Financial Reform and Vulnerability: How to Open but Remain Safe?

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

3. Definition of a Banking Crisis • Ratio of nonperforming loans to total bank loans exceeded 10%. • Cost of the rescue operation (or bailout) was at least 2% of GDP. • Episode involved a large-scale nationalization of banks (and possibly other institutions). • Extensive bank runs took place or emergency measures (deposit freezes, prolonged bank holidays, or generalized deposit guarantees) were enacted by the government. June 7th 2007

4. 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) June 7th 2007

5. Capital Account Liberalization and Financial Crises Last crises: Argentina 2001-2003 June 7th 2007

6. Capital Account Liberalization and Financial Crises June 7th 2007

7. Capital Account Liberalization and Financial Crises: Macroeconomic Factors • Microeconomic Factors: • Mismatches between assets and liabilities. • Government interference. • Weaknesses in the regulatory and legal framework. • Premature financial liberalization. • External shocks • The Exchange Rate Regime • Openness • Financial Repression • Domestic shocks • Lending booms Deposit Runs June 7th 2007

8. 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 “t+2” period: Chile 1981: 20% Philippines 1981: 41% South Africa 1985: 53% Turkey 1985: 35% Venezuela 1994: 34% June 7th 2007

9. 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. June 7th 2007

10. 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. June 7th 2007

11. 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) June 7th 2007

12. 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) June 7th 2007

13. 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 June 7th 2007

14. 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. June 7th 2007

15. 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 June 7th 2007

16. Micro Factors: Balance Sheet Mismatches • Bank assets and bank liabilities: differ in terms of liquidity, maturity, and currency of denomination. • Maturity and currency mismatches: more acute in a context of rapidly increasing bank liabilities (capital inflows). • Maturity mismatch and sequential service constraint: create the possibility of self-fulfilling bank runs. • 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. • Lending in foreign currency by banks to domestic borrowers transforms currency risk into credit risk. June 7th 2007

17. 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. June 7th 2007

18. 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. June 7th 2007

19. 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. June 7th 2007

20. Route of a classic financial crisis June 7th 2007

21. 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 June 7th 2007

22. Early warning signals June 7th 2007

23. 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 June 7th 2007

24. 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 June 7th 2007

25. 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. June 7th 2007

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