates 20%) for developed (Charlie Calomiris advocates 20%) for developed countriescountries

42

3. Complexity – Cross 3. Complexity – Cross BorderBorder

Basel N (N=1,23), Pillar II, still contains the Basel N (N=1,23), Pillar II, still contains the myth that the role of a Supervisor is to supervise myth that the role of a Supervisor is to supervise a Banka Bank..

But Lehmann Bros. had 2985 legal entities But Lehmann Bros. had 2985 legal entities operating in 50 countries with many supervisors.operating in 50 countries with many supervisors.

Pillar II focuses on a lead Supervisor supervising Pillar II focuses on a lead Supervisor supervising a consolidated entity. Majnoni and Powell (2005, a consolidated entity. Majnoni and Powell (2005, 2007) argued that Consolidated Supervision may 2007) argued that Consolidated Supervision may be be necessarynecessary but it is but it is NOTNOT sufficientsufficient..

Pillar 2 should state explicitly what the role Pillar 2 should state explicitly what the role of the different supervisors should be when of the different supervisors should be when there are many significant entities with there are many significant entities with different regulatorsdifferent regulators

43

Complexity – Cross BorderComplexity – Cross Border If a Subsidiary (or a Branch) is significant for the Host If a Subsidiary (or a Branch) is significant for the Host

that entity should be jointly supervised and the that entity should be jointly supervised and the HostHost should be the primary agent to Monitor and should be the primary agent to Monitor and Supervise.Supervise.

The The HostHost should have access to any information from should have access to any information from the Home (consolidated or lead) supervisor that it the Home (consolidated or lead) supervisor that it needs to be able to execute its duties.needs to be able to execute its duties.

When times get tough, voluntary “regulatory When times get tough, voluntary “regulatory cooperation” will break down, “Colleges” are not cooperation” will break down, “Colleges” are not enough. enough.

The Board of Subsidiaries in host countries must act The Board of Subsidiaries in host countries must act only in the interests of the subsidiaryonly in the interests of the subsidiary

G20/BCBS needs to work more here as international G20/BCBS needs to work more here as international law is inconsistent (“single” vs. “multiple entity” law is inconsistent (“single” vs. “multiple entity” resolution) and the legal position regarding resolution) and the legal position regarding international banks’ responsibilities to their local international banks’ responsibilities to their local depositors remains murky.depositors remains murky.

44

What Should LAC do?What Should LAC do?

LAC is host to many legal entities in complex LAC is host to many legal entities in complex corporate structures; where its unclear how a corporate structures; where its unclear how a Subsidiary fits into a structure, action is requiredSubsidiary fits into a structure, action is required

LAC should make very explicit governance rules LAC should make very explicit governance rules for subsidiaries and board members fiduciary for subsidiaries and board members fiduciary dutiesduties

Host supervisors should know how any actions Host supervisors should know how any actions by the home supervisor (such as Living Wills, by the home supervisor (such as Living Wills, Chinese Walls or other measure may affect Chinese Walls or other measure may affect subsidiaries in their country)subsidiaries in their country)

More analytical work required…. More analytical work required….

45

South-South Complexity South-South Complexity

LAC needs to pay attention to increased LAC needs to pay attention to increased South-South cross border banking, in South-South cross border banking, in South America, Central America and the South America, Central America and the Caribbean.Caribbean.

LAC Supervisors may wish to agree rules LAC Supervisors may wish to agree rules on cross border supervision.on cross border supervision.

An interesting recent example of the An interesting recent example of the dangers come from the Caribbean: The dangers come from the Caribbean: The CLICO Group (CL Financial) in Trinidad CLICO Group (CL Financial) in Trinidad and Tobagoand Tobago

46Source: CCMF Report on CL Financial

Complex structure across many countries

47

Cross Border Issues Abound in the Caribbean Financial System (Commercial Banks Only)

Network visualization by Pajek software: for a short description see Batagelj V., Mrvar A.: Pajek - Analysis and Visualization of Large Networks. in Jünger, M., Mutzel, P., (Eds.) Graph Drawing Software. Springer, Berlin 2003. p. 77-103

Haiti, Guyana and Suriname in the

Periphery

T&T in the CenterBy ownership & by

market

48

Complexity – InstrumentsComplexity – InstrumentsStandardization vs. InnovationStandardization vs. Innovation

The recent crisis has amply demonstrated that much The recent crisis has amply demonstrated that much financial innovation is motivated by regulatory (and financial innovation is motivated by regulatory (and tax) arbitragetax) arbitrage

LA countries perhaps given the French Law tradition LA countries perhaps given the French Law tradition and limited liquidity have favored Standardizationand limited liquidity have favored Standardization

The world may now focus more on Standardization The world may now focus more on Standardization and less on innovation: banks more akin to utility and less on innovation: banks more akin to utility companies companies

Standardization also eases Supervision and the Standardization also eases Supervision and the possibility to collect meaningful data - information.possibility to collect meaningful data - information.

