Surviving Financial Turbulence: Tales from and for Latin America

1. Surviving Financial Turbulence: Tales from and for Latin America Andrew Powell Inter American Development Bank Pontificia Universidad Católica del Perú Lima, November 9th 2011 Opinions are strictly those of the author and are not necessarily those of the IDB or any other institution.

2. Outline A) Latin America has learned important lessons from its financial history, and escaped the worst of the crisis B) The G20 has set an ambitious agenda regarding financial sector reform in response to the crisis C) Regulatory innovations in the North: (Dodd-Frank (US), ICB (UK) – Euroland overtaken by events). D) Given capital inflows and strong growth in credit, LAC needs a strong financial sector! E) What is LAC doing, what needs to be done? F) A Proposal – Lima I

3. Lessons from LAC Financial History

4. On LAC’ s (Recent) Financial History • The debt crisis of the 1980’s – US interest rates, commodity prices, sovereign debt, banking crises. • Tequila in the 1990’s – liquidity, financial crises • The 1997 Asian crisis & 1998 Russian default – contagion! • The Argentine crisis of 2002 – fixed money with not so flexible prices/wages, sovereign debt & banks and “innovative” resolution: “asymmetric pessification”, “aggressive default”, deep recession but then growth...

5. Financial vs. Other Crises • Financial crises are crises of stocks, balance of payments crises are related to flows • Rheinhart and Rogoff (“This time is different: eight centuries of financial folly”), document that financial crises are deeper and more persistent • Financial crises: resolution frequently requires significant use of public money and may provoke redistributions of wealth

6. LAC Has Strengthened Its Defenses • Reserves • Financial Systems • Regulation and Supervision • International Insurance

7. Reserves Pre-Crisis and End of 2010 Reserves as % of GDP, end of period

8. Bank (Regulatory) Capital Average requirements (exigencias) are around 11%, the average regulatory ratio (integracion) is around 16%. Source: IMF, GFSR.

9. Regulation and Supervision • LAC regulators have become more professional • Supervision has improved • Monitoring has been useful • – e.g.: IMF/WB FSAP program

10. International Insurance B) Countries with access to ILOR in Lehman with same credit ratings as A A) LAC Countries with no access to ILOR during Lehman C) LAC Countries with access to ILOLR during Lehman Source: Bloomberg and Staff estimations

11. The Ambitious G20Reform Agenda and Regulatory Innovations from the North

12. Elements of the G20 Agenda Basel N (N=1,2,3) • 1. Bank Capital • 2. Bank Liquidity • 3. Complexity and cross border issues • Other Issues: • Systemic institutions intensive supervision, additional capital, liquidity, and other prudential requirements • Derivatives: standardized OTC contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties • Rating Agencies, oversight of the ratings business • Compensation packages • A single set of global accounting standards • Countermeasures against tax havens • Other LA issues I will not talk about today (dollarization, lending to public sector, related lending)

13. Dodd-Frank (US) • Includes a serious attempt to limit the Executive’s powers to bail-out financial institutions • A failing institution to be liquidated or resolved by “title 2” resolution • Under “Title 2”, the State has the power to create a good and bad bank and then sell the good bank (to some extent similar to some LAC bank resolution rules) • But rules on market concentration may prevent selling the “good bank” to another large existing entity. • The idea is that limiting bail out powers ex ante will create discipline • Significant uncertainty as to how would be applied in practice, especially in a potentially systemic crisis • See a simulation of a major US bank failure under Dodd-Frank at a recent Economist conference in NY. www.economist.com/blogs/freeexchange/2011/11/banking-regulation

14. Independent Commission on Banking, ICB – (Vickers Report, UK) • Separation of Investment and Retail Banking with Chinese walls • Prohibited Services in Retail include: • any service which would result in a trading book asset; • any service which would result in a requirement to hold regulatory capital against market risk • any service which results in an exposure to a non-ring-fenced bank or a non-bank financial organization, except those associated with the provision of payments services where the regulator has deemed this appropriate • the purchase or origination of derivatives or other contracts • which would result in a requirement to hold regulatory capital against counterparty credit risk; and services relating to secondary markets activity including the purchase of loans or securities. • Authors note: “A ring-fence of this kind would also have the benefit that ring-fenced banks would be more straightforward than some existing banking structures and thus easier to manage, monitor and regulate”. • See Chapter 3, Independent Commission on Banking (2011): Final Report: Recommendations, London: ICB. • Commission also recommends UK following Switzerland’s lead and introduce the use of Coco’s

15. The Latin American Context:Now is the time to Act

16. Latin America: Capital Inflows 2008 was an interruption of the current episode % of GDP Inflows Net Flows Outlfows For LAC 7 Economies

17. The Changing Composition of Inflows Now More Capital Inflows are Portfolio and Bank – in “Other” In 2006, FDI was >2/3, now <1/3

