Surviving Financial Turbulence: Tales from and for Latin America

Andrew Powell Inter American Development Bank

Pontificia Universidad Católica del Perú

Lima, November 9 th 2011 Opinions are strictly those of the author and are not necessarily those of the IDB or any other institution.

1

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 2

Lessons from LAC Financial History

3

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...

4

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 5

LAC Has Strengthened Its Defenses

 Reserves  Financial Systems  Regulation and Supervision  International Insurance 6

Reserves Pre-Crisis and End of 2010

Bolivia Trinidad and Tobago Guyana Peru Nicaragua Haiti Paraguay Suriname Uruguay Barbados Honduras Jamaica Belize Guatemala Argentina Brazil Chile El Salvador Costa Rica Venezuela Bahamas Mexico Panama Colombia Dominican Rep Ecuador 0%

Source: LMW on National Sources

10%

Reserves as % of GDP, end of period

20% Reserves 2010 30% Reserves 2007 40% 50% 60%

7

Bank (Regulatory) Capital

Venezuela Uruguay Peru Paraguay Panama Mexico Guatemala El Salvador Ecuador Dominican Republic Costa Rica Colombia Chile Brazil Bolivia Argentina 8 10 12 14 16 18

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

20 8

Regulation and Supervision

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

International Insurance

EMBI Yields

20 15 30 25 A) LAC Countries with no access to ILOR during Lehman B) Countries with access to ILOR in Lehman with same credit ratings as A 10 C) LAC Countries with access to ILOLR during Lehman 5 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 Source: Bloomberg and Staff estimations

Days around crisis

10

The Ambitious G20 Reform Agenda and Regulatory Innovations from the North

11

Elements of the G20 Agenda

  

1. Bank Capital 2. Bank Liquidity 3. Complexity and cross border issues Basel N (N=1,2,3)



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)

12

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 13

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 14

The Latin American Context: Now is the time to Act

15

Latin America: Capital Inflows

% of GDP

8% 6% 4% 2% Inflows

2008 was an interruption of the current episode

Net Flows 0% 2000 -2% 2001 2002 Outlfows -4% 2003 2004 2005 2006 2007 2008 2009 2010 -6%

Inflows Outflows E&O (Net) Net Flows

For LAC 7 Economies

16

The Changing Composition of Inflows

1% 0% -1% -2% 7% 6% 5% 4% 3% 2%

2000 2001 Now More Capital Inflows are Portfolio and Bank – in “Other” 2002 2003 2004 2005 2006

FDI Portfolio

2007 2008

Other

2009 2010 In 2006, FDI was >2/3, now <1/3

17

Strong Growth in Domestic Credit

Credit to the Private Sector Current Prices- annual average

% change

Paraguay Argentina Dominican Rep Brazil Bolivia Venezuela Ecuador Peru Guyana Panama Colombia Chile Mexico Guatemala Honduras Barbados Haiti Costa Rica Uruguay Bahamas Suriname Belize Jamaica Nicaragua El Salvador Trinidad and Tobago

Source: National Sources -10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

2009 2010 40.0

18

130 120 110 100 90

Strong Appreciation Pressures

Multilateral Real Exchange Rates (a higher index implies depreciation)

Mexico: the only “depreciator” in this sample

80

Significant depreciations in

70

the crisis, save Uruguay Large appreciations and Peru post crisis

60

2006 -Jan 2006 -Ma r 2006 -Ma y 2006 -Ju l 2006 -Se p 2006 -N ov 2007 -Jan 2007 -Ma r 2007 -Ma y 2007 -Ju l 2007 -Se p 2007 -N ov 2008 -Jan 2008 -Ma r 2008 -Ma y 2008 -Ju l 2008 -Se p 2008 -N ov 2009 -Jan 2009 -Ma r 2009 -Ma y 2009 -Ju l 2009 -Se p 2009 -N ov 2010 -Jan 2010 -Ma r 2010 -Ma y 2010 -Ju l 2010 -Se p 2010 -N ov 2011 -Jan 2011 -Ma r 2011 -Ma y

Brazil Chile Colombia Costa Rica Mexico Peru Uruguay

19 Source: Staff on National Sources

Current Accounts Now Mostly in Negative Territory Trinidad and Tobago Venezuela Bolivia Chile Suriname Argentina Uruguay Mexico Peru Guatemala El Salvador Brazil Haiti Belize Colombia Paraguay Costa Rica Ecuador Honduras Barbados Jamaica Dominican Republic Guyana Panama Bahamas Nicaragua -5 -25

Source: WEO, IMF

-15 5 15 Current Account 2010 Current Account 2011 f 25 35

20

Fiscal Balances have Deteriorated

Chile Peru Ecuador Uruguay Panama Venezuela Honduras Argentina Colombia Brazil El Salvador Costa Rica -2,0 0,0

