Financial Reform and Vulnerability:
How to Open but Remain Safe?
José Luis Escrivá
Chief Economist - BBVA Group
June 7th, 2007
June 7th 2007
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Banking Problems since late 1970s
Systemic banking crises
Episodes of non-systemic banking crises
No crises
Insufficient information
Source: Caprio and Klingebiel (1999).
June 7th 2007
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Definition of a Banking Crisis
1. Ratio of nonperforming loans to total bank loans
exceeded 10%.
2. Cost of the rescue operation (or bailout) was at least
2% of GDP.
3. Episode involved a large-scale nationalization of banks
(and possibly other institutions).
4. Extensive bank runs took place or emergency
measures (deposit freezes, prolonged bank holidays, or
generalized deposit guarantees) were enacted by the
government.
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Impact of financial crises on long-run growth
Financial crises have a large, negative impact on GDP.
Countries typically do not return to their old growth path (IMF research).
GDP loss is largest for poor countries.
Typical Growth Path after Financial Crises in Rich and Poor Countries
Source: Cerra and Saxena (2005: 24)
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Capital Account Liberalization and Financial Crises
CAPITAL-ACCOUNT LIBERALIZATION AND FINANCIAL CRISES
Country (First
Year of Financial
Difficulties)
Severe Crisis
Argentina (1980)
Argentina (1989)
Argentina (1995)
Chile (1981)
Mexico (1994)
Venezuela (1994)
Liberalization
Capital Inflows
Short-Term
Porfolio
Prior to Crisis
Open
Closed
Open
Open
Open
Closed
Open
Closed
Open
Open
Open
Closed
Yes
n.a.
Yes
Yes
Yes
n.a.
Malaysia (1985)
Philippines (1981)
Thailand (1997)
Open
Open
Open
Open
No
n.a.
Yes
South Africa (1985)
Turkey (1985)
Turkey (1991)
Closed
Open
Open
Open
Closed
Last crises:
Argentina 2001-2003
No
No
Yes
Williamson and Mahar, (1998, p. 53).
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Capital Account Liberalization and Financial Crises
CAPITAL-ACCOUNT LIBERALIZATION AND FINANCIAL CRISES
Country (First
Year of Financial
Difficulties)
Less Severe Crisis
United States (1980)
Canada (1983)
Liberalization
Capital Inflows
Short-Term
Porfolio
Prior to Crisis
France (1991)
Italy (1990)
Australia (1989)
New Zealand (1989)
Open
Open
Open
Open
Open
Open
Open
Open
Open
Open
Open
Open
Open
No
No
Yes
Brazil (1994)
Closed
Closed
n.a.
Indonesia (1992)
South Korea (mid-1980s)
Open
Closed
Open
Open
No
Turkey (1994)
Open
Open
Yes
Sri Lanka (early 1990s)
Closed
Open
Yes
Yes
Williamson and Mahar, (1998, p. 53).
June 7th 2007
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Capital Account Liberalization and Financial Crises:
Macroeconomic Factors
1.
2.
3.
4.
5.
6.
External shocks
The Exchange Rate Regime
Openness
Financial Repression
Domestic shocks
Lending booms
Microeconomic Factors:
1.
2.
3.
4.
Mismatches between assets and liabilities.
Government interference.
Weaknesses in the regulatory and legal framework.
Premature financial liberalization.
Deposit Runs
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Macroeconomic Factors: External shock
A change in the terms of trade.
An unanticipated drop in export prices, for instance, can impair the capacity of
domestic firms (in the tradable sector) to service their debts.
This can result in a deterioration in the quality of banks' loan portfolios.
Adverse shock to domestic income associated with a decline in the terms of
trade: may slow output and raise default rates.
