Public Event with members of the Latin America Shadow Financial Regulatory
Committee
Wednesday, September 8, 2004
10:30 a.m. - 12:00 p.m.
The Brookings Institution
Falk Auditorium
1775 Massachusetts Avenue, Northwest
Washington, D. C.
[TRANSCRIPT PREPARED FROM A TAPE RECORDING.]
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P R O C E E D I N G S
MS. BIRDSALL : Good morning, ladies and gentlemen.
I'm Nancy Birdsall. I am the President of the Center for Global
Development.
I see some friends in the audience who know something about the center, but let me say a word of introduction about the center before we begin the program.
For those of you who are relatively new to us, the Center for Global
Development is a group, which worries about how the policies and programs and practices of the global institutions and of the advanced economies affect prospects for reducing poverty and inequality in the developing world. So, we are concerned with the
World Trade Organization and the World Bank and the IMF and, of course, with the policies of the United States and the Europeans and other donor countries.
In that context, we are very pleased to welcome today and to be the hosts for this meeting of the Latin America Shadow Financial Regulatory Committee. It is a long name for an impressive group, which is chaired by Liliana Rojas Suarez, who is a senior fellow at the center.
This Latin America Shadow Financial Group was founded some years ago, I believe, originally as a counterpart or another shadow committee like committees of the same ilk in Europe and in the U. S., of independent persons, in this case, of great eminence, concerned with insuring that the changes in the banking and prudential regulatory arrangements to be recommended by the Basel Committee, in the context of what is called the Basel II set up, would be appropriate and sensible for the developing world in the case of this--or for Latin America, in the case of this shadow committee and for the U. S., in the case of the similar shadow committees formed in the U. S. and, similarly, in Europe.
So, the idea of these committees in other settings and in the case of Latin
America, has been to bring together people who are independent, highly knowledgeable and whose ideas, recommendations and concerns could make a difference, would have influence at the global level in what will be the future regulatory set up for banking institutions in terms of global standards.
You will see from the list of people who are sitting at the table here--I will not introduce them one by one, but they will introduce themselves as they speak.
During our discussion, you will see that they are, indeed, a very eminent group. Former
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finance ministers are here, former heads of central banks and the former chief economist of the Inter-American Development Bank, among other institutions that are represented.
Let me say a word about Liliana, who is going to introduce the discussion. She is the former deputy chief economist at the Inter-American
Development Bank. She was the chief economist for Latin America at Deutsche Bank and she took the initiative some years ago to set up and insure the work would be ongoing of this distinguished shadow committee.
With that, let me turn it over to Liliana and ask her to tell us what the committee has been doing and what they are thinking about and recommending regarding the financing of small and medium size enterprises in Latin America.
MS. ROJAS-SUAREZ : Thank you, Nancy. It is a pleasure to be here.
Just a very few words before going to our statement. The committee-you have copies of the statement. You are going to see that this is Statement No. 11.
The committee has been meeting in a number of countries in the region and making a statement, sharing our views with different people in Latin America regarding key financial issues in the region. Now, you want to know more about us before I say anything else. If you want to read all the statements that we have produced, let me give you our web page. That is kind of important. That is www.claaf.org, so that you know more about the whole committee.
Now, we have today focused, over the last few days focused on a topic that is of central importance for Latin America and it is the financing of small and medium size enterprise. Why did we focus on this issue? Because when we were looking around, regardless of what source we searched, we found that it was a major source of employment. In almost all countries, it hires about 50 percent of the former sector. At the same time, we found out that a major problem they find is that there is not sufficient access to sources of finance.
Now, what is the major fact that we have observed?
We have observed that the region has made significant progress in improving regulatory practices. Banks now follow more stringent standards to assess the quality of their portfolios. The idea of the regulation was to give more stability, to create more stable and sound financial systems and we agree. We think that is the right move.
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However, at the same time that we strengthened regulations, we did not develop sufficiently the institutions that need to back up those regulations, as well as the creation of markets and instruments that would allow for the provision of credit.
For example, in terms of institutions, yes, we said, you are only going to lend to firms that satisfy A, B and C conditions. However, the legal system did not develop or, in many countries, do not have up to date bankruptcy laws. Also, the capital markets were not there and still are not there to satisfy the requirements that were--or to fulfill the demands that were not going to be served by the banking system.
The fact is that, we have like two trains running, one that talks about being safe and the other that is being dynamic. The safer move forward; the dynamic is lagging behind. So, what do you do under those circumstances if you want to align both trains? Do you go back in regulations so as to align with the lagging institutions?
We said, no. What you do is you make proposals that push the institutions, the markets, the instruments that are consistent with the more safe financial system. That is what we have at the core of the statements that you have in front of your.
What we found is that, there is a problem. This problem that I have described to you is common to all financial systems and it goes beyond being small, but it heeds small enterprises, small and medium enterprises more. So, on the one hand, the issue is systemic, in the sense that it affects all sizes of firms, but because of the particular fissures of small and medium size enterprise, they get hit the most.
Now, why is that the case?
Basically for two reasons. We found that relative to large firms, the small and medium size enterprises faced two particular characteristics. First, they are the higher credit risks and I am going to tell you why and there is higher monitoring costs faced by creditors.
Let me explain. I don't want to go into a lot of detail into this, but by the way they operate, they are a higher credit risk for the following reasons. Let me give you one example.
SMEs, I'm going to call them SMEs for short, rather than to have to say small and medium enterprises. SMEs are a very [unintell] sector. You have one firm for the use in shoes, another for the use or selling bread and you have some in the trade sector. The [unintell] of products and industries in which they operate is enormous. The are very heterogenous. That means that almost by definition, it does not lend itself
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easily to be assessed using scoring techniques that are new--not so new, but it is a common technique used by banks to assess larger size firms, larger corporations.
Now, because of the characteristics of the small and medium size enterprises, the [unintell] do not have sufficient collateral and they have capital deficiencies, because it is not so easy to trade or put in the market the particular inputs or outputs of production that they do produce. So, because of the differentiation, they are very unique on themselves, each one of them.
In addition to that, they suffer from opacity. On balance sheets and in weak accounting practices, they have no transparent information and it is not a clear distinction between the corporation and the shareholder. You have many, many unwell functions in terms of managing the company in the sense that, the resources of the person is actually moved back and forth in the company. The company and the person sometimes becomes the same thing and that is not a good practice for managing a firm.
