Presentaci

1
Financial Reform and Vulnerability How to Open
but Remain Safe?
José Luis Escrivá Chief Economist - BBVA
Group June 7th, 2007
2
Banking Problems since late 1970s
Systemic banking crises
Episodes of non-systemic banking crises
No crises
Insufficient information
Source Caprio and Klingebiel (1999).
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Definition of a Banking Crisis

1. Ratio of nonperforming loans to total bank loans
   exceeded 10.
2. Cost of the rescue operation (or bailout) was at
   least 2 of GDP.
3. Episode involved a large-scale nationalization of
   banks (and possibly other institutions).
4. Extensive bank runs took place or emergency
   measures (deposit freezes, prolonged bank
   holidays, or generalized deposit guarantees) were
   enacted by the government.

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Impact of financial crises on long-run growth
Financial crises have a large, negative impact on
GDP. Countries typically do not return to their
old growth path (IMF research). GDP loss is
largest for poor countries.
Typical Growth Path after Financial Crises in
Rich and Poor Countries
Source Cerra and Saxena (2005 24)
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Capital Account Liberalization and Financial
Crises
Last crises Argentina 2001-2003
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Capital Account Liberalization and Financial
Crises
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Capital Account Liberalization and Financial
Crises
Macroeconomic Factors

1. External shocks
2. The Exchange Rate Regime
3. Openness
4. Financial Repression
5. Domestic shocks
6. Lending booms

• Microeconomic Factors
• Mismatches between assets and liabilities.
• Government interference.
• Weaknesses in the regulatory and legal framework.
• Premature financial liberalization.

Deposit Runs
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Macroeconomic Factors External shock

• A change in the terms of trade.
• An unanticipated drop in export prices, for
  instance, can impair the capacity of domestic
  firms (in the tradable sector) to service their
  debts.
• This can result in a deterioration in the
  quality of banks' loan portfolios.
• Adverse shock to domestic income associated with
  a decline in the terms of trade may slow output
  and raise default rates.

Maximum decrease of the terms of trade in the
t-7 to t2 period Chile 1981
20 Philippines 1981 41 South Africa
1985 53 Turkey 1985 35 Venezuela 1994 34
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Macroeconomic Factors External Shock
Capital outflows induced by an increase in world
interest Drop in deposits may force banks to
liquidate long-term assets to raise liquidity or
cut lending abruptly. May entail a recession and
a rise in default rates.
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A credibly-fixed exchange rate provides an
implicit guarantee (no foreign exchange risk)
which may lead to excessive (and unhedged)
short-term foreign borrowing.This increases the
fragility of the banking system to adverse
external shocks, particularly if the degree of
capital mobility is highUnder any pegged rate
regime, capital outflows affect the financial
system through an expansion or contraction of
bank balance sheets they can lead to instability
in the banking sector.
Macroeconomic Factors Exchange Rate
A flexible exchange rate may also create
problems An abrupt outflow of capital can lead
to a sharp depreciation of the nominal exchange
rate.The depreciation may raise the
domestic-currency value of foreign-currency
liabilities, for banks and their
customers.Large, unhedged foreign-currency
positions increase risk of default on existing
loans and vulnerability to adverse (domestic or
external) shocks. The fall in borrowers net
worth may also lead to a rise in the finance
premium and to increased default rates higher
incidence of nonperforming loans may lead to a
banking crisis.
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Countries of currency crashes tend to be
less open to trade, especially those with sudden
stops as well. An increase in trade openness of
10 percentage points decreases likelihood of a
sudden stop (definition of Calvo, et al.) by
approximately 32.
Macroeconomic Factors Opennes
Source Calvo, Izquierdo Mejia (2003) Edwards
(2004a,b)
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Countries that are less open to trade are
more prone to sudden stops currency crashes.
Increase in openness also decreases the
likelihood of currency crash, defined as 25
increase in exchange market pressure (exchange
rate reserves)
Macroeconomic Factors Opennes
Source Calvo, Izquierdo Mejia (2003) Edwards
(2004a,b)
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Macroeconomic Factors Financial Repression

• Financial system in most developing countries is
  repressed by government interventions. This
  keeps interest rates that domestic banks can
  offer to savers very low.
• By keeping interest rates low, it creates an
  excess demand for credit. It then requires the
  banking system to set a fixed fraction of the
  credit available to priority sectors.
• Combination of low nominal deposit interest
  rates and moderate to high inflation has resulted
  in negative rates of return on domestic financial
  assets.
• Financial Repression Leads to Low Growth
• 1. Poor legal system
• 2. Weak accounting standards
• 3. Government directs credit
• 4. Financial institutions nationalized
• 5. Inadequate government regulation

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Macroeconomic Factors Domestic shock

• Domestic shock increase in domestic interest
  rates (to reduce inflation or defend the
  currency). Slows output growth and may weaken the
  ability of borrowers to service their loans may
  lead to an increase in non-performing assets or a
  full-blown crisis.

