Ample Stable Credit & Adequate Financial Regulation: Finding the Balance for Emerging Countries

June 7th, 2007 1

Ample Stable Credit & Adequate Financial Regulation: Finding the Balance for Emerging Countries.

José Luis Escrivá

Chief Economist BBVA Research Department

June 7th 2007

June 7th, 2007 2

Outline

1. From turmoil to stability: linkages between the macroeconomy and the financial sector .

2. Financial Regulation and performance: assessing the links.

a. Institutional challenges to regulatory success.

3. Priorities for regulatory reform

June 7th, 2007 3

A VOLATILE ECONOMIC PATH

In the past, drastic credit expansions have been

associated with boom-bust cycles in the region, which

shows a greater tendency to suffer crises…

Countries with recurrent crises 1974-2003 (%)

0

10

20

30

40

Lata

m

Sub.

Sah

aran

Afr

ica

East

ern

Euro

pe &

Cent

ral A

sia

East

Asi

a an

d Pa

cific

MEN

A

Sout

h As

ia

Hig

h in

com

e O

ECD

Hig

h in

com

e no

n-O

ECD

1,25*

0,380,40,380,890,83 0,090,21

* Average crises per region

Source: BBVA from World Bank data

GDP Growth Volatility (std deviation)

0

0.5

1

1.5

2

2.5

3

3.5

4

1980-1989 1990-1999 2000-2005

East Asia & Pacific High income Latin America & Caribbean South Asia Sub-Saharan Africa

…and higher volatility on its macroeconomic aggregates,

particularly growth.

June 7th, 2007 4

Financial Sector Effects

This pattern of economic growth has constrained the stability and development of the financial sector, which has inherited the same

volatile pattern...

Argentina: Credit over GDP

0

5

10

15

20

25

30

35

40

45

19

60

19

63

19

66

19

69

19

72

19

75

19

78

19

81

19

84

19

87

19

90

19

93

19

96

19

99

20

02

20

05

Mexico: Credit over GDP

0

5

10

15

20

25

30

35

40

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

Venezuela: Credit over GDP

0

5

10

15

20

25

30

35

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

* Latest data December 2004

Brazil: Credit over GDP

0

10

20

30

40

50

60

70

80

90

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

June 7th, 2007 5

…and a tendency to suffer crises.

Financial Sector Distress in Latin America Financial Sector Crisis Financial System

Distress Argentina 1980, 1989, 1995, 2001

Bolivia 1986, 1994 2003 Brazil 1990, 1994, 1998 2002 Chile 1976, 1981

Colombia 1982, 1999 Costa Rica 1987 1994 Dominican

Rep. 2003

Ecuador 1982, 1996, 1998 2002 El Salvador 1989

Mexico 1981, 1994 Nicaragua 1990, 2000 Panama 1988 Paraguay 1995 2002

Peru 1993 2002 Uruguay 1981, 2001

Venezuela 1994 1978, 1985, 2002 Source: BBVA; Carstens et al. (2004)


June 7th, 2007 6

Crises have also had a persistent deferring effect over the growth of the financial sector, taking several years to recover.

Credit Index (real terms)

0

100

200

300

400

500

600

1 3 5 7 9 11 13 15 17 19 21 23 25

(years after crises)

Chile

1981=100Colombia

1998=100

Venezuela

1994=100

Brasil1994=100

Argentina

2001=100

Perú

1999=100


June 7th, 2007 7

…which has resulted in a banking sector in Latin American that is both smaller than OECD or East Asian averages, as well as unable to follow

their upward trend.


Credit-to-GDP ratio (avg. % )

0

50

100

150

200

1980-1989 1990-1999 2000-2005

Latam OCDE East Asia


June 7th, 2007 8

Macroeconomic Stability

In contrast to previous decades, Latin America faces today a much more stable macroeconomic scenario: Inflation has plunged, GDP

growth rates are higher while less volatile…

-3.0%

-1.5%

0.0%

1.5%

3.0%

4.5%

6.0%

7.5%

9.0%

10.5%

12.0%

13.5%

15.0%

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Latin America: GDP growth (%)

Source: BBVASource: World Bank

Latam: GDP growth volatility (period std dev)

0.5

1

1.5

2

2.5

3

3.5

1980-1989 1990-1999 2000-2005

June 7th, 2007 9

…in the context of current

account and fiscal surpluses, and along with a

significant partial

liquidation of its external debt.