Terms of Trade Index (100=first year of financial difficulties[t])
220
Chile 1981
South Africa 1985
Venezuela 1994
200
Philippines 1981
Turkey 1985
180
Maximum decrease of the terms of
trade in the “t-7” to “t+2” period:
Chile 1981:
Philippines 1981:
South Africa 1985:
Turkey 1985:
Venezuela 1994:
160
140
120
100
20%
41%
53%
35%
34%
80
t-7
t-6
t-5
t-4
t-3
t-2
t-1
t
t+1
t+2
Source: BBVA from IIF data
June 7th 2007
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Macroeconomic Factors: External Shock
Capital outflows induced by an increase in world interest
Drop in deposits; may force banks to liquidate long-term assets to raise
liquidity or cut lending abruptly. May entail a recession and a rise in default
rates.
Interest rates in the United States (in %)
20
18
10-year Treasury Note
16
Federal Funds
14
12
10
8
6
4
2
0
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Source: BBVA
June 7th 2007
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Macroeconomic Factors: Exchange Rate
A credibly-fixed exchange rate provides an implicit guarantee (no foreign
exchange risk) which may lead to excessive (and unhedged) short-term
foreign borrowing.
This increases the fragility of the banking system to adverse external shocks,
particularly if the degree of capital mobility is high
Under any pegged rate regime, capital outflows affect the financial system
through an expansion or contraction of bank balance sheets; they can lead to
instability in the banking sector.
A flexible exchange rate may also create problems
An abrupt outflow of capital can lead to a sharp depreciation of the nominal
exchange rate.
The depreciation may raise the domestic-currency value of foreign-currency
liabilities, for banks and their customers.
Large, unhedged foreign-currency positions increase risk of default on existing
loans and vulnerability to adverse (domestic or external) shocks.
The fall in borrowers’ net worth may also lead to a rise in the finance premium
and to increased default rates; higher incidence of nonperforming loans may
lead to a banking crisis.
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Macroeconomic Factors: Opennes
Countries of currency crashes tend to be less open to trade, especially those
with sudden stops as well. An increase in trade openness of 10 percentage
points decreases likelihood of a sudden stop (definition of Calvo, et al.) by
approximately 32%. Average Opennes and Fitted Opennes by category of Crisis
0.14
0.65
0.64
0.12
0.63
0.62
0.61
0.08
0.6
0.06
Openness
Fitted Openness
0.1
Fitted Open
Open
0.59
0.58
0.04
0.57
0.02
0.56
0
0.55
No crash, no SS (1815 events)
Crash but no SS (317 events)
Crash and SS (18 events)
Source: Calvo, Izquierdo & Mejia (2003); Edwards (2004a,b)
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Macroeconomic Factors: Opennes
Countries that are less open to trade are more prone to sudden stops &
currency crashes. Increase in openness also decreases the likelihood of
currency crash, defined as 25% increase in exchange market pressure≡
(exchange rate * reserves)
Sudden Stops (SS1) and Currency Crises (Crash) by level of openness
350
292
300
Number of Episodes
250
200
> Mean open
< Mean open
150
127
100
52
50
34
0
SS1 (86 events)
Crashes (419 events)
Source: Calvo, Izquierdo & Mejia (2003); Edwards (2004a,b)
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Macroeconomic Factors: Financial Repression
Financial system in most developing countries is “repressed” by government
interventions. This keeps interest rates that domestic banks can offer to savers
very low.
By keeping interest rates low, it creates an excess demand for credit. It then
requires the banking system to set a fixed fraction of the credit available to
priority sectors.
Combination of low nominal deposit interest rates and moderate to high
inflation has resulted in negative rates of return on domestic financial assets.
Financial Repression Leads to Low Growth:
1. Poor legal system
2. Weak accounting standards
3. Government directs credit
4. Financial institutions nationalized
5. Inadequate government regulation
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Macroeconomic Factors: Domestic shock
Domestic shock: increase in domestic interest rates (to reduce inflation or
defend the currency). Slows output growth and may weaken the ability of
borrowers to service their loans; may lead to an increase in non-performing
assets or a full-blown crisis.
Interest and exchange rates in Brazil (1993-1994)
14.000
0,90
0,80
12.000
Money market interest rate (in %)
Exchange rate vs USD (r.h.s.)