Now, when you focus on monitoring costs, which is the other side of the spectrum, because monitoring costs is what the banks actually do to assess whether they are lending to these kinds of firms. Think about what I just told you. First, when you monitor a firm, there are fixed costs. It really doesn't matter too much--it is not a question of size. it doesn't matter whether you are monitoring a small firm, a medium firm or a large firm. Still, you have to check the flow statements, the balance sheets, the sources of credit. You have to go through the whole process, do the due diligence of the whole process.
Now, you may have many of them and you have high fixed costs. Then you have a problem. You don't have an incentive to be actually directing your [unintell] or to do this kind of enterprise.
In this conflict, in addition to that--I am telling you that, because of the peculiarities that I just mentioned to you, if you put them together, if you put high monitoring costs plus the fact that the fissures [?] of the SMEs are particular, then the question of why don't you get financing is a no-brainer. You don't have the environment that would foster the financing of the small and medium size enterprise.
So, what do we say about it? There's a problem. So, what do we say about that?
We say, if we have characterized SMEs in that fashion, the first thing we want to do or what we call in this statement our first line of attack, is to remove the
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constraints. I just clarified for you that, we don't want to relax regulatory practices.
We want to move ahead to the other side of the two trains that I was referring to.
So, for that, we said we have a number of recommendations and assessments that we would like to present to you. First, which sounds kind of obvious to us is, banks find it more costly and riskier to lend to SMEs. Naturally, some banks lack more collateral. I mean, if you do not have enough information or if you find it too costly to go into the full cost of assessing the enterprise fully, there is a way for you. It is to ask for more collateral.
So, what do we say about that? Well, we want to have proposals to improve the financial infrastructure, which basically we have summarized in two recommendations. There are many more, but we want to emphasize two. The first one is the provision of credit information through credit bureaus. You see, I would be able to, if were a small firm or a medium size firm and I want to beef of my credit record, the best way, if I am serious about my business, the best thing I can do is to disseminate information that I have good credit, that I have been performing.
Every time that I apply for a loan, I don't want to have the whole reassessment again that increases the costs of the institution that is assessing me.
Instead, I want to have a track record.
Now, in many countries in Latin America, these credit bureaus exist, but they do not work properly. Sometimes, the information that is provided is useless. It is too complex. It makes reference to web pages that have an enormous amount of information, but it is not systematically presented. Also, it is not updated at the right time. If I, as the bank, know that the information is not being updated, then I run the risk that somebody else is given credit and I really don't know exactly the level of indebtedness of this company.
So, the dynamics that I want for these credit bureaus is far superior to what we have in the region. That is the first part.
Now, the second part is, yes, I'm riskier. I'm a small enterprise, so I have to put up collateral. In the region, mobilizing collateral is extremely difficult. One of the reasons this is difficult is, because the ownership of the collateral is not credibly defined. For that, what we propose is the establishment of registries that basically clarify and define properly the ownership of the collateral. So, that is from the point of view of infrastructure.
So, we are facilitating the assessment of banks of the weak.
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Then we have all the recommendations. I have been reminded that I need to rush a bit. We move to assessing and you will find that in this statement. Issues like the recommendation, for example, in the Basel report, I don't want to spend too much time on that, but basically there are a number of distortions in the proposed Basel
II that work against the small and medium size enterprise.
Our core recommendation, what basically surrounds or the framework in which we are moving our recommendations is to allow a small and medium size enterprise to be assessed correctly in terms of risk. Small and medium size enterprises are different among themselves. There are better and there are worst risks among them.
The fact that the financial institutions are not able to differentiate among them is a serious constraint to their ability to finance.
The recommendations in the Basel basically are summarized to remove the constraints that basically imply that all small and medium enterprises are treated equally. Then we move--and I am going to go a little bit faster on a number of other recommendations.
We want to consider the institution of a mutual fund-like institution that has assets formed by the portfolio of loans to small and medium size enterprises that
[unintell] side and the liability are shares owned by institutional investors including pension funds. Again, this does not mean that we want the pension funds to immediately invest in the small and medium size enterprises. What we want is to give the capacity to assess the risk in a special way that, if you have a mutual fund that trades in the market, that the pension fund has the possibility to assess the right risk in these portfolios, rather than telling the pension fund, no, you cannot get into this kind of investment.
Do not relax the fact that you want stringent regulations in terms of how those enterprises are behaving, but do not exclude them because they are small. Exclude them because they have no good qualities. That is where our emphasis goes.
Then we explored the issue of second-tier banking. We found that in the experience of Latin America, these kinds of institutions have not performed really very well. The fact that they have not performed very well did not leave us to conclude that they should be eliminated.
Basically, what we concluded from that--and you have that in the statement--is that there should be a number of conditions and under which second-tier banking should be established. We recognize that there are public, good elements in the
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provision of credit in some circumstances. We have seen successful stories [unintell] in
Chili, in which second-tier banking is being financed by multilateral organizations that then finance banks, not the government, to the small and medium size enterprises, but banks that then take the risks.
Again, we have a set of qualifications here that we can develop during the question and answer period, but basically under certain conditions, well managed second-tier banking could be useful. So far, in the region, the experience is limited.
You don't kill a proposal only because it has not worked because it has not been rightly implemented. You correct for the [unintell] implementation.
Then we also have the consideration of how to better integrate the SMEs into the banking system through what is called in countries like Spain and Italy, mutual guarantee societies. These take a number of forms, including the form of [unintell].
Basically, the idea is to provide a guarantee for SMEs that can be used to obtain bank loans. SMEs, just the fact that they could get together could help significantly in assessing the sources of financing from banks.
Finally, we developed some recommendations regarding technical assistance. The truth of the matter is that, a major constraint from entrepreneurial development in Latin America is lack of education, sheer lack of education.
Now, the first, the best solution is to [unintell] educate the population that can make decisions that can--that no basic analysis, financial analysis basic, not even a very sophisticated one, but that is lacking in the region. The long term solution, of course, is the obvious public sector reform to the location system. We recognize that is a long term endeavor. Therefore, as a transition process, we support the development of technical assistance for providing particular education in the skills to entrepreneurialship that would allow not to, not to promote the certain kinds of industries of a certain kind of business, but the skills in terms of accounting, preparing balance sheets, filling out applications, assessing risk. That is just the basic source of education that SMEs can very well use in the region.
