Financial Sector Reform

Financial Sector Reform Discussion on Bekaert, Harvey and Lundblad Galindo and Micco Sergio Schmukler Rethinking Structural Reform Conference Federal Reserve Bank of Atlanta Inter-American Development Bank October 2003

Discussion Outline • Reform agenda: logic and scope • Broader than these papers • Broader than financial sector reforms • Outcomes for Latin America: mixed or disappointing • Extensive to other regions • Not as predicted by these papers • If reforms did disappoint, why? • Policy alternatives to these papers’ recommendations • Liberalization papers • Creditor rights paper

1. Reform Agenda: Logic Generate more and cheaper financing GOVERNMENT FIRMS Supervision and regulation More financing BANKS (fragile and inefficient) Increased competition Higher returns Cheaper financing CAPITAL MARKETS Wider set of instruments INVESTORS

1. Reform Agenda: Logic Sweeping reforms throughout financial sector • Supervisory agency • Investor protection • Depository and clearing • Trading platforms More retail investment Mitigate information and agency problems Improve exchange infrastructure Lower transaction costs CAPITAL MARKETS DEMAND SUPPLY Long-term financing and specialization Foreign capital available More discipline and efficiency Increase liquidity Promote stocks dissemination • Pension funds • Mutual funds • Insurance companies • Financial liberalization • Privatization • Tax incentives

1. Reform Agenda: Actions Financial liberalization increasing since late-1980s Latin America: Indices of Financial Liberalization by Sector More liberalization Less liberalization Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. The value 1 means repression, 2 partial liberalization, and 3 full liberalization. Figures correspond to end-of-month values. Source: Kaminsky and Schmukler 2002

1. Reform Agenda: Actions Other reforms implemented in the early-1990s Percentage of Latin American Countries that Implemented Reforms The figure shows the percentage of countries (from a group of 16 countries) that had implemented reforms before 1990, in 1990-1995, and in 1996-2001. Countries included are Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, Guatemala, Honduras, Jamaica, Mexico, Panama, Paraguay, Peru, Uruguay, Venezuela. Sources: Bhattacharya and Daouk 2000, ICRG, and local data

1. Reform Agenda: Actions Reforms occurred mostly after liberalization Sequencing: Financial Liberalization and Institutional Reforms The table shows the percentage of coutries that had implemented reforms before partial and full liberalization. Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. Sources: Bhattacharya and Daouk 2000, Kaminsky and Schmukler 2001, and ICRG

2. But Results Not as Expected • (Reforms are good according to these papers) • Equity markets • Visible growth (market cap), but not as in OECD • Rising concentration and delisting • Migration to international equity markets • Small relative to bond markets

2. But Results Not as Expected • Bond markets • Dominated by government paper • Dollarization • Short duration • Currency and maturity mismatches • Institutional investors • Fast growth but tapped by governments

2. But Results Not as Expected Latin America Equity Market Growth Is Poor Stock Market Capitalization Percentage of GDP Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. Asian countries: Hong Kong, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand. G-7countries: Canada, France, Germany, Italy, Japan, U.K., and U.S. Figures correspond to end-of-year values. Sources: IFC's Emerging Markets Database, World Federation of Exchanges (FIBV), and The World Bank

2. But Results Not as Expected Stock Exchanges Affected by Increasing De-listing Domestic Stock Exchanges: Number of Companies Source: IFC's Emerging Markets Database

2. But Results Not as Expected Large Companies Migrate to International Markets Latin American Companies: Value Traded USD Millions Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. Internationalized companies are defined as companies that cross-list or raise capital in international stock markets at some point in time. Figures correspond to end-of-year values. Sources: The Bank of New York, Euromoney, and IFC's Emerging Markets Database

2. But Results Not as Expected Equities Traded Belong to a Handful of Large Firms Stock Market Concentration (end-2000) Percentage Source: IFC's Emerging Markets Database

2. But Results Not as Expected Public Bond Trading Outweighs Equity Trading Value Traded in Domestic Markets (2000) Percentage of GDP The figure shows the value traded through the domestic exchanges. However, in the case of Mexico, repo operations (conducted or not through the exchange) are also considered. Sources: Local data, The Handbook of World Stock, Derivative & Commodity Exchanges 2001, Federacion Iberoamericana de Bolsas de Valores (FIABV), and The World Bank

