Financial Market Fragilities in Latin America: From Banking Crisis Resolution to Current Policy Challenges


WP/94/117-EA
Financial Market Fragilities in Latin America: From Banking Crisis
Resolution to Current Policy Challenges by Liliana Rojas-Suarez and
Steven R. Weisbrod

This paper deals with key issues in Latin American financial markets.
After examining a sample of countries dealing with severe banking
difficulties, the paper analyzes remaining fragilities and current
challenges faced by policymakers who have the complementary objectives of
maintaining long-run macroeconomic stability and a healthy financial system.

The experiences of five Latin American countries--Argentina, Chile,
Colombia, Mexico, and Peru--over the last decade are reviewed to derive
lessons regarding the most effective ways to deal with banking difficulties
in developing countries. It is shown that the strength of banks at the
onset of the banking crises and the quality of central bank leadership were
important determinants in how quickly public confidence was restored in each
of the financial systems. Where the banking system was relatively strong,
bank supervisors and bankers were able to implement credible programs to
restore confidence in the banking system; the soundness of the rescue
programs prevented the eruption of inflation, even though substantial
increases in credit were involved. In sharp contrast, in those countries
with relatively weak banking systems, banking regulators further aggravated
the problem by attempting to take over the role of banks as direct lenders.
In those cases, credit expansion was associated with episodes of high
inflation.

Having just resolved the financial difficulties of the 1980s, however,
Latin American policymakers faced new challenges to the stability of banking
systems in the early 1990s. This paper analyzes two of the issues involved:
(a) financial market risks associated with the recent large capital inflows;
and (b) the potential threat to the profitability of banks in the form of
increased competition from recently developed domestic capital markets.

Regarding financial market risks associated with the capital inflows,
the paper concludes that the quality of the inflows invested outside the
banking system--say, in the equity markets--is strongly related to the
strength of the domestic banking system. It is also shown that the policy
response to the inflows may have an important impact on the soundness of
banks. Conclusions regarding both the desirability and the method of
sterilization are linked to the strength of the central bank relative to
that of the commercial banks. As for bank competition from domestic capital
markets, the paper argues that such developments are still years away from
seriously threatening bank soundness. Even in those countries where fixed
income markets have developed, open market interest rates are still high
relative to bank interest expenses, and the instruments are still held by
only a few investors.

Finally, the paper deals with the key macroeconomic issue of the
capacity of central banks to withstand speculative attacks on the exchange
rate. It argues that the degree to which a Latin American central bank
succeeds in this task is influenced by the strength of the banking sector.
The paper also addresses the issue of the appropriate holdings of foreign
exchange reserves by central banks and the role of dollarization.