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Latin America’s financial sector needs to prepare for new risks

Alain Ize's picture

Finances

In stark contrast with Latin America’s rich history of financial crises and turbulence, this time around the region’s financial systems have weathered the current global volatility and the Great Recession rather well.

Why should then one want to conduct an extensive study on financial issues in Latin America and the Caribbean? We think the study, Financial Development in Latin America & the Caribbean, the Road Ahead, is timely because the region still faces substantial developmental gaps and issues that require attention.

And because the global crisis has brought to the surface many new issues that the region needs to face and prepare for. Let’s look at the positives first.

Latin America’s financial systems have made much progress –in soundness, depth, and diversity- since the last wave of financial crises that swept through the region in the late 1990s and early 2000s.

Some examples of this include the growing size of banking systems and stock markets, and of the role of institutional investors which have become more important relative to banks, making the financial system more complex and diversified.

Notably, this expansion has moved up the financial inclusion agenda with more low-income households and micro business getting access to payments, savings, and credit services. Despite these advances, the financial system’s to-do list is proportionate to its gains.

Our report concludes that the region’s financial systems remain underdeveloped in several key respects. Latin American banks lend less and charge more than they should, and while consumer credit has expanded, it has done so at the expense of business and housing financing.

Moreover, domestic equity markets in the region are illiquid and highly concentrated and insurance is relatively underdeveloped. To address these gaps, the region needs to take a long, hard look at some tough issues, including the need to revisit the role of the state in financial development and financial stability, and the role of finance in growth.

Conceptual vs. empirical

Our study follows two central organizing threads, one conceptual, the other empirical.

On the conceptual side, we analyze the process of financial development, and its interface with financial stability, from the perspective of the frictions that need to be overcome for development to proceed in a sustainable fashion.

Frictions can be divided into two types, bilateral and multilateral. The bilateral (agency) frictions are those one immediately encounters when lending to a stranger. Will he invest the money wisely? Will he repay me?

The multilateral (collective) frictions are those that hinder participation in deep and liquid financial markets or large and reliable financial intermediaries. The grinding down of both types of frictions is what drives financial development (the bright side). However, it can also lead to the gradual accumulation of tensions and fault lines that ultimately end up in financial crises (the dark side).

This leads to a richer developmental policy agenda than the traditional one, which mainly focuses on the strengthening of the enabling environment. The state may also need to ease collective participation frictions in other ways, including pointed catalytic supports, regulations that mandate participation, or public guarantees that help spread risk.

At the same time, the state should help contain the demons of the dark side by putting into place an effective framework for systemic oversight.

Thus, five chapters focus on various aspects of this expanded policy agenda, two (going long and taking public risk) dealing with the bright side, and three (macro-prudential policy, micro-systemic regulation and systemic supervision) with the dark side.

On the empirical side, the flagship first takes extensive stock (in three introductory chapters) of the current status of financial development in LAC. Abundant use is made of a new statistical benchmarking methodology recently developed at the Bank.

Pinpointing the Gaps

By making all countries fully comparable, after controlling for differences in economic development or country-specific structural characteristics, the methodology provides a powerful tool to identify areas where LAC’s financial development is lagging.

And where the region is lagging, the methodology provides clues as to why this might be the case. Two chapters of the report (the banking gap and the equity gap) conduct such exercises. In the case of the banking gap, for example, the report finds that LAC’s devastating financial crises of the past have left visible imprints that endure up to today.

The lack of productive investment (good bankable projects) explains another sizable chunk of the gap, with LAC’s remaining contractual and institutional weaknesses (enforcement costs, creditor and property rights) explaining most of the remainder. The report also finds out that long maturity lending is where the gap is worse.

This analysis immediately orients the policy agenda. It should emphasize ways to facilitate lending at longer maturities, avoiding a costly repeat of the crises of the past through enhanced systemic oversight, putting a premium on growth-promoting financial policies, and correcting the remaining contractual and institutional weaknesses in the lending environment.

We hope that this study helps spur the debate on these important financial issues for Latin America and the Caribbean. This kind of dialogue becomes more urgent as the global turbulence continues to impact the region, calling for quality financial development and financial oversight policies that can adapt to a rapidly changing environment.

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