10.000
0,70
0,60
8.000
0,50
6.000
0,40
0,30
4.000
0,20
2.000
0,10
jun-94
may-94
abr-94
mar-94
feb-94
ene-94
dic-93
nov-93
oct-93
sep-93
ago-93
jul-93
jun-93
may-93
abr-93
mar-93
feb-93
0,00
ene-93
0
Source: IFS (IMF)
June 7th 2007
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Macroeconomic Factors
Credit Booms: Rapid increases in bank credit to the economy.
Source of increase in banks' capacity to lend: often large capital inflows.
Often at the expense of credit quality. Distinguishing between good and bad credit
risks is harder when the economy is expanding because borrowers may be at least
temporarily profitable and liquid
Boom is often accompanied by asset price bubbles (stock market, real estate).
Absolute Deviations in the Credit-GDP Ratio with Respect to Trend
Source: Credit Stagnation in Latin America. Adolfo Barajas and Roberto Steiner 2001
June 7th 2007
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Micro Factors: Balance Sheet Mismatches
1.
2.
3.
4.
5.
First year of
Bank assets and bank liabilities: differ Emerging country
financial
in terms of liquidity, maturity, and
difficulties [t]
Argentina
1995
currency of denomination.
Brazil
1994
Maturity and currency mismatches:
Chile
1981
more acute in a context of rapidly
Indonesia
1992
Mexico
1994
increasing bank liabilities (capital
Turkey
1991
inflows).
Turkey
1994
Venezuela, Rep. Bol.
1994
Maturity mismatch and sequential
Source: BBVA from IFS (IMF)
service constraint: create the
*(Foreign Assets-Foreign Liabilities)/Total Assets
possibility of self-fulfilling bank runs.
Large, unhedged foreign-currency
First year of
positions (banks and their
Developed country
financial
difficulties [t]
customers): increase risk of default
Australia
1989
on existing loans and overall financial
France
1991
vulnerability to adverse (domestic or
Italy
1990
New Zealand
1989
external) shocks.
Source: BBVA from IFS (IMF)
Lending in foreign currency by banks *(Foreign Assets-Foreign Liabilities)/Total Assets
to domestic borrowers transforms
currency risk into credit risk.
June 7th 2007
External mismatch of
deposit banks in [t]*
-9%
-7%
-30%
-2%
-22%
3%
9%
11%
External mismatch of
deposit banks in [t]*
-6%
-4%
-9%
-12%
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Micro Factors: Government interference
If lending decisions remain subject to government discretion: It will encourage
reckless behavior by bank managers; poor quality of loan portfolios. Liberalization
will not improve credit allocation or deepen financial markets.
Deposit banks claims on private sector
(% of GDP)
Financial system and governance (2005)
200
180
160
140
120
100
80
60
40
20
0
-2,5
-2,0
-1,5
-1,0
-0,5
0,0
0,5
1,0
1,5
2,0
2,5
Governance index {-2.5,2.5}
Source: BBVA based on IMF and World Bank
June 7th 2007
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Micro Factors: Weak Regulatory and Legal
Framework
Weak legislation against concentration of ownership
Weaknesses in the accounting, disclosure, and legal infrastructure: hinder the
operation of market discipline and effective banking supervision.
Accounting rules for classifying assets as non-performing:
Often not tight enough; make it easy to conceal losses.
Often depend on payment status, not on an evaluation of the borrower's
creditworthiness and the market value of collateral.
200
20
180
18
160
16
14
100
12
80
10
60
8
6
LATAM = 2,5
4
June 7th 2007
10
2
0
Source: GFSR - IMF
Korea
9
Hong Kong
8
India
Source: BBVA based on IMF and World Bank
7
Sri Lanka
6
Malaysia
5
Indonesia
4
Legal rights index (0-10)
Philippines
3
Chile
2
Venezuela
1
Mexico
0
Brazil
0
Uruguay
20
Peru
40
ASIA = 9,3
Colombia
120
Thailand
140
Argentina
Deposit banks claims on private sector
(% of GDP)
Banking Default Rates 2006
%
Financial system and legal framework (2006)
18
Micro Factors: Premature Financial Liberalization
Evidence of financial liberalization exacerbated by financial weaknesses in
developing countries.