Macroeconomic Stability

Source: World Bank

Latin America: External Debt / GDP (% )

20%25%30%35%40%45%50%55%60%65%

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

June 7th, 2007 10

Improved Financial Indicators

…events that have elicited a reduction of bank spreads and default rates.

Default rates in Latin America fall since 2002, and currently are lower than in emerging Asia.

Banking Default Rates 2006

0

2

4

6

8

10

12

14

16

18

20

Arg

enti

na

Braz

il

Colo

mbi

a

Peru

Uru

guay

Mex

ico

Vene

zuel

a

Chile

Phili

ppin

es

Indo

nesi

a

Thai

land

Mal

aysi

a

Sri L

anka

Indi

a

Hon

g Ko

ng

Kore

a

LATAM = 2,5

ASI A = 9,3

Source: GFSR - I MF

%

*excluding BrazilSource: BBVA from IMF data

Latam: Avg. Bank Spreads (pp.)*

0

2

4

6

8

10

12

14

1994-97 1998-2001 2002-06

June 7th, 2007 11

Credit Surges

…with financial depth ratios generally growing, except in the cases of Argentina and Venezuela.

Source: BBVA from IMF data

Credit/GDP ratio

0

10

20

30

40

50

60

Argentina Brasil Chile Colombia México Perú Venezuela

1976-1990

1991-2006III

* Venezuela average 1991-2004

In sum, a macro and financial scenario that fostered a credit expansion in the last few years...

June 7th, 2007 12

Financial institutions perceive a much better scenario for credit development.

1- A more stable and favorable macroeconomy 2- Interest rates are lower than previous years.

3- Risk premiums have declined.

Greater and more solvent credit demand

Credit Supply expansion enhances the balance sheets of

financial institutions.

June 7th, 2007 13

Outline





June 7th, 2007 14

What is the role of policy reform in the current expansion of the financial sector?

Prior to the current benign macroeconomic environment, reform of the financial sector has been extensive in the region

In many instances,

however, reforms have not precluded

financial crises. Particularly in Latin America,

the link between financial reform and performance

is not clear. Source: ICRG*higher values imply a sounder environment for investments

Investment Risk Index* (period avg.)

0

2

4

6

8

10

Arge

ntin

a

Braz

il

Chile

Colo

mbi

a

Mex

ico

Peru

Vene

zuel

a

84-87 88-91 92-95 96-99

June 7th, 2007 15

Regulation “per se” does not achieve financial stability.

Financial sector performance

Institutional Endowment Financial regulationMacroeconomic

Stability

A key conclusion that emerges from the wave of reforms in Latin America is that regulation is an imperfect substitute of other

determinants of financial sector performance. A minimum threshold of institutional quality and macroeconomic stability are also requirements

for achieving a sound financial sector.

June 7th, 2007 16

Consequently, there is not a linear relation between regulation and financial stability

In Latin America, the stricter regulation does not necessarily deliver better financial performance.

Chile, while having a less repressive financial sector than most Latin American examples, is among the most stable financial sectors in

the region.

Source: Stallings and Studart (2003)* a higher value implies a stricter regulatory framework

Overall Supervision Index* (2003)

66.5

77.5

88.5

99.5

Braz

il

Mex

ico

Peru

Arge

ntin

a

Chile

Boliv

ia

Latam avg: 0.18


June 7th, 2007 17

Outline





June 7th, 2007 18

The Institutional Challenge

In all, and especially after the progress on the macroeconomic front, consolidating the current expansion of the financial sector in

Latin America requires enhancing the institutional endowment.

0

20

40

60

80

100

120

140

160

180

200

-2,5 -2,0 -1,5 -1,0 -0,5 0,0 0,5 1,0 1,5 2,0 2,5

Governance index {-2.5,2.5}

Dep

osi

t ban

ks

clai

ms

on p

riva

te s

ecto

r(%

of G

DP)

Source: BBVA based on IMF and World Bank

Financial system and governance (2005)

Positive relationship between size of domestic

financial sector and

institutional quality.

