Private Enterprise and Financial Markets > Infrastructure and Financial Markets
Financial Market Development: Issues, Strategies and Inter-American Development Bank Activities
(03/98, En)
Part One: Critical Issues and Strategies
Part Two: IDB Group Activities (up to October 1997)
Part One: Critical Issues and Strategies
I. Background: Financial Sector Reform in Latin America and the Caribbean
During the last decade, the countries of Latin America and the Caribbean have achieved significant progress in the restructuring and developing their financial markets. With few exceptions, they have undertaken important reform programs which have been built upon a foundation of political, legal and macroeconomic stability. Inflation and government deficits have been reduced, monetary growth is under better control, and the external debt as a percentage of both GDP and exports earnings has fallen. As the financial markets of the region have become increasingly liberalized, the countries have been able to attract increasing amounts of direct as well as portfolio investment from international investors. By 1995, the economies had solidified to the point that the crisis suffered by the Mexican economy, though resulting in a temporary strain on some countries, did not spread. Likewise, the impact of the current Asian crisis to date has been limited. The reforms undertaken by most of the countries in the region are recognized as being substantive and lasting. (For discussion of the impact of the reform programs, see "Latin America After a Decade of Reform," Economic and Social Progress in Latin America, 1997 Report, Inter-American Development Bank, Washington, D.C.)
Financial reform is, above all, a continual process. The initial reforms undertaken in the last decade need to be consolidated and extended so that more sophisticated markets, institutions and instruments will develop. The countries of Latin America and the Caribbean need to take steps to move away from their reliance on bank-dominated systems. Undoubtedly, commercial banks will continue to play a central role in financial markets, facilitating credit, savings and payments services, but their product offerings will likely be insufficient for the investment and risk transfer needs of the vibrant, growing economies of the region.
Banks that depend on par deposits are unable to underwrite or invest in equities. Loans are inappropriate for risky venture capital projects and banks are not structured to underwrite traditional insurance risks (especially those that are characterized by low frequency but high severity losses). Nor can banks be expected to undertake foreign exchange, interest rate or commodity price risk on behalf of their borrowers when they are unable to hedge these risks. Nevertheless, when other instruments and institutions do not exist, banks are often pressured by their customers to lend to projects wherein the underlying risks are best suited for venture capital or equity financing. This, in turn, increases the risk of the underlying project since the liability structure may not match the cash flows generated by the firm's assets. And when private banks are unwilling to provide funds for these riskier investment projects, the demand for government-owned banks to step in and compensate for a claimed "market failure" is heightened, leading to increased risk and the tendency to politicize the allocations of scarce investment capital.
The economic history of emerging economies is replete with periodic episodes of severe market crises. Careful analysis shows that the structure of the financial markets, along with the dominance of banking, has contributed to, or extended the crises. Excessively optimistic extensions of credit, uncontrolled levels of exposure to foreign exchange risk, a lack of adequate risk disclosure, inadequate capitalization (and the related perverse incentives toward increased risk taking by financial institutions), and the lack or uneven enforcement of prudential regulatory standards have created situations where whole financial systems have collapsed. Given the importance of the banking system, governments have felt constrained to intervene to protect depositors. The cost of safeguarding small depositors, and often large, sophisticated depositors or even bank shareholders, after a crisis occurs, has been high. Better supervision of financial intermediaries has been critical to preventing crises, but steps must also be taken to allow non bank markets to develop. Of particular interest to the development of the financial sector is the new paradigm of government involvement in financial markets that has been adopted throughout the region. There is a wide recognition that the comparative advantage of government is in the establishment of an enabling environment, creating the legal, regulatory and information structures upon which private financial markets can develop and flourish. Under this new paradigm, the direct role of the state has been reduced. Many government-owned and managed financial institutions have been reformed and others have been privatized. Most countries have adopted the basic capital adequacy standards established by the Basle Committee of International Bank Supervisors (or slight modifications thereof) placing increased emphasis on the capital adequacy of the banking sector. Interest rates and the allocation of scarce investment resources, previously set by administrative fiat, are now determined by market forces.