Let me stop here, just with one concluding remark. Again, the most important proposal that encompasses the whole thing is, yes, we do want safe financial systems, but we also want them to be dynamic. We want them to move. We recognize that SMEs are a key component of the provision of employment in every society in the world. And we solved creating distortions in the market. We want to think of new ideas
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to facilitate the creation of instruments and markets for the provision of trade to the sector.
Pablo Guidotti would like to complement something that I--
MS. BIRDSALL: What I would like to do, if I may, Liliana and Pablo, I actually have a question for Pablo. So, perhaps, after he said something--
MS. ROJAS-SUAREZ
MS. BIRDSALL
: Very good.
: --I could start the ball rolling with some discussion.
MR. GUIDOTTI: I wanted just to complement a little bit what Liliana said by simply asking or reviewing. What are the typical demands that actually small and medium size enterprises channel in the region through the associations that collect normally a small and medium enterprise?
Typically, the arguments there--in fact, in response to the changes in prudential regulations, in fact, I would say they can be summarized in a request for relaxation of the standards in terms of prudential regulations and in asking for direct subsidies in the form of subsidizing inter-Trade. In part, I think this has to do with the way in which the small and medium enterprises have typically been defined. They are defined through the objective characteristics of the number of workers, sales, amount of sales or amount of assets.
What we find--and behind this definition, there seems to be an implication of a sort of infant industry argument, that we are talking about small firms that need to be somehow helped in the transition towards becoming larger firms. When we look at the evidence, in fact, what we see is that we can think of the economy as a continuum of firms of different sizes. What matters is really the problems that we see in financial markets.
So, in a certain sense, the definition based on, say, the number of workers is somewhat arbitrary and can actually lead to introducing distortions in the legislation where we see--you know, given [unintell] available for a firm that meets such-and-such criteria. We need to actually solve the problems, which then may be of more relevance to a sound economic [unintell] than others.
The second fact is that, when we look at where the firms, small firms actually--well, actually, all levels of firms actually change size over their life, we see, in fact, that the largest movements are in or out the market, but not in terms of size. So, really the evidence does not support the infant industry.
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So, that is why, when we look at the recommendations, we focus essentially on two main issues. One is how to improve, how to respond to the fact that markets are not there and maybe regulation for the good purpose of providing for safer banking systems has actually left a gap there. So, how do we create a better functioning for financial markets and how do we provide for additional instruments and institutions?
The second is, how do we help companies to actually be a better risk?
This has to do essentially with actions designs or directed at improving the quality of entrepreneurship. So, this is, in a certain sense, a very profound difference between the type of factions that are suggested in the statement relative to what is a traditional, I would say, a position that is expressed through associations that represent small and medium enterprises in several of our [unintell].
MS. BIRDSALL : May I go to my question?
MS. ROJAS-SUAREZ : Please.
MS. BIRDSALL : And at the same time, let it be the first in opening up some space for questions and responses from different members of the committee.
It is actually a question that I thought to pose to Pablo and/or Roque.
Each might want to comment on it. We are in Washington and I think one of the recommendations that will be of great interest in Washington in your set is the one that says, it is perfectly legitimate; let's revisit the idea that the World Bank, the Inter-
American Development Bank and the other international financial institutions would do loans for second-tier banking operations. I think that has been going on to some extent, but it is quite noteworthy that this group is returning to that issue, because as you know, as Liliana noted, there has been concern in the past about the benefits of these loans.
Now, the fact is that, for the banks, the IDB and the World Bank, these loans are great because they--and for the countries engaged. They have fairly low transactions costs between the IFI and the borrower and there is an anxiety now in the
World Bank about insufficient lending to some countries to insure a continuation of net transfers.
So, the question is, whether in a country like--well, let me put it in two ways.
Are there differences today compared to 15 years ago when these loans, in the end, were often abused in the region on average? And are there differences across countries? In the case of Argentina, where small and medium enterprises are clearly starved for credit at the moment, do you believe that the political arrangements are such
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that there could be sufficient confidence that some of the same problems that plagued these kinds of loans years ago would not recur?
And a second part of the question is, should these banks be making these loans in a situation in which the government is guaranteeing them, which is, of course, required in the case of the World Bank, though not necessarily in the case of the IDB, given that then there is the additional risk that if things go badly in the end, that debt will become a public debt?
MR. GUIDOTTI : I can, at least, respond to part of the question.
I think that in our discussion, we clearly identified that, the experience of public banks in the region has been bad. Partly one of the--the main problem is that, since it was simply subsidized credit and many times the allocation of this credit was based on conditions or reasons that were not necessarily economic, we had a--their role actually just started in many cases, the functioning, the proper functioning of competition between good firms and bad firms, providing actually help to the bad firms.
So, in this sense, I think we have to distinguish, first of all, second banking, second-tier banking from the role played by some of the public banks in the region. Once you go to the second-tier banking in the sense that, say, a multilateral organization provides funds for the development for a bank in the country, but then--and this bank provides financial lines long term to the banking system, but really the risk and the evaluation of risk is done by banks without the intervention of government guarantees. I would say, certainly, it seems that in many countries there are a few long term credit. I think these programs actually have some help in producing long term financing to banks. So, actually, it allows for better risk management and a better matching of assets and liabilities within banks.
What is not clear and the experience has shown that, this does not necessarily mean that you have more credit for small and medium enterprises. This is the reason why. As we point out, when we described the characteristics of why these type of units have a higher risk, you need to have sort of a comprehensive strategy that actually attacks both sides.
If you pretend to lend to them with tight prudential standards, then they have to have a certain quality of entrepreneurship that actually matches these conditions.
I think many times, these programs have only focused on one part. But then you see that one's banks go to small and medium enterprise. They find that essentially we have all
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these non-transparency situations. We have a lot of tax uncertainty, which is another issue that we discussed.
Finally, we did not enter it in the statement, but there is a question about what are the potential contingent liabilities association with the tax system, tax administration and whether, say, there is some role for a simplified system for small contributors to improve or to actually reduce some of these abatements.
So, I would say that the experience, at least, in the case of Argentina, I know for sure it is like that. Maybe these programs have not produced a significant increase in or success in terms of lending. I think that is because maybe we have lacked the other part of the strategy that actually connects these programs with actual lending.
MS. BIRDSALL : So, you would be okay with a big loan today in
Argentina for a second-tier bank?
MR. GUIDOTTI : Well, you know, it is a matter of different priorities.