Indeed non-standard instruments, if permitted, Indeed non-standard instruments, if permitted, should attract higher capital and/or liquidity should attract higher capital and/or liquidity requirements.requirements.

49

4. Market & Supervisory 4. Market & Supervisory DisciplineDiscipline

Market discipline and supervisory discipline intimately Market discipline and supervisory discipline intimately related, the crisis was a failure of both.related, the crisis was a failure of both.

Financial innovation allowed practices that were not Financial innovation allowed practices that were not detected by regulators, heightened the information detected by regulators, heightened the information asymmetries – Powell, Miller and Maier 2011.asymmetries – Powell, Miller and Maier 2011.

Perhaps market has some information not available to Perhaps market has some information not available to supervisorssupervisors

Market and supervisory discipline are complements (re: Market and supervisory discipline are complements (re: Argentina’s BASIC system in the 1990’s – Information, Argentina’s BASIC system in the 1990’s – Information, Auditing, Credit Rating, Bonds, Supervision).Auditing, Credit Rating, Bonds, Supervision).

An automatic market trigger may also limit forbearanceAn automatic market trigger may also limit forbearance Coco’s provide additional capital and a market trigger: Coco’s provide additional capital and a market trigger:

Switzerland has two triggers, preemptive and crowd-in Switzerland has two triggers, preemptive and crowd-in level.level.

50

A Proposal: Lima 1A Proposal: Lima 1

51

A Proposal: Lima 1A Proposal: Lima 1 Given the unprecedented crisis in the North, Given the unprecedented crisis in the North,

Basel N (N=1,2,3) has been driven by the North, Basel N (N=1,2,3) has been driven by the North, arguably the sequence is moving further away arguably the sequence is moving further away from a good fit for LACfrom a good fit for LAC

There is a danger that a “standard” is being lost There is a danger that a “standard” is being lost across LACacross LAC

More importantly LAC has a lot to offer:More importantly LAC has a lot to offer: It has learned from its own historyIt has learned from its own history It has implemented many “macro prudential” It has implemented many “macro prudential”

measuresmeasures It is blessed with good data (and economists)It is blessed with good data (and economists)

At a meeting of ASBA held in Lima, I proposed a At a meeting of ASBA held in Lima, I proposed a LAC Accord - “Lima 1”LAC Accord - “Lima 1”

This is meant to be fully consistent with Basel N This is meant to be fully consistent with Basel N – which are – which are minimumminimum standards. standards.

52

Selected Proposed elements of Selected Proposed elements of “Lima 1”“Lima 1”

A LAC-calibrated basic requirement, likely to be >8%, and A LAC-calibrated basic requirement, likely to be >8%, and with appropriate core tier 1/tier 1 requirements likely to be with appropriate core tier 1/tier 1 requirements likely to be higher than Basel III.higher than Basel III.

A Centralized Rating Based approach consistent with IRB A Centralized Rating Based approach consistent with IRB procedures but calibrated to LAC (subject to the Basel procedures but calibrated to LAC (subject to the Basel minimum) and facilitating supervision.minimum) and facilitating supervision.

A LAC standard on forward-looking, anti-cyclical provisionsA LAC standard on forward-looking, anti-cyclical provisions Anti-cyclical capital rules, more aggressive than Basel IIIAnti-cyclical capital rules, more aggressive than Basel III Standardization of contracts or possibly higher capital Standardization of contracts or possibly higher capital

(and/or liquidity) requirements on non-standard products(and/or liquidity) requirements on non-standard products Possible use of Coco’s in LACPossible use of Coco’s in LAC Systemic remunerated liquidity requirements, lower Systemic remunerated liquidity requirements, lower

remuneration rates for foreign currency and short term non-remuneration rates for foreign currency and short term non-core liabilitiescore liabilities

Clear statements on what LAC supervisors expect from home Clear statements on what LAC supervisors expect from home supervisors to supervise the subsidiaries and branches of supervisors to supervise the subsidiaries and branches of foreign banks and what LAC authorities expect from the foreign banks and what LAC authorities expect from the Board of LAC banks that happen to be part of complex Board of LAC banks that happen to be part of complex groupsgroups

These elements additional or compatible with Basel N These elements additional or compatible with Basel N