Outside of the banking sector, the role of the government is increasingly becoming the provision of an enabling environment to support private sector activity. The management of pension fund assets has been moved to the private sector. Markets for longer term debt and equity securities are beginning to emerge in some countries. Financial innovation is on the rise. Asset-backed securities for mortgages and other financial instruments are being developed to enhance liquidity. Markets, both on organized exchanges and over-the-counter, for commodities, futures and forwards, foreign exchange and interest rate contracts, swaps, options and other derivatives are being created, increasing the number of tools available for risk management. Despite significant differences in the financial markets of the countries of Latin America and the Caribbean, reform efforts point in one direction: the development of complete financial markets. The private sector is actively involved in developing the financial innovations that can build upon earlier progress. This is being supported by a public sector that is moving forward to provide an adequate regulatory structure. Legal reforms have strengthened financial market regulators and their oversight of bank, insurance, pension and securities markets. Supervisory standards and practices are moving toward international levels, including a greater emphasis on the adoption of the Core Principles of Bank Supervision prepared by the Basle Committee. Supervisors are better trained and compensated, leading to a greater degree of professionalism. Enforcement powers, and in many cases, the political will to use them has increased. It is recognized that while good regulation is expensive, the cost of inadequate regulation, in terms of future insolvencies and economic dislocation, is far higher. Countries are beginning to provide adequate resources to implement needed regulatory and supervisory oversight. Disclosure standards are being set to impose market discipline. Insolvent financial institutions are being forced to close or merge and the losses associated with poor investment decisions are progressively being borne by the responsible shareholder rather than the taxpayer (or inflation-inducing money creation).
The development of non bank financial markets has been limited. Insurance and capital markets remain underdeveloped in most countries. Capital market activity remains concentrated in a small number of firms in a limited number countries. There is a relation between country size and capital market development--it is harder for a small country to support a well diversified capital market. Similarly, there is also a strong relationship between a country's market size and the timing of its economic reforms. Those countries which have been following consistent policies in support of financial market development have developed more rapidly. The remaining sections of this report look at the critical issues which, in our opinion, will need to be addressed by the countries of Latin America and the Caribbean as they move forward in a second generation of financial reforms: the legal and regulatory framework, the information environment, the development of institutional investors (insurance markets, private pension funds, mutual funds), the need for increased innovation in financial market instruments, and the capital market infrastructure. The report also presents the Inter-American Development Bank's strategic approach to support the development of financial markets in the region.
Part Two: IDB Group Activities (up to October 1997)
Financial Sector Reform in Latin America and the Caribbean
Throughout the 1990s, the Inter-American Development Bank Group (IDB Group; refers to the Inter-American Development Bank (IDB), the Inter-American Investment Corporation (IIC) and the Multilateral Investment Fund (MIF)) has provided significant support for financial sector reform in Latin America and the Caribbean. The reforms have been aimed at making member countries more attractive to private investors, promoting economic growth, increasing competitiveness, and promoting integration with the world markets. The IDB Group has actively supported the transition from state dominated systems, where the public sector is extensively involved in direct financial intermediation and where central banks are assigned a wide range of quasi-commercial activities, to new schemes with increasing private sector participation. In these transformations, the independence of central banks and their concentration on monetary policy has been increased, and the role of the state has been redefined.
The IDB Group has provided support for legal reform and the strengthening of bank and securities markets supervision as two fundamental pieces of the financial reform process. The IDB Group has supported capital market development, pension fund and insurance market reforms, and the restructuring and strengthening of financial institutions. It has also provided professional training and assistance in the development of new financial markets, intermediaries and instruments. Most of the reforms have been focused on building markets and strengthening the safety and soundness of financial markets in order to prevent the reoccurrence of systemic crises. It should be noted, however, that in some instances the IDB Group has provided support as part of broad economic emergency plans, including short-term immediate actions, but have included long-term conditionalities as well.
This report presents the degree of IDB Group involvement and support in the reform and modernization of financial and securities markets in Latin America and the Caribbean, and is intended to serve as a reference for the IDB Group in the development of its strategies in this area. It is hoped that by compiling in a single document all the actions in this area, a better appreciation will be developed inside and outside the Group of the contribution it has made and the the degree to which more action is required. Section II presents the IDB Group's lending activities for financial market development. Section III discusses the impact of the IDB Group's operations on reform programs. As non-lending activities have become an increasingly important component of the support provided by the Inter-American Development Bank (IDB), Section IV discusses the types of non-lending support provided. Non-lending support includes: conferences, publications, special meetings, special projects and the preparation of IDB strategies. In Section V we provide concluding remarks.
Although the report does not attempt to evaluate the results of specific operations or of national or regional-level reforms, it is hoped that this effort will evolve and may be eventually combined with the evaluation efforts of the IDB's Evaluation Office (EVO) and the Office of the Chief Economist (OCE) to produce a comprehensive document.
Last updated: 02/26/07