I'm not so sure whether a big loan, but what I would certainly try to be sure is that, whatever you lend is actually lent [sic]. What I think is the problem is that, many times one has problems that simply take capital resources, but they don't produce a resource.
MR. FERNANDEZ : Well, let me just have some comments.
I think that we are doing now with respect what we were doing 15 or 20 years ago is different. So, probably one of the topics that we have been able to emphasize in this report, in this statement is that, we don't believe that the problem of the small and medium enterprise is a kind of infant industry argument.
I think that most of the developing arguments 20 years ago and this second-tier lending that the multilateral organizations were doing in Latin America somehow was connected to the infant industry argument in the sense that, well, we have to provide some sort of capital, because they have to grow. I think that the experience that we have been discussing in different countries like Mexico, Brazil and Argentina say that, well, this experience has not be in general very, very good in the past. So, we will not repeat the same sort of a problem that we had with multilateral organizations in the past.
It is true what Pablo has mentioned. Now, we have a much better financial system than we had in the past, in the sense that, we have better regulation.
We have better supervision. So, in the region we have improved a lot in the technology.
I think that I will recommend today that, it is more easy to go along with some credit
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lines maybe that are for specific purposes that have not the ones that we were having in the past.
I will emphasize that, that has to be then with no government collected in it. So, I think that, given that we have improved the risk management in the private sector, I think that multilateral organizations should take a little bit more risk and go along with some credit lines to the private sector, but not--the problem that we have in the [unintell] of Argentina particularly is that, we are not credit-worthy at this point.
The private sector was able to transfer the debt problem to the public sector. So, the private sector, they have the potential to grow in credit, not the public sector.
MS. BIRDSALL : Right.
Okay, let's open it up to questions and issues.
Please introduce yourself.
QUESTION ; [Off microphone].
Looking back to Latin America, no real banking [off microphone]. That was taken care of not only just the local knowledge of the banker and the size of the loans. All of the problems [off microphone].
Why are we not just looking at this issue a little bit, changing the way, not only to regulate it [inaudible], but who is doing the regulating? The way we approach the system is like having regulation from 10,000 miles away. I would submit that, if in the city there is a bank manager that has been living in that city and knows that society for 20 years, he, by making a credit decision, should be able to use a much smaller research allocation than if it is a recent arrived foreign banker that tries to understand what is going on.
I think that type of [inaudible] open up, because that's what we lived in
Latin America all these years. We used the local knowledge of the bank manager who knew the client and who didn't care nothing about balance sheets or whatever and he managed and it worked. The--
MS. BIRDSALL: Okay, so, Liliana, I suggest we take three or four questions and then you allocate them as you see fit.
MS. ROJAS-SUAREZ:
MS. BIRDSALL
All right, okay, that's good.
: Please?
MR. GRAVER: Good morning, my name is Eric Graver. I am with the
National Economist Club.
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MS. ROJAS-SUAREZ: I cannot hear you. Is that working?
MR. GRAVER: I'll speak louder. My name is Eric Graver. I'm with the
National Economist Club. My question revolves around the tax reform.
I'm wondering to what extent is your SME business strategy coordinated with tax reform. Might not the registry that you are proposing where you denote attention to the assets put that [inaudible] on the basis for a property tax? We have situations like that in our various states here. I'd be interested in knowing about that.
MS. BIRDSALL: Very interesting question.
Yes, let's go in the back.
QUESTION: [Off microphone] --two questions very quickly.
One, this mutual fund sounds very much like securitization, which is something that has been tried and there have been difficulties with it. I wonder if somebody could comment on that.
The other point is, you talk about technical assistance to borrowers, which is good. There are banks and financiers in Latin America who have been lending to small enterprise. Maybe it would be possible to learn their secrets and provide some technical assistance, [unintell], something of that sort to banks and financiers as well.
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MS. BIRDSALL: One more.
Peter.
QUESTION: [Off microphone].
MS. BIRDSALL:
MR. KNIGHT:
Use the mic.
Oh, sorry.
Peter Knight, [unintell] in Rio de Janeiro.
I have attended various meetings in Brazil in which the issue of taxation and finance to small and medium enterprise comes up and the fact that I have not heard explicitly--it says significant uncertainty regarding potential lax liabilities. Is that a euphemism for the fact that, many small and medium enterprises are informal in the sense that they are not paying their full tax obligation and, therefore, having a full accounting as normally required by banks would basically expose them to taxation they couldn't support. So, therefore, the question of tax reform, which was brought up by the previous questioner and simplification for these small and medium [unintell] is pretty critical.
MS. BIRDSALL: Thank you.

Liliana, you want to--
MS. ROJAS-SUAREZ : Assign, yes.
MS. BIRDSALL : --assign or take volunteers perhaps?
MS. ROJAS-SUAREZ: Well, as a matter of fact, for some of them, they are clear members that I think--I am just going to ask the members to be as brief as the people in the audience.
On the tax reformations, I would like to ask Pablo to give a few words.
On mutual funds organizations, Ricardo, could you please? Technical assistance programs, the experience in the banking system, maybe Miguel Mancera. Where is he?
Are you there, Miguel? And does anyone want to volunteer about the old-fashioned way of doing banking? I thought that maybe Miguel [inaudible].
All right, so please maybe we can start with Pablo, but brief.
MR. GUIDOTTI: Yeah and I will be brief.
Now, of course, when we define the uncertainties regarding continued tax liabilities, these in part reflect that the general lack of transparency of the way in which companies, in fact, are carried out, of course, provides incentives and provide uncertainties to borrowers regarding whether these companies are informal or have tax liabilities. It is not only a question about the company itself, but also of shareholders.
Many times, it is not clear the separation between the corporation and the shareholder. So, in fact, there are--I think the solution in this aspect has two ways.
First of all, of course, provide assistance or to actually instrument a better quality of entrepreneurship and better system. Also, there is a part of the uncertainty that has to do with the way in which tax administrators work, which they in the objective of actually always keeping the possibility of collecting additional taxes, in fact, do not give a lot of importance about the information and the potential risk that these provide to greater relations, in many cases, in the case of small and medium enterprise.
Because it is magnified by this lack of transparency, the potential that you have a tax audit and this actually sends the company into bankruptcy is significant degree of uncertainty. In some cases, for instance, in the case of Argentina, we have implemented at some point the [Spanish], which is a system which essentially simplifies the cost for a number of important taxes, such as, income tax, value added tax and contributions to social security.
I would say that one of the important elements that an initiative has for great markets is that, once you know that you paid whatever is the amount that you need
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to pay, you know that you met all your tax liabilities. So, there is no uncertainty regarding the possibility that somebody comes and tell you, well, you missed such-andsuch.
So, these initial [sic] that is--has actually both sides, responsibilities by entrepreneurs, but also maybe some actions to start in terms of tax administration.
Also, we have specific taxes that are problems. For instance, the value added tax, many times, discourages leasing. So, this is something that has to be--is central for countries that have a value added tax. The transaction tax is also a tax that may be distorted.
Also, I think that the question about the registries, I think that these are very central, the taxation at the local levels. But not only the matter of taxation at local levels, but also other costs. We have in Argentina the problem that many of the local-the provinces and the local governments actually--in the provinces you have, for instance, [Spanish]. You have lawyers who, essentially, have their own private taxes, which actually make prohibitive the implementation of registries.
For instance, in Argentina, it is very common that all of the mortgages are actually done in Buenos Aires, because it is the only place where actually these things have been deregulated. So, there are many aspects of it.
MS. ROJAS-SUAREZ: Ricardo.
MR. HAUSSMAN: In this initiative we put on the table on this mutual fund, comes to address a problem we think is present. That is the idea that we try to serve like, create American-style financial system, where we will have banks on the one side, being relatively safe and well-regulated and then a capital market on the other side that could take more risks. So, you will have securities being traded whether it is bonds, stocks and this other market and so on.
Now, then we will privatize social security and we will put these forced savings by workers, a pile of money into these funds and this money will go to the capital markets to buy these securities. These funds are regulated to buy these securities.
Now, once you get to understand sort of like the micro-economics of securities as opposed to loans, well, securities, you know, they have to be traded. So, you have to deliver much more information about who issued them and so on. They have to be issued in sufficiently large size for there to be a liquid market in them.
Essentially, it is relatively costly to issue a bond. So, you are not going to issue for less than, say, $25 million, easier done with $100 million. So, immediately you
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realize that you are talking about something completely different from small and medium enterprises.
So, the securities markets are for the government and maybe for a few blue chip companies. In some countries, not even the few blue chip companies.
So, essentially, we have this pile of money in the pension funds and no way to channel it to small and medium enterprises. That is typical [unintell]. The worst thing that can happen to a pension fund is a government that starts running a public surplus, because then they really don't know what to put their money in.
So, we need to create some channels for intermediation of those monies.
Now, Latin America is telling you that, the preferred instrument of choice is the loan, not the security. Loans are easier to negotiate. It is a private contract, not a public contract. They are harder to sell and buy, because there is a lot of private information involved. They are easier to renegotiate and so on. So, loans are the preferred instrument.
Now, loans are given by banks and banks are regulated with Basel I and now Basel II, because banks intermediate with deposits. Deposits are repayment systems. When banks go under, they affect the payments system and when a payment system gets affected, it's the end of the world. Ergo, we don't want banking crises. We regulate banks very severely, because they take deposits.
So now, we have that banks are regulated very severely, because they take deposits. They are the ones that give loans and then securities markets are off the table for anything that smells like a small and medium enterprise. So, that's where we find out gap.
So, what we are trying to create is a hybrid of an institution that is not a bank, because it does not take deposits. It takes in something else that involves risks of asset prices going up and down. So, it is not a bank in that sense, but it is a bank in the sense that it gives loans and does not invest in securities. It gives loans. So, it is going to buy a portfolio of loans.
So, what we want to do is create these mutual funds that buy a portfolio of loans and get funded with these longer term obligations. Call them shares in this mutual fund. Now, these mutual funds are going to give loans to a bunch of SMEs.
They are going to create a portfolio of these loans. Their shares are going to be backed by these loans.
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You might restrict, say, the liquidity of these investments in the pension fund, so that the pension fund can actually give longer term loans--this mutual fund could give longer term loans. To tell you the truth, the pension funds are not really that desperate about liquidity, because their liabilities are to pay workers in the future their pensions and so on.
This participation in these mutual funds, these shares in these mutual funds could have a secondary market. Now, the mutual funds would have to be rated, but the underlying companies in which they invest will not be rated in the same sense that you rate a bank and the bank's shares get traded, but the bank owns a portfolio of loans that have a lot of private information about them.
So, what we are trying to create is a vehicle whereby you can give loans and not ask SMEs to issues securities, but get loans, but from a channel different from a bank, that is outside the regulatory regime of banks.
[End tape 1, side 1 and begin side 2.]
MR. HAUSSMAN: not taking deposits.
[In progress] --deposits. So, these institutions are
MS. BIRDSALL: Is this a Fannie Mae for SMEs without any government subsidy?
MR. HAUSSMAN: Well, there is no--this is sort of like--it is the investor who is taking the full risk of the loan.
MS. BIRDSALL: There is no subsidy?
MR. HAUSSMAN : No subsidy. The investor is taking the full risk of the loans. He is just--but they are loans, but they are loans. They are not securities.
They are easier to--
MS. BIRDSALL: What is the government's--what is the policy step that creates the incentives for these institutions to spring up?
MR. HAUSSMAN : Well, right now, right now, we had a discussion about this. But our sense is that, in most countries, pension funds are not allowed to invest in these things. Pension funds are highly restricted. So, the idea will be to adjust pension fund legislation, so that these things can be financed by these institutional investors.
In other countries, you know, if something does not exist in law, then it cannot exist. So, you might need to adjust the regulations for the existence of this of financial institution. You know, what are their responsibilities vis-a-vis the
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shareholders? What are their capital requirements to eventually solve incentive problems, so that managers have incentive to actually collect on these loans? So, you might have to align the incentives of managers so that investors feel that somebody is really watching over their money.
So, that is the idea; it is to create an alternative channel to mobilize institutional investor funds, because the capital markets are not there and will not be there in any relevant future for the SMEs.
MS. ROJAS-SUAREZ: Miguel Mancera, on technical assistance.
MR. MANCERA: Which technical assistance are we referring to?
Mostly technical assistance to small firms that do not have proper accountancy, they do not know how to keep the books well or the owner has great difficulty in having simply the time to keep the books well.