3. If Reforms Did Disappoint, Why? • Wrong sequencing • Financial integration went too fast • Imperfections in international markets lead to vulnerabilities when domestic sector is not ready • Thus, follow right sequencing • But, are there sufficient incentives to reform institutions without the discipline from openness and crisis? • Wait for the fruits of reforms and do more • The dividends from reforms have long gestation period • Thus, accelerate pace • But, we all know what happens in the long run

3. If Reforms Did Disappoint, Why? • Wrong expectations • Recommendations based on cross-sectional evidence • Reforms did not tackle well some basic issues for EMs • Macro policy • Systemic risk • Domestic and external shocks, e.g. capital flows volatility • Institutional factors – size, information asymmetries, moral hazard • Globalization • Thus, redesign reform to address the basic issues, and revise expectations • But, many of these issues are intrinsic to emerging markets and solving them is a daunting task

4. Liberalization Papers • Great papers! • Important contributions • Welfare implications relative to previous work • Growth mean and volatility • Solid work • Almost painful to read, “overwhelming force” • Incorporated most comments received in the past years, so difficult to discuss • Particularly for the growth mean paper • Volatility paper needs to address the same comments that spur paper already did

4. Liberalization Papers • Potentially relevant issues to consider • “One of the most fundamental national policy decisions of the past 25 years has been the liberalization of equity markets across the world.” • Here, allowing foreigners to purchase domestic stocks • But witness size of stock markets • And witness effects of capital account liberalization • Which samples/estimations make sense? • Mix of developed and developing, including very poor countries • Including countries with no change in liberalization • Time series for emerging markets • Fixed effects estimations • Coefficient diminishes to 0.56 • But why including countries with no variation in liberalization here?

4. Liberalization Papers • Potentially relevant issues to consider (continued) • More on econometrics • Overlapping observations • How are common factors treated besides SUR specification? • How is endogeneity addressed, specially given that it comes up in the growth paper? • Removing 97-00 seems arbitrary • Crises as outliers? Rationale? • Why including 99 and 00? • Perhaps, crises consequence of liberalization, as suggested • Even with crises, other evidence points towards lower volatility

4. Liberalization Papers • Caveats related to liberalization measures • Wider set of financial liberalization measures • Pace of liberalization • Reversals • Intensity of liberalization • Capital account liberalization • Might seem more important to many readers • Treatment of capital account liberalization

4. Liberalization Papers • Other specific points • More on economic significance would be welcomed • Results weakened with other controls • For LAC countries, mean results insignificant • Other regressors • Other controls, like GDP per capita • Level of inflation might matter • Risk sharing • Perhaps, could be another paper • Ability versus actual risk sharing

5. Creditor Rights Paper • Great paper! • Important points of the paper • Effectiveness of creditor rights, interacted with • With rule of law • With efficiency of the judiciary • With small and medium firms • Perhaps nicest results • Three effects of creditor rights • Credit/GDP • Share of bank credit financing of small and medium firms • Change in real credit (procyclicality)

5. Creditor Rights Paper • Potentially relevant issues to consider • More consistency across empirical analysis • Creditors rights, rule of law, or broad institutions? • No multivariate analysis, omitted variables • Only done very partially for change in credit, when controlling both for creditor rights and rule of law • Perhaps, control for GDP per capita, given that GNP and GDP growth not significant • Interaction might result more from law and order explanatory power than from creditor rights • Perhaps interact with GDP per capita and other variables • Why is creditor rights insignificant by itself second part?

5. Creditor Rights Paper • Potentially relevant issues to consider (continued) • Why procyclicality? • Risk can be reduced ex-ante, knowing state of institutions • More explanation would be welcomed • Policy recommendations • Cross section evidence versus time series recommendation • More reforms needed • Foreign jurisdictions • Systemic shocks and creditors right • Repudiation of contracts • Shocks to collateral • In fact, acknowledged importance in institutional analysis

5. Creditor Rights Paper • More on data and variables • Macro variables not significant, except budget deficit • WEBS survey • Only for 1999 • Share of investment financed with bank credit and legal protection • What about other type of financing • Other specific point • Econometrics • Procyclicality results weak using IVs • Clustering standard errors

Financial Sector Reform