More than a year after the beginning of the current financial crisis, the causes that originated the crisis are quite clear. The evolution of the crisis, contrary to the somewhat naïve perspective that was dominant, confirmed that financial markets suffer from severe limitations that prevent their self regulation. Latin America has suffered several financial crises during the last 30 years and the social consequences, in terms of output losses, and unemployment and poverty increases, have been very costly. Although many countries have improved their financial regulation and supervision, the ongoing crisis, although not originated in the LAC region, highlights some key shortcomings that are also present in the region’s financial systems.
In order to obtain lessons that are relevant for the Latin American financial systems, the original paper (in Spanish) analyzes in detail the antecedents and first causes of the current crisis, the serious deterioration in the credit origination and distribution process, the role played by derivatives, and presents statistical information that supports such analysis.
The lessons for Latin America and the Caribbean that can be learned from the current crisis up to now, refer to internal regulatory aspects and may be grouped into four major areas: i) the need for a macro-prudential framework complementing the present regulatory scope which focuses entirely on individual banks; ii) the reduction of the pro-cyclicality of the financial systems; iii) the extension of the financial regulation and supervision to all financial institutions that generate systemic risk; and iv) aspects concerning the relationship of the risk rating agencies, external auditing companies and financial institutions which lead to a poor treatment and disclosure of the risks.
The present regulatory framework needs to be complemented by a more comprehensive approach that recognizes as propelling elements of financial crises the accumulation of macroeconomic imbalances, sustained increases in debt levels and the concentration of credit in some sectors of the economy. The experience demonstrates that it is not realistic to expect markets to self regulate and moderate rapid loan growth or reduce credit concentration. The authority has a role to play and therefore, as opposed to the present regulations which focus on financial institutions in individual terms, it is necessary to incorporate aspects related to systemic risks. Whether monetary policy or other financial policy tools are better suited for the task of limiting systemic risk growth is something that has to be resolved in the context of the nature of the region’s financial systems. As is well known, banks dominate the financial system in Latin America and the Caribbean. Capital markets, with some few exceptions, are small and unsophisticated.
As in developed countries, the region’s financial systems have inherently pro-cyclical characteristics, which accentuate economic fluctuations and certain aspects of the regulatory framework tend to exacerbate this feature. It is therefore necessary to adopt mechanisms that resist such behavior, as demonstrated by the experience of developed economies. Spain is a relevant example, as its financial system has resisted better the consequences of the present crisis. However, it must be borne in mind when designing countercyclical regulatory policies that the cyclical patterns of the regional economies are different from developed economies. Small economies of the region are subject to frequent external shocks that make them far more volatile than larger and more developed economies. Hence, a measure that works well in less volatile economies may overly constrain risk taking and therefore reduce economic activity and growth. This implies that designing automatic countercyclical mechanisms may be less preferable and places greater responsibility on discretional policy and the way decisions are adopted.
The analysis of the present financial crisis highlights the role of of non regulated and poorly supervised financial market segments, which contributed to an excessive credit expansion and a reckless risk taking. In Latin America there are many unregulated market segments and we can observe the irruption of intermediaries that, on account of their size, represent systemic risk, but that are subject to poor regulations and almost no supervision. This is a growing potential factor of instability in Latin American countries. Recent examples are the Ponzi-type institutions whose bankruptcy created social unrest in Colombia. Also, department stores and supermarkets have been very active in introducing their own credit cards, which are used as a means of payment in a multitude of different businesses, even many small ones. Beyond certain size they clearly become a source of systemic risk, but still most of them are unregulated and unsupervised. Although we must bear in mind the risks of an excessive regulatory framework, this should not diminish efforts aiming at preventing financial crisis caused by the bankruptcies of institutions, that, albeit not banking institutions, also create systemic risks for the financial system and the economy as a whole.
Finally, as in previous occasions (such as ENRON and Worldcom) the relationship between banks and external auditing companies and risk rating agencies, demonstrated to be an area full of conflicts of interest, which conspire against an adequate evaluation and trustworthy disclosure of risks. This prevented the knowledge of the true risk level incurred by banks, to which investors and depositors where exposed to. This situation was exacerbated even more after the introduction of complex financial derivative instruments, whose characteristics and risk patterns were mostly unknown and, in most cases, poorly measured both by investors and regulators. For the economies of the Latin America, although their financial systems are far less sophisticated, this implies that, at least, banks loan portfolio risk evaluation and disclosure standards and practices should be examined. The same applies concerning the risk in banks financial investment portfolios, which sometimes include domestic assets (including public debt) whose default risk may be considerable. Regarding risk evaluation and disclosure, it is not an exaggeration to say that the region’s financial systems also exhibit important deficiencies and its investors and small savers do not have good information regarding their real exposure.
In summary, financial regulation ant supervision in Latin America and the Caribbean is an area that requires a new analysis, in the light of the catastrophic results of the present crisis. This crisis may have started in developed economies, but the lessons have important consequences for the countries of Latin America.
The Spanish version of this document, which includes many statistical tables and a discussion of the factors which originated this crisis and its lessons for financial regulation in Latin America and the Caribbean, can be found at ECLAC’s website.