June 7th, 2007 19


Latin America is in a discouraging situation regarding governance, especially regarding rule of law and control of corruption

Business Environment Index

2

3

3

4

4

5

5

6

MEN

A

Euro

pe&

Centr

al Asia

Lata

m

Asia-Pacifi

c

Áfr

ica

Sub-S

ahara

n

World

Business Environment Index

2

3

3

4

4

5

5

6

MEN

A

Euro

pe&

Centr

al Asia

Lata

m

Asia-Pacifi

c

Áfr

ica

Sub-S

ahara

n

World

Index based on 11 business-related variablesSource: BBVA

June 7th, 2007 20


0

20

40

60

80

100

120

140

160

180

200

0 1 2 3 4 5 6 7 8 9 10

Legal rights index (0-10)

Deposit

banks c

laim

s o

n p

rivate

secto

r

(%

of G

DP)

Source: BBVA based on IMF and World Bank

Financial system and legal framework (2006)

Financial systems in particular lack larger protection on borrowers and lenders rights…

June 7th, 2007 21

Outline





June 7th, 2007 22

Given the vulnerabilities embedded in the institutional framework, and the resulting tendency of the region to suffer financial crises, some Latin American nations have opted for a strong regulation of

the banking sector.

Regulation as a response to domestic vulnerabilities

Yet, some harsh regulatory aspects may stand against the establishment of an efficient financial system, reinforcing the

ambiguous relation between regulation and performance.

Weak Institutions

Exposure to crises

Strict Regulation

June 7th, 2007 23

Source: IMF

Foreign Bank Assets as % of Total Bank Assets

0

10

20

30

40

50

60

Arg

entina

Bra

zil

Chile

Colo

mbia

Mexic

o

Peru

Venezu

ela

1994 1999 2000

A case in point is vetoing foreign entry in the banking sector, a measure that has been increasingly eradicated.

In Latin America, foreign banks have been a crucial way to increase competition and efficiency.

Foreign Bank Presence

June 7th, 2007 24

Credit Promotion

Credit promotion to sectors deemed strategic has translated into an inefficient allocation of resources, crowding more profitable (generally

private) investment out.

BrasilLibre

57%

Direcciona

do

36%

Leasing

3%

Sector

público

4%

Venezuela

Hipotecari

a **

10%

Microcrédi

to*

3%

Agropecuar

ia

16%

Resto

71%

*Max

** In effect during 2007

Source: BBVA

Other regulatory measures that reduce the efficiency of the financial sector are on the other hand, still present.

June 7th, 2007 25

Public Banks Share

Most Latin American countries have a structure of public banks that competes directly with private banks. A reduction in the market share of public institutions is desirable, as well as a stronger orientation towards

underbanked segments of the population.

Source: National Central Banks

Public Banks, Share of Credit

0

10

20

30

40

50

Argentina Brasil Chile Colombia Venezuela** 2004

2000

2005

A similar problem occurs with the share of public banks, which in some countries still comprise a sizeable share of the domestic credit market.

June 7th, 2007 26

Increasing market-regulated arrangements.

Further reform should reduce measures resulting in greater interventionism, while fostering those based on market-regulated

arrangements.

Latam: Banks adopting Basel II as percentage

of total banking assets

0

20

40

60

80

100

ene-06 2007-09 2010-15

Local banks Foreign banksMinority foreign presence

Latam: Banks adopting Basel II as percentage

of total banking assets

0

20

40

60

80

100

ene-06 2007-09 2010-15

Local banks Foreign banksMinority foreign presence

Percentage of banks assets expected to fall under Basel II , at different time

horizons.

End of 2006

2007-09

2010-15

Group 1 (6 countries)

23 100 100

Group 2 (5 countries)

0 20 94

The attachment of Latin American banking systems to Basel II is an example of the right path to follow.

June 7th, 2007 27

Conclusions.

Volatility and exposure to crises have traditionally limited the growth of the financial sector in Latin America, which has remained

underdeveloped compared to East Asian emerging economies.

Easing foreign presence or following Basel II prescriptions are examples of the effort that Latin America is doing towards a good

regulatory framework of the financial sector. Nevertheless, examples of inadequate measures still exist (e.g., compulsory credit, large

public bank presence, etc.)

The consolidation of the current financial development requires minimum thresholds of macroeconomic stability, institutional quality, and an adequate regulatory framework. The absence of any of these

is likely to deter further financial development.

The current macroeconomic scenario has helped to revert the above tendency, facilitating an intense growth of local credit markets.

June 7th, 2007 28

Ample Stable Credit & Adequate Financial Regulation: Finding the Balance for Emerging Countries.

José Luis Escrivá

Chief Economist BBVA Research Department

June 7th 2007

Documents

Ample Stable Credit & Adequate Financial Regulation: Finding the Balance for Emerging Countries