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IDB report says Latin America and the Caribbean need stronger banking systems to achieve higher rates of growth and stability

Latin America and the Caribbean must strengthen and continue to reform their banking systems to achieve higher macroeconomic growth rates, business competitiveness and stability, according to a new report issued by the Inter-American Development Bank titled Unlocking Credit: The Quest for Deep and Stable Bank Lending.

Banking systems in Latin America have a disproportionate financial impact as credit and investment tools because other capital markets, such a stock exchanges, are relatively small, leaving investors and entrepreneurs with few alternatives outside the banking system to access funding. “Unfortunately, bank credit remains scarce, costly and extremely volatile,” said the report, the latest of annual IDB Economic and Social Progress Report.

“In the context of few alternative sources of financing, the development of stability of the banking sector is crucial for achieving a stable economic path,” the report said.

Banking sectors in other, faster-growing developing regions of the world provide much greater credit to the private sector than does Latin America, according to the study. “During the 1990s, the average level of credit to the private sector in the region was only 28 percent of GDP, a rate significantly lower than that of other groups of developing countries, such as East Asia and the Pacific (72 percent) and the Middle East and North Africa (43 percent),” the report said. Credit to the private sector in East Asia grew from an average 15 percent of the GDP in the 1960s to 70 percent today, while in that same period Latin America’s grew from 15 to 28 percent.

To strengthen Latin America’s banking systems, the report recommended that countries take steps to reduce their vulnerability to financial crises, improve regulation and supervision, enhance property rights – including creditors rights and the effective use of collateral for inducing greater lending – and improve the availability of financial information, particularly through credit bureaus and credit registries.

Strengthening the financial safety net

Latin America’s banking systems, in addition to being shallow, are the most vulnerable in the world to recurrent shocks and crises, according to the report.

“Compared with other regions, Latin America displays the highest average number of crises per country,” the study said. “Moreover, when ranking regions by the share of countries that have experienced two or more crises, Latin America comes out first, with 35 percent of its countries having experienced recurrent crises. This share is almost three times higher than any other region.”

In addition to macroeconomic policies that will reduce vulnerability to “sudden stops” in international flows and volatile credit and exchange rate cycles, Latin American nations must also take steps to deal with specific vulnerabilities, such as financial dollarization, and strengthen the regulation and supervision of their banking systems.

The report noted that highly dollarized banking systems, in which banks lent in hard currency for local nontradable investments, and a high concentration of public debt in the asset structure of banks were the two leading vulnerabilies of banking systems in Latin America during the 1990s.

By transferring exchange rate risks to nontradable sectors, “a sizeable component of banks assets was vulnerable to real exchange rate fluctuations.”

To build a financial safety net, the report suggested a balance of tighter banking supervision and regulation in combination with market discipline by the private sector. “This means that appropriate regulations can enhance the disciplining power of markets, and markets may enhance the disciplining power of supervisors.”

Despite many reforms throughout the region during the 1990s, “All in all, it is clear that prudential regulation and supervision are not tight enough, and further reforms are needed in order to improve banking oversight.”

In an examination of the Basel II international agreement on banking supervision and regulation, however, the study recommended a cautious approach to adopting its principles. It said Basel II “cannot easily be implemented in Latin America and the Caribbean” and before doing so countries should first guarantee “stronger compliance with the basic core principles of supervision and regulation.”

Stronger Property Rights

The report said Latin America’s credit markets, particularly for small businesses, were inhibited by weaknesses in property rights, particularly enforcing loan contracts based on collateral.

Developed countries have stronger property rights and enforce loan contracts more effectively than Latin America, where laws “tend to favor debtors in case of dispute, and make it excessively costly for creditors to recover collateral in case of borrower default.”

In addition, titling and property registries are “weak and poorly managed, which makes it difficult for creditors to establish the priority and seniority of their claims.”

An improvement in the region’s credit registries and financial information systems can reduce banking costs and lead to more credit, because they will allow “creditors to sort good and bad debtors before granting credit.”

Fighting money laundering

The report in a separate chapter urged that countries adopt measures to combat money laundering, an issue growing in importance because of growing world concern about terrorism and drug trafficking. It said a successful fight against money laundering in the region requires a “comprehensive view,” because “some of the structural weaknesses in the region contribute to thriving money laundering activities, and, as long as such weaknesses are not properly dealt with, purely legislative measures may not suffice.”

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