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Macroeconomic Factors

• Credit Booms Rapid increases in bank credit to
  the economy.
• Source of increase in banks' capacity to lend
  often large capital inflows.
• Often at the expense of credit quality.
  Distinguishing between good and bad credit
• risks is harder when the economy is expanding
  because borrowers may be at least
• temporarily profitable and liquid
• Boom is often accompanied by asset price bubbles
  (stock market, real estate).

Absolute Deviations in the Credit-GDP Ratio with
Respect to Trend
Source Credit Stagnation in Latin America.
Adolfo Barajas and Roberto Steiner 2001
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Micro Factors Balance Sheet Mismatches

1. Bank assets and bank liabilities differ in terms
   of liquidity, maturity, and currency of
   denomination.
2. Maturity and currency mismatches more acute in a
   context of rapidly increasing bank liabilities
   (capital inflows).
3. Maturity mismatch and sequential service
   constraint create the possibility of
   self-fulfilling bank runs.
4. Large, unhedged foreign-currency positions (banks
   and their customers) increase risk of default on
   existing loans and overall financial
   vulnerability to adverse (domestic or external)
   shocks.
5. Lending in foreign currency by banks to domestic
   borrowers transforms currency risk into credit
   risk.

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Micro Factors Government interference

• If lending decisions remain subject to government
  discretion It will encourage
• reckless behavior by bank managers poor quality
  of loan portfolios. Liberalization
• will not improve credit allocation or deepen
  financial markets.

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Micro Factors Weak Regulatory and Legal Framework

• Weak legislation against concentration of
  ownership
• Weaknesses in the accounting, disclosure, and
  legal infrastructure hinder the
• operation of market discipline and effective
  banking supervision.
• Accounting rules for classifying assets as
  non-performing
• Often not tight enough make it easy to conceal
  losses.
• Often depend on payment status, not on an
  evaluation of the borrower's
• creditworthiness and the market value of
  collateral.

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Micro Factors Premature Financial Liberalization
Evidence of financial liberalization exacerbated
by financial weaknesses in developing countries.
Banking crisis more likely in liberalized
financial systems, with significance placed on
strength of institutional environment.
Prior to liberalization banks and other
financial institutions enjoy substantial
rents. Liberalization leads to increased
competition, higher marginal cost of funds,
higher bank deposit rates and banks responding by
increasing the riskiness of their loan
portfolios.
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Route of a classic financial crisis
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Empirical evidence of twin crises

• Do banking crises typically precede currency
  crises do currency crises deepen banking crises?
• Are both types of crises caused by bad
  fundamentals?
• Kaminsky and Reinhart (1999) find supportive
  evidence for both, showing that in the build up
  to a crisis, one typically observes
• excessive liquidity growth
• excessive bank lending growth
• excessive capital inflows
• an overvaluation of the currency
• a fall in foreign exchange reserves
• ? these trends reverse after the crisis!
• Can these indicators predict a financial crisis?

banking crisis
currency crisis
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Early warning signals
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Are financial crises only due to bad fundamentals?

• Note that the analysis so far
• attributes financial crises to a certain extent
  to weak domestic fundamentals
• implicitly assumes that financial crises are
  essentially solvency crises
• So, what about international investors?
• Recall currency crises models incorporating
  self-fulfilling expectations a financial crisis
  may also result from a liquidity shortage created
  by international investors, while fundamentals
  were intrinsically sound!
• A crisis occurs solely because portfolio
  investors withdraw their funds to make a
  speculative gain

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What have we learned?

• Financial crisis arise from disruptions on
  financial markets that increase the asymmetric
  information problems such that the financial
  system can no longer efficiently allocate funds
• Disruptions can be caused through an
• a. internal channel (leading to a banking
  crisis)
• b. external channel (leading to a currency
  crisis)
• c. both (leading to a twin crisis)
• Level of private risk determines domestic
  financial fragility, determined by
• a. moral hazard (guarantees)
• b. excessive optimism
• Fundamentalists view a financial crisis as a
  solvency crisis, self-fulfillers as a liquidity
  crisis
• Combination of both embodied in third generation
  models of currency crisis

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What have we learned?

• Capital account liberalization with macro and
  financial weaknesses in developing countries is
  the responsible of financial crises
• In this case, open the market in a phased manner
  (1, 3, 5, etc.)
• Change the maturity structure of foreign
  capital.
• Not capital control
• Financial integration helps developing countries
  to improve their financial markets, enhance
  governance, impose discipline on macro policies,
  break power of interest groups that block
  reforms, etc.

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Financial Reform and Vulnerability How to Open
but Remain Safe?
José Luis Escrivá Chief Economist - BBVA
Group June 7th, 2007