June 7th 2007 1

Financial Reform and Vulnerability:

How to Open but Remain Safe?

José Luis Escrivá

Chief Economist - BBVA Group

June 7th, 2007

June 7th 2007 2

Banking Problems since late 1970s

Systemic banking crises

No crisesEpisodes of non-systemic banking crises

Insufficient information

Source: Caprio and Klingebiel (1999).

June 7th 2007 3

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.

Definition of a Banking Crisis

June 7th 2007 4

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)

June 7th 2007 5

Country (First Liberalization Year of Financial Difficulties) Short-Term Porfolio Prior to Crisis

Capital Inflows

CAPITAL-ACCOUNT LIBERALIZATION AND FINANCIAL CRISES

Severe Crisis Argentina (1980) Open Open Yes Argentina (1989) Closed Closed n.a. Argentina (1995) Open Open Yes Chile (1981) Open Open Yes Mexico (1994) Open Open Yes Venezuela (1994) Closed Closed n.a.

Malaysia (1985) Open Open No Philippines (1981) n.a. Thailand (1997) Open Open Yes

South Africa (1985) Closed Open No Turkey (1985) Open Closed No Turkey (1991) Open Yes

Williamson and Mahar, (1998, p. 53).

Capital Account Liberalization and Financial Crises

Last crises:Argentina 2001-2003

June 7th 2007 6

Country (First Liberalization Year of Financial Difficulties) Short-Term Porfolio Prior to Crisis

Capital Inflows

CAPITAL-ACCOUNT LIBERALIZATION AND FINANCIAL CRISES

Less Severe Crisis United States (1980) Open Open No Canada (1983) Open Open

Open Open No France (1991) Open Open Yes Italy (1990) Open Open Australia (1989) Open Open Yes New Zealand (1989) Open

Brazil (1994) Closed Closed n.a.