Banking crisis more likely in liberalized financial systems, with
significance placed on strength of institutional environment.
Prior to liberalization banks and other financial institutions enjoy
substantial rents.
Liberalization leads to increased competition, higher marginal cost of
funds, higher bank deposit rates and banks responding by increasing the
riskiness of their loan portfolios.
June 7th 2007
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Route of a classic financial crisis
Stage I Banking crisis
Domestic financial fragility due to ill-devised financial
liberalisation; under-regulated and over-guaranteed banks.
Large capital inflows; bank lending boom, but poor quality
of bank loans. Banking sector increasingly vulnerable,
possible bank runs.
1) Deterioration of firms and bank balance sheets.
2) Drop in asset prices.
3) Increase in uncertainty.
1) + 2) + 3): Problems of asymmetric information increase.
Stage II Currency crisis
Loss of confidence (foreign) investors; pressure on the
exchange rate.
Currency crisis and reversal of capital flows;
4) Debt-deflation (debt in foreign currency).
5) Interest rate increase.
4) + 5): Further increase in problems of asymmetric
information.
June 7th 2007
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Empirical evidence of twin crises


•
Do banking crises typically precede currency crises; do
currency crises deepen banking crises?
Are both types of crises caused by bad fundamentals?
Kaminsky and Reinhart (1999) find supportive evidence for
both, showing that in the build up to a crisis, one typically
observes:
– excessive liquidity growth
banking crisis
– excessive bank lending growth
– excessive capital inflows
currency crisis
– an overvaluation of the currency
– a fall in foreign exchange reserves
→ these trends reverse after the crisis!
Can these indicators predict a financial crisis?
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Early warning signals
Percent of crises accurately called
Indicator:
banking crisis
currency crisis
twin crisis
Domestic credit / GDP
73
59
67
Money supply
75
79
89
Exports
88
83
89
real exchange rate
58
57
67
Foreign exchange reserves
92
74
79
Output
89
73
77
Source: Kaminsky and Reinhart (1999). Twin crises: banking crisis is followed by currency crisis
within 48 months.
June 7th 2007
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Are financial crises only due to bad fundamentals?
Note that the analysis so far:
• attributes financial crises to a certain extent to weak domestic
fundamentals
• implicitly assumes that financial crises are essentially solvency crises
So, what about international investors?
Recall currency crises models incorporating self-fulfilling expectations :
a financial crisis may also result from a liquidity shortage created by
international investors, while fundamentals were intrinsically sound!
A crisis occurs solely because portfolio investors withdraw their funds
to make a speculative gain
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What have we learned?





Financial crisis arise from disruptions on financial markets that
increase the asymmetric information problems such that the financial
system can no longer efficiently allocate funds
Disruptions can be caused through an
a. internal channel (leading to a banking crisis)
b. external channel (leading to a currency crisis)
c. both (leading to a twin crisis)
Level of private risk determines domestic financial fragility,
determined by
a. moral hazard (guarantees)
b. excessive optimism
‘Fundamentalists’ view a financial crisis as a solvency crisis, ‘selffulfillers’ as a liquidity crisis
Combination of both embodied in third generation models of
currency crisis
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What have we learned?
Capital account liberalization with macro and financial
weaknesses in developing countries is the responsible of
financial crises
In this case, open the market in a phased manner (1%,
3%, 5%, etc.)
Change the maturity structure of foreign capital.
Not capital control
Financial integration helps developing countries to
improve their financial markets, enhance governance,
impose discipline on macro policies, break power of
interest groups that block reforms, etc.
June 7th 2007
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Financial Reform and Vulnerability:
How to Open but Remain Safe?
José Luis Escrivá
Chief Economist - BBVA Group
June 7th, 2007
June 7th 2007
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