Finding the Balance: Financial Regulation for Emerging Countries

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

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

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… …and higher volatility on its macroeconomic aggregates, particularly growth. June 7th, 2007

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... June 7th, 2007

Financial Sector Effects …and a tendency to suffer crises. June 7th, 2007

Financial Sector Effects Crises have also had a persistent deferring effect over the growth of the financial sector, taking several years to recover. Credit Index (real terms) 600 Chile 500 1981=100 Colombia Perú 400 1998=100 1999=100 300 Argentina Venezuela 2001=100 200 1994=100 100 Brasil 1994=100 0 1 3 5 7 9 11 13 15 17 19 21 23 25 (years after crises) June 7th, 2007

Financial Sector Effects …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. June 7th, 2007

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… June 7th, 2007

Macroeconomic Stability …in the context of current account and fiscal surpluses, and along with a significant partial liquidation of its external debt. June 7th, 2007

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. June 7th, 2007

Credit/GDP ratio 60 1976-1990 1991-2006III 50 40 30 20 10 0 Argentina Brasil Chile Colombia México Perú Venezuela * Venezuela average 1991-2004 Credit Surges In sum, a macro and financial scenario that fostered a credit expansion in the last few years... Source: BBVA from IMF data …with financial depth ratios generally growing, except in the cases of Argentina and Venezuela. June 7th, 2007

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

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. June 7th, 2007

Regulation “per se” does not achieve financial stability. Macroeconomic Stability Institutional Endowment Financial regulation Financial sector performance 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

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. June 7th, 2007

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. Positive relationship between size of domestic financial sector and institutional quality. June 7th, 2007

The Institutional Challenge Latin America is in a discouraging situation regarding governance, especially regarding rule of law and control of corruption June 7th, 2007

The Institutional Challenge Financial systems in particular lack larger protection on borrowers and lenders rights… June 7th, 2007

Regulation as a response to domestic vulnerabilities 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. Weak Institutions Strict Regulation Exposure to crises Yet, some harsh regulatory aspects may stand against the establishment of an efficient financial system, reinforcing the ambiguous relation between regulation and performance. June 7th, 2007

Foreign Bank Presence 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. June 7th, 2007

Credit Promotion Other regulatory measures that reduce the efficiency of the financial sector are on the other hand, still present. *Max ** In effect during 2007 Source: BBVA Credit promotion to sectors deemed strategic has translated into an inefficient allocation of resources, crowding more profitable (generally private) investment out. June 7th, 2007

Public Banks Share A similar problem occurs with the share of public banks, which in some countries still comprise a sizeable share of the domestic credit market. Source: National Central Banks 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. June 7th, 2007

Increasing market-regulated arrangements. Further reform should reduce measures resulting in greater interventionism, while fostering those based on market-regulated arrangements. The attachment of Latin American banking systems to Basel II is an example of the right path to follow. June 7th, 2007

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. The current macroeconomic scenario has helped to revert the above tendency, facilitating an intense growth of local credit markets. 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. 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.) June 7th, 2007

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

Finding the Balance: Financial Regulation for Emerging Countries