Fiscal Balance % of GDP

2,0 -6,0

Source: WEO, IMF

-4,0 4,0

2011 f 2008

6,0

21

“Structural Balances” Deteriorated

Evolution of Structural Fiscal Balances: LAC 7

3 2 1 0 -1 -2 -3 -4 ovbalance stb_pot_trad_adj stb_pot_chi_adj Simple average. Based on LMW; National Sources, WEO and IFS. Fiscal Balances Include: Public Sector (Mexico), Non 22

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 23

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

Inflow Characteristics

Total Inflows Portfolio Inflows Debt Securities Banking Flows

Banking Characteristics

Directed Credit Banking Supervision Increase in Credit

Inflows and their Impacts

Outflows/GDP Real Appreciation Change in Reserves +

Def 1 Banking Crisis Def 2 Def 3 Def 1 Recession Def 2 Def 3

24

On LAC Financial Reform:

Capital, Liquidity, Complexity, Discipline

25

1. Bank Capital

 Level and Quality  Cyclical Behaviour  Basel II “Approaches”  Provisions 26

14 18 16 20

Bank Capital: where was the crisis?…

Germany Japan Spain Switzerland United Kingdom United States 12 10 8 2005 2006 2007 2008 Regulatory Capital to Assets at Risk. Source: IMF GFSR 2009 27

Quality Not Quantity: Capital Increases by Type 2000-2008

1400 1200 1000 800

US$bn

600 400 200 0 Subordinated Debt Preferential Shares Ordinary Shares -200 US UK Euro  Source: Archyra et al (2009) for a sample of major banks in each region 28

Basel II vs. Basel III:

Schematic Representation of Requirements

14 12 10 8 6 National and Individual Cyclical Buffer (0-2.5%) ea.

Capital Conservation Buffer (0-2.5%) Minimum Total Requirement 8% Tier 2 Additional Tier 1 4 2 Tier 1 Core Tier 1 0 Basel II Basel III 6% 4.5% 29

Quality of Capital in Brazil and Mexico

Tier 1 Capital Levels: Top 10 Brazilian and Mexican Banks

100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 0.0% 2.0% 4.0%

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)

6.0% 8.0% 10.0%

Excess Tier 1 over Basel III

Mexico Brazil 12.0% 14.0% 16.0% 30

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… 31

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%.

32

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 33

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 34

Sailing through the Sea of Standards

 Powell (2002, 2004) and Majnoni and Powell (2005) 1 the following arguments:    made 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 1 Majnoni, G. and A. Powell (2005). “Reforming Bank Capital Requirements” Economia, Spring 2005. See also Powell (2002) and Powell (2004). 35

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) 36

Galindo and Rojas-Suarez propose an index of the Quality 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?

37

Survey Results

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

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 39

Liquidity vs. Capital

Alternative 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 … 40

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 41

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 NOT sufficient.

Pillar 2 should state explicitly what the role of the different supervisors should be when there are many significant entities with different regulators

42

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.

43

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…. 44

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 45

Complex structure across many countries

Cross Border Issues Abound in the Caribbean Financial System (Commercial Banks Only) By ownership & by market T&T in the Center Haiti, Guyana and Suriname in the Periphery 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 47

    

Complexity – Instruments

Standardization 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.

48

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.

49

A Proposal: Lima 1

50

A Proposal: Lima 1

     Given the unprecedented crisis in the North, Basel N (N=1,2,3) has been driven by the North, arguably the sequence is moving further away from a good fit for LAC There is a danger that a “standard” is being lost across LAC More importantly LAC has a lot to offer:    It has learned from its own history It has implemented many “macro prudential” measures It is blessed with good data (and economists) At a meeting of ASBA held in Lima, I proposed a LAC Accord - “Lima 1” This is meant to be fully consistent with Basel N – which are minimum standards.

51

Selected Proposed elements of “Lima 1”

         A LAC-calibrated basic requirement, likely to be >8%, and with appropriate core tier 1/tier 1 requirements likely to be higher than Basel III.

A Centralized Rating Based approach consistent with IRB procedures but calibrated to LAC (subject to the Basel minimum) and facilitating supervision.

A LAC standard on forward-looking, anti-cyclical provisions Anti-cyclical capital rules, more aggressive than Basel III Standardization of contracts or possibly higher capital (and/or liquidity) requirements on non-standard products Possible use of Coco’s in LAC Systemic remunerated liquidity requirements, lower remuneration rates for foreign currency and short term non-core liabilities Clear statements on what LAC supervisors expect from home supervisors to supervise the subsidiaries and branches of foreign banks and what LAC authorities expect from the Board of LAC banks that happen to be part of complex groups

These elements additional or compatible with Basel N

52