18. Strong Growth in Domestic Credit Source: National Sources

19. Strong Appreciation Pressures Mexico: the only “depreciator” in this sample Significant depreciations in the crisis, save Uruguay and Peru Large appreciations post crisis Source: Staff on National Sources

20. Current Accounts Now Mostly in Negative Territory Source: WEO, IMF

21. Fiscal Balances have Deteriorated Fiscal Balance % of GDP Source: WEO, IMF

22. “Structural Balances” Deteriorated

23. Ongoing analysis of Emerging Economy Capital Inflow Episodes • Of the 91 Capital Inflow Episodes: • 29% Ended in a Banking Crisis • 53% Ended in a Recession • 59% Ended in a Banking Crisis or a Recession

24. Key: Red implies greater risk of a crisis higher is variable E.g.: Higher portfolio inflows imply greater risks, as does faster increase in credit and appreciation

25. On LAC Financial Reform:Capital, Liquidity, Complexity, Discipline

26. 1. Bank Capital • Level and Quality • Cyclical Behaviour • Basel II “Approaches” • Provisions

27. Bank Capital: where was the crisis?… Regulatory Capital to Assets at Risk. Source: IMF GFSR

28. Quality Not Quantity:Capital Increases by Type 2000-2008 • Source: Archyra et al (2009) for a sample of major banks in each region

29. Basel II vs. Basel III:Schematic Representation of Requirements National and Individual Cyclical Buffer (0-2.5%) ea. Capital Conservation Buffer (0-2.5%) Minimum Total Requirement 8% Tier 2 Additional Tier 1 6% Tier 1 4.5% Core Tier 1

30. Quality of Capital in Brazil and Mexico 50% of these Financial Systems operate with Tier 1 Buffer of about 5% (i.e.: 13.5% of assets at risk = 6 + 2.5 + 5)

31. What Should LAC do? • LAC should publish core tier 1 and tier 1 ratios • And adopt Basel III perhaps with stricter rules (as LAC has adopted Basel I and II with stricter ratios) • Analytical work required to consider what those stricter ratios should be…

32. On Anti-Cyclical Capital Rules • Basel III’s cyclical buffers force banks to hold more capital in the good times, with an expectation it will be used in the bad • But LAC banks already hold significant capital cushions, perhaps to avoid hitting the requirement levels. • Anti-cyclical rules may have less effect than may be imagined, depending on why we think banks hold these buffers, as banks may reduce the optimal buffers held • Aliaga-Diaz, Olivero and Powell (2011) show this formally in a SDGE model calibrated to LAC countries. • Bottom Line: If Basel III rules are applied on total capital, they will have little effect. Assuming they are applied to Tier 1 Capital (as they should), and banks are expected to increase tier 1 capital by 2.5% in the best simulations, we find consumption volatility may be reduced by 4-5%.

33. What Should LAC do? • Adopt anti-cyclical capital rules • These should be specified on core tier 1 • Given the amplitude of cycles in LA, these rules should be more aggressive than Basel III • Work needs to be done to calibrate the rules appropriately

34. On the Basel II Approaches • LAC countries have taken different views • IDB Project on Basel II Implementation in the Region: • Brazil: Simplified Standardized and IRB for qualifying banks (no Credit Ratings) • Chile: Standardized Approach (i.e.: Using External Ratings) • Colombia: Initially IRB, now more SA • Uruguay (and others): Softly-Softly, gradually adopting measures consistent with Basel II • Are the Basel II approaches a good fit for Emerging Economies? Basel II Pillar 1 Approaches Simplified Standardized Approach (SSA) – Basel 1+ Standardized Approach (SA) – Use of Credit Ratings and a table to map to requirements Internal Rating Based Approach (IRB) - Banks’ rating methodologies and estimated PD’s and a standard curve

35. Sailing through the Sea of Standards • Powell (2002, 2004) and Majnoni and Powell (2005)1 made the following arguments: • A lack of rated claims reduces the value of Standardized Approach • Arguably, the Internal Rating Based Approach: • gives too much autonomy to banks • requires very significant supervisory resources beyond many countries • is too much of a black box and the calibration is suspect for LAC (correlation assumptions and 99.9% tolerance) • At the same time, many countries have centralized “rating systems” to determine provisions… • Majnoni and Powell’s proposal: • A Centralized Rating Based (CRB) approach would have banks rate claims according to a standard scale, this has a cost as banks must use a common scale but a huge benefit in terms of ease of supervision • Should be calibrated appropriately 1Majnoni, G. and A. Powell (2005). “Reforming Bank Capital Requirements” Economia, Spring 2005. See also Powell (2002) and Powell (2004).

36. On Provisions • Many countries in Latin America maintain provisions on the basis of losses incurred • Basel III now calls explicitly for forward looking (expected loss) provisions and negotiations are underway with the accountancy standard setters. • Some countries have made progress on Anti-Cyclical provisions (e.g.: Bolivia, Colombia, Peru, Uruguay)

37. Galindo and Rojas-Suarez propose an index of theQuality of the Provisioning Regulation • Micro-prudential questions • Does it reflect expected loss (and if so over which categories of loans)? • Does it specify provisions over other assets or only loans (investments, contingent claims, other assets)? • Macro-prudential questions • Does it have an anti-cyclical component? • Are provisions counted as capital?