Of course, when we speak about small and medium size firms, there is a range. Of course, the bigger have much problem in this respect. They are merely large firms. But when you go to the other extreme and you deal with very small firms, then you find an owner of the firm, which has to perform all the managing duties. He has to be the manager of production, the manager of sales, the manager of personnel, et cetera, et cetera.
He faces two difficulties. Probably he doesn't have the education with regard to financial matters sufficient to know how to have a proper accountancy and how to present applications to banks, et cetera, et cetera. It may happen that, even if he knows something about it, he doesn't have the time, simply.
So, what kind of technical assistance do to help this entrepreneur [sic]?
You know, for instance, that now days, there exists software to keep the books of small firms and these programs of software are very, very good really. But one has to learn how to handle them, how to operate those programs. So, probably one way to provide technical assistance efficiently would be to teach the small entrepreneurs how to operate this modern software.
We debated on whether our government subsidy would be justified to do this. We concluded that it is justifiable, because it is an aspect of the general education of the population. It is certain center of the population, but quite large. So, as the government provides money to universities where accountancy is taught, well, it's perfectly legitimate that the government could provide money for entrepreneurs to be taught accountancy.
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So, that we think that if the accountancy and related aspects are better handled in the small firms, the likelihood for them to obtain credit from banks is much better than it is now in our days.
MS. ROJAS-SUAREZ:
MR. CHAPMAN:
Thank you, Miguel.
Guillermo, some comments on [off microphone].
Old-fashioned banking reminds me of a friend of mine who told me recently, back in the '60s, I used to know everybody who drove a
Cadillac in Panama City. Now days, there are many who drive BMWs and Mercedes and I don't know any of them.
So, one element is that the market has grown. The one-to-one, the very personal relationship is very difficult to maintain.
Number two, banks have grown. A typical bank in my country in the '60s would have assets running from 50 to $100 million. Today, they are several billion dollars.
So, again, you have to have procedures, methods, systems to deal with loan applications and management does not allow individual bank officials to do it on a hunch or on a personal basis.
Then you have the regulations. Regulations today are much more strict than they were back in the '60s. At least, in my country, it was almost free banking, with very few regulations. On top of that, you have competition. You have larger bankers, banks, who want to show a better [unintell]. So, they seek creative ratings. They have to adhere to more strict standards. They have to comply with Basel as well as with local regulations. We have to be Basel consistent.
So, in essence, there is a host of factors that have to do with the size of the market, the size of banks, regulations and competition. So, the old-fashioned way of banking is no longer viable.
MS. ROJAS-SUAREZ: Thank you, Guillermo.
We can go to another round--
MS. BIRDSALL : Yes, we can have another round of questions.
Let's go all the way to the very back.
QUESTION: My name is Antonio Galloso[ph]. I am a professional banker-financier at [unintell] University.
The question of old-fashioned banking reminds me that one of the things-
-first of all, I entirely agree with most of the recommendations of the report, having
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come from the credit [unintell] in the past. But that leads to the question that, in essence, old-fashioned banking is really new-fashioned banking if you look at the financial cooperatives both in this country and in Latin America and Europe.
In that sense, I would like the opinion of No. 12, which is the next report of [unintell], to focus on that segment. If you were to define small and medium size for us, a small might be a firm with less than, fewer than five employees. If that is the case, no bank would touch them. So, you need to look at the sense of [unintell] for those sectors of the population, of the entrepreneurship population that cannot be dealt with by the banking system. You need to look at the system of loan banking financial institutions, credit unions, solidarity banks and those who are really trying to serve.
In that sense, they don't need to be subsidized. They should not. They should be regulated every stringently as banks, more so because they are dealing with the monies of the poor, of the poorest. In that sense, I think that at least the job of the government to create an environment which is conducive to the growth of those institutions by protecting them with legislation, regulation and lack of subsidization.
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MS. BIRDSALL: Thank you very much.
That's the larger question also of micro-finance and in this continuum, where does it fall.
QUESTION: [Off microphone].
Given the fact that banks have constrained the loans across Latin America due to--
MS. BIRDSALL: Could you use your mic? I don't think people--
QUESTION: --due to financial situation, I was wondering if you will support a major role of government to support financial small and medium enterprise across the region, especially since President Fox in Mexico, at the beginning of the government, he implement this novel program to support the so-called changaros [ph], which I don't know if they fit in the description of the small or medium enterprise. At this point, we don't know for sure if that program was basically aimed to support the destruction of small enterprise has been a success or not.
MS. ROJAS-SUAREZ: Thank you.
MS. BIRDSALL: Okay, please.
QUESTION: My name is [unintell] and I'm with [unintell] Bank
Advisory Services.

My question to you is whether you have looked into the model of credit lines being disbursed through commercial banks to small enterprises? My second question is, have you looked into the other model of working with commercial banks or second-tier banks in those markets to establish investment funds, loan investment funds owned by the banks?
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MS. BIRDSALL: Okay. Yes?
QUESTION: John Zimco [ph], with the Center For International Private
Enterprise.
For those of us who have been working with business groups throughout the region for a very long time, I have to say that many of the recommendations that you're making here are not new news to us. I applaud you for certainly putting much necessary attention on them.
My question is really twofold. Number one, if this is not new news, I would like to know your point of view as to why these types of reforms were not made during the great era of economic reforms of the 1990s?
Number two, a lot has been said about the policies of international institutions, financial institutions in this regard, but not much has been said today about creating local political wealth to institute these reforms on the national and local levels in the region. I was hoping that some people could say something about how you can create that will to create a reform effort to institute these reforms.
MS. BIRDSALL: Bob?
QUESTION: Thanks.
Bob Burke and I have advised the micro-credit summit in the past.
When legislation was proposed at USAID to restrict micro-credit funding to the very poorest, there was opposition from groups working in Latin America, in essence saying, we are above that market and kind of a parallel to the notion of the poverty goal, the millennium development goal being something that was excellent for
Asia and Africa, but we have gone beyond this.
I wonder now whether there are other ways of approaching goals in this area. For example, large commercial banks in this country have established goals to reach small enterprises and housing markets that are for the poor. Are you now--do you think one of your next steps might be to have some creative way of benchmarking, so that there is some confidence that, perhaps, with the acceptance of the recommendations

you have made so far, that you are confident enough about them to be able to encourage at the national level and regional level really defining the, particularly, the small enterprise market and suggesting timetables to reach that market?
MS. BIRDSALL: Okay, I think we'd better stop there and ask the responders to be brief.
MS. ROJAS-SUAREZ: Okay, [off microphone].