38. Survey Results Source: Galindo and Rojas-Suarez (IDB, forthcoming)

39. 2. Liquidity • Heralded as part of Basel III’s macro-prudential tools…. • Suggested characteristics of liquidity rules to be macro-prudential: • Should be held in assets that remain liquid even if there is macro (systemic) stress. • Should be held and used for systemic purposes • This indicates a system of requirements in a central bank or centralized custodian with tough rules on their composition • Basel III liquidity rules do not appear to satisfy these characteristics

40. Liquidity vs. CapitalAlternative Views • 1) Two Risks: Solvency Risk vs. Liquidity Risk • 2) Size Matters: capital requirements limit size, liquidity rules are a restriction on asset composition • 3) Capital (the difference between of assets and liabilities) may be volatile and may disappear, if liquidity is cash in the central bank, its actually more real • Appropriate liquidity policy depends on what you think is the problem and the role of liquidity …

41. And what does/should LA do? • Several countries have liquidity requirements (remunerated, so less of a tax) and banks must satisfy in the central bank and in some more sophisticated cases may satisfy in other centralized custodians • Flexible tools: can be adjusted over the cycle, remuneration rates can penalize anti-social behaviours such as lending in dollars or riskier (more flighty) types of liabilities • Work needed to determine the appropriate level (Charlie Calomiris advocates 20%) for developed countries

42. 3. Complexity – Cross Border • Basel N (N=1,23), Pillar II, still contains the myth that the role of a Supervisor is to supervise a Bank. • But Lehmann Bros. had 2985 legal entities operating in 50 countries with many supervisors. • Pillar II focuses on a lead Supervisor supervising a consolidated entity. Majnoni and Powell (2005, 2007) argued that Consolidated Supervision may be necessary but it is NOTsufficient. • Pillar 2 should state explicitly what the role of the different supervisors should be when there are many significant entities with different regulators

43. Complexity – Cross Border • If a Subsidiary (or a Branch) is significant for the Host that entity should be jointly supervised and the Host should be the primary agent to Monitor and Supervise. • The Host should have access to any information from the Home (consolidated or lead) supervisor that it needs to be able to execute its duties. • When times get tough, voluntary “regulatory cooperation” will break down, “Colleges” are not enough. • The Board of Subsidiaries in host countries must act only in the interests of the subsidiary • G20/BCBS needs to work more here as international law is inconsistent (“single” vs. “multiple entity” resolution) and the legal position regarding international banks’ responsibilities to their local depositors remains murky.

44. What Should LAC do? • LAC is host to many legal entities in complex corporate structures; where its unclear how a Subsidiary fits into a structure, action is required • LAC should make very explicit governance rules for subsidiaries and board members fiduciary duties • Host supervisors should know how any actions by the home supervisor (such as Living Wills, Chinese Walls or other measure may affect subsidiaries in their country) • More analytical work required….

45. South-South Complexity • LAC needs to pay attention to increased South-South cross border banking, in South America, Central America and the Caribbean. • LAC Supervisors may wish to agree rules on cross border supervision. • An interesting recent example of the dangers come from the Caribbean: The CLICO Group (CL Financial) in Trinidad and Tobago

46. Complex structure across many countries Source: CCMF Report on CL Financial

47. Cross Border Issues Abound in the Caribbean Financial System (Commercial Banks Only) Haiti, Guyana and Suriname in the Periphery T&T in the Center By ownership & by market Network visualization by Pajek software: for a short description see Batagelj V., Mrvar A.: Pajek - Analysis and Visualization of Large Networks. in Jünger, M., Mutzel, P., (Eds.) Graph Drawing Software. Springer, Berlin 2003. p. 77-103

48. Complexity – InstrumentsStandardization vs. Innovation • The recent crisis has amply demonstrated that much financial innovation is motivated by regulatory (and tax) arbitrage • LA countries perhaps given the French Law tradition and limited liquidity have favored Standardization • The world may now focus more on Standardization and less on innovation: banks more akin to utility companies • Standardization also eases Supervision and the possibility to collect meaningful data - information. • Indeed non-standard instruments, if permitted, should attract higher capital and/or liquidity requirements.

49. 4. Market & Supervisory Discipline • Market discipline and supervisory discipline intimately related, the crisis was a failure of both. • Financial innovation allowed practices that were not detected by regulators, heightened the information asymmetries – Powell, Miller and Maier 2011. • Perhaps market has some information not available to supervisors • Market and supervisory discipline are complements (re: Argentina’s BASIC system in the 1990’s – Information, Auditing, Credit Rating, Bonds, Supervision). • An automatic market trigger may also limit forbearance • Coco’s provide additional capital and a market trigger: Switzerland has two triggers, preemptive and crowd-in level.

50. A Proposal: Lima 1