MS. BIRDSALL: And perhaps to make any other closing remarks anyone wants to make, wrap it all up into one big closing.
MS. ROJAS-SUAREZ:
MS. BIRDSALL
[Off microphone].
: You don't have--
MS. ROJAS-SUAREZ: I'm sorry.
May your role of government to support SMEs, Roberto Zahler. Ricardo, could you give some words on the loan investment funds? What types of reforms were not done in the past and what is it looking on in the future? I will give a couple of remarks and if any other member in the committee wants to make any remarks, I will give the word at that time.
All right, why don't we start with Roque?
MR. FERNANDEZ: I think that some of the questions are really connected because the [unintell] bank financial institutions and what happened in the
'90s is that, the reforms were oriented to a consolidated system in several countries, in the sense that, we wanted to have financial intermediation, having the same regulation process. So, there was not a difference between one sort of an institution that would not follow the Basel procedure for financial intermediation and on the other side, we would have a regulated bank that could not have competition with the other one that is unregulated.
As Guillermo mentioned, this sort of a tightening the controls on the commercial banks or on the financial intermediation implies that we will use the risk in the economy or the possibility of financing risk in the same way that, for example, you can in an economy say, well, I am going to increase minimum wages, real minimum wages. What would happen is, that would produce unemployment if you go above the market level.
Then if you go in an economy and to produce a very heavy regulation in avoiding companies and financial intermediation to take some sort of risk, then what you will end up doing is just reduce the financing of risk. What Guillermo has emphasized
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is, perhaps, we went too far away in that operation and the one that suffered most of this change in the regulator environment was the small and medium enterprises.
I believe that in the question that you mentioned, which affected the possibility that the [unintell] of trust funds based on commercial bank loans is what
Guillermo is thinking about stimulating in the future. He is not living outside the banks.
He is, in a way, trying to help the regulation in pension funds so they can cooperate with the commercial banks and to build up this new market.
So, what I believe that we can talk about in one way is that, we may have some sort of banking instrument that are Basel banking instruments. Then we have something there that we can call Basel-free risk instruments. We can think about that a little bit. That is what we were talking about. It is one way that maybe we can produce some additional funding to the small and medium enterprises.
MS. ROJAS-SUAREZ : Thank you, Roque.
On what role there is a major role for government intervention to support
SMEs, Roberto Zahler.
MR. ZAHLER: Yes, thank you, Liliana.
I would like just to make a couple of comments regarding the issue of traditional banking. I would add two comments. One is the fact that foreign banks have become extremely important in most of our countries. They have another way of doing business and I think that is a fact of life. We have to deal with that. They have their own, let's say, from their headquarters, their own way of managing risk and this is a different reality that you have to face.
The second point I would like to mention is the fact that I think that, unhappily, the experience of many of our countries' banking crises show that, in a sense, the fact of knowing your client has been in some cases precisely the cause of the crisis. I am just coming from the Dominican Republic, which perhaps is an extreme case of this, where knowing too well your clients which were yourselves, you know, ended up in a major, major crisis.
So, I think there might have been good arguments overall to really have a more professional way of looking at risk management and a prudential relation.
Regarding the issue of lending to small and medium enterprises through government programs, I will say that I have two or three main comments. One is, first of all, our analysis shows or we really recognize that there is not a problem of financing in Latin America today. There is not a problem of lack of funds.
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Secondly, I will say that the experience with lending to small and medium enterprises or in general, I will say, through government programs and especially through government program guarantees has not been good enough in Latin
America. On the contrary, I will say it has been generally a disaster. I will say that that is the second [inaudible].
So, I will say that, in general, when you consider the government analyzing the risk of whom you lend directly, I think it's really something we do not think is reasonable. We do not think it is sufficient. We really think it would be a major problem.
That is why we are trying here to suggest methods through which you create markets. You create instruments. You create institutions, which in a sense, would build--will fill the gap that the market has today, but not through direct government lending, because the government really has nothing to really evaluate risk properly and you would end up with problems of corruption, with problems of not assigning the funds properly. You could end up with a major fiscal crisis. Really I will say that, our opinion is that, that is not the proper way of doing things.
One point I would like to mention is that, although--one person mentioned that this is no new news. I tend to agree with that. We are not really in show business. So, we are not really--it is not our business to do, bring news back.
I will say that the fact that we traced the issue of incomplete markets, institutions that may be already a little bit lagging behind, perhaps, some sort of overregulation in some areas, I think, is not a minor element, given the way policy making is being done today in the financial sector in Latin America.
I really think, for example, the issue of pension funds or institutional investors being allowed to have a small share of their assets being assigned to a little bit of more risk in general terms, is not something minor. I think if you would put that into the discussion of Latin America, I think it would create a lot of noise, in terms of what I was suggesting, you know, in terms of really putting more weight in regulations regarding giving more relevance to risk-taking activities in the region.
25 please.
MS. ROJAS-SUAREZ: On the issue of loan investment funds, Ricardo,
MR. HAUSSMAN : Let me make three--a little bit broader points in reaction to the discussion.

The first one is that, we started saying, look, the problem with Latin
America is that there is a lack of formal jobs. The lack of formal jobs, the other side of the coin of that is that, there is a lack of formal employers. The bulk of the formal employment outside of the government comes from SMEs.
So, we want SMEs to be more than to grow, to generate more employment, because we want to improve the living standards of people. That does not mean that we need to have the owners of the SMEs to be poor or disadvantaged people.
I think that there is a confusion of roles here in a lot of the justification for these programs.
You have to sort of like justify that these guys are somehow disadvantaged, because they are going to be getting some public resources. You don't really--I mean, the guy may be a slick, young MBA, right. You are not helping him.
You are focused on the jobs.
So, when you start thinking of micro-finance or small finance to the disadvantaged, to the poor, you're mixing two policy goals. It is important to keep them separate. You're on a social policy, a social policy; if you're on enterprise development, is enterprise development. You will get the social policy through employment, not through the other things. You might be confusing roles.
The second point is that, the main argument, in my mind, the most convincing argument against a strategy that relies on public money is that there ain't public money. So, if you want big money, it will have to come from the market, because the government will have very limited resources. Any government program will be of very limited nature. So, if you want big bucks, if you want ten percent of GDP, 20 percent of GDP it is because you are mobilizing the markets, because you are allowing these transactions to take place.
So, that is why I think it is important to focus on that aspect.
Then you ask yourself the question: How can the government be helpful?
Is it worth more than building a road or building a school, et cetera? You know, it will come through the budget. That will inevitably be limited, given the fiscal realities of
Latin America.
Finally, you know what? I like the name loan investment funds. I haven't heard it before, but it is a good description of what essentially we are perusing. It is an investment fund, but the assets that it is buying are loans and loans have different characteristics from securities. They lower the transaction costs for the people who you
26

are funding. They create other kinds of governance problems and pricing problems for the investor to know what it is that he is investing in.
Essentially, I will use the term now.
MS. ROJAS-SUAREZ : Thank you, Ricardo.
Ernesto Talvi and Pedro Carvalho de Mello would like to make some remarks on tax issues.
MR. TALVI: Just I think one of the questions of the previous round was not answered. I would like to share with you a few comments. I don't want to compromise in any way the other members of the committee, since this was not a topic we discussed in depth.
We are in the process of finishing a study in Uruguay. There were two questions related to if tax reform should be coordinated in a way in which it creates the incentives to reveal your property or your cash flows. The information that you need to reveal property or cash flows to obtain financing will not at the same time create a liability with the tax man.
What we found, we are finding in this study is that, contrary to widely held beliefs, taxes on earnings and capital are statutorily very high in many countries in
Latin America. They are very high in Uruguay, in excess of 50 percent once you take into account both earnings and property taxes as an income tax or earnings tax equivalent.
So, if you are going to start the business in Uruguay, you start by sharing half of your profits with the government in an economy that is widely under-capitalized and in a region that is widely under-capitalized.
So, what are the solutions to this problem? With those marginal tax rates, many firms would not be viable. So, what happens? You create exoneration or exemption systems that would declare certain firms of national interest, certain projects of touristic or local interest. Then you see who gets access to those exemptions and they are pretty large firms in very specific sectors. It takes a lot of paperwork and maybe some oil in the process to get the declaration of national interest, of local interest.
So, what is left for the small to medium size enterprise that cannot oil or produce the fixed cost of getting the exemption? We are left with tax evasion in order to become viable. But once you become an evader, you are disconnected, by definition, from other formal networks. In particular, one of the networks is the ability to get
27

financed, because if you are going to produce the information necessary to get it, you're going to reveal the true nature of your tax liabilities. That would make you unviable.
So, we are, by the nature of the taxation that we are creating, a dual society in which the well-off can get the exemptions and work under the legality by not paying taxes through exemptions and the less well-off or the small ones, who are forced into being evaders and, therefore, get disconnected from other networks that would, in a sense, promote their growth and promote a dynamic entrepreneurial sector.
If we add to this--and with this, I finish--that the incidence of these taxes on earnings and capital--we made some instant calculations based on a very simple model. The incidence falls close to 100 percent on wage earners, not on capital. Then I can submit to you that, we are in an extremely bad equilibrium.
We should put forth in the Latin America social agenda--and this may sound like a sort of paradox--the way we treat earnings and we treat capital in the region.
MS. ROJAS-SUAREZ: Thank you, Ernesto.
Pedro.
MR. CARVALHO DE MELLO : I think I was trying to answer Peter
Knight's question. He was our professor in Brazil many years ago.
Ernesto Talvi basically said what I was going to say. That is the feeling in Brazil, that you have a very high tax rate and you don't expect that all the small and medium size companies who pay the taxation. So, we have a kind of effective tax rate that earns the desired revenue.
So, I understand that the companies, the enterprises, they go to the banks.
They have this opacity. Sometimes, for several of them, it is a question of survival. If they are going to report all the revenues and pay all the taxes, they would be unviable.
So, I think the way is really to think in a major tax reform. The problem is that, the country, they don't want to lose revenue in the short run. So, they are facing this dilemma of either having a very deep tax reform and losing revenue in the process or keeping the old system and pretending that it is working well.
MS. ROJAS-SUAREZ : Okay, I [unintell] of taking one of the questions to close. It is the question of why this time of reforms that we are proposing were not in the past.
Well, we need to understand and to remember that, many of the reforms that were implemented in Latin America responded, were the result of economies being
28

in major crisis, where states could basically be [unintell] had not been able to create a stable micro-financial environment. Under these circumstances, the kind of reforms you implement basically have to contain the excessive risk-taking that was being taken at the moment.
Now, the issue is, okay, you stabilize and you create the framework and so what? Do you stop there? If you have changed the environment, now you have to start thinking of the kind of policies that would actually allow for the second part, which is to put the economy functioning again.
So, our kind of recommendations now are taken from that. We are saying, okay, you did the first part of the job. We don't see the hyper-inflation anymore.
We have better behaved governments. Okay, now allow us to put some dynamic behavior in the financial system and the entrepreneurial relationships. So, that is the core of our statement and of our view.
Do not go a step backwards in terms of the progress you have made. That is not sufficient. You have done one part of the job under certain conditions. Those conditions have changed. Now, keep moving forward into making the society more forward.
With this, I thank all of you for your presence here.
MS. BIRDSALL: Let me--
[Applause]
MS. BIRDSALL: Yes, let's thank all of the--
[Applause]
MS. BIRDSALL: Liliana and members of the committee, I would like to just end with three points, to remind you that you have before you a very experienced, highly respected group of people who can only be characterized as being in the center of the mainstream, if anything, somewhat to the conservative side in the long and excellent tradition of central bankers.
In that context, I don't think we can emphasize enough the importance of their saying first, SMEs matter, because jobs matter. Second, there is a need to think of some new institutions to fill what might be incomplete markets in the region, to balance the tremendous and successful efforts at improving, reducing risks in the financial sector.
Third, if I can suggest for the future--they don't need to react now--an agenda. It does seem to me that some of the complementary issues like tax reform and
29

capital markets in general could be on your agenda in the future, because what you have to say about those issues will receive many echoes in Washington. Indeed, if I think of the IMF, it's been working on technical assistance in the tax area for many decades.
If you look carefully, there is very little real policy pressure on countries in the region from the IMF on the kinds of tax reforms that would complement the financial's sectors ability to reach small and medium enterprises.
Thank you all for bearing with us and for staying even a little late. I hope that we will be able to bring you together with this committee in the future.
[Applause]
MS. BIRDSALL: Thank you, Liliana.
[Whereupon, the proceedings in the aforementioned matter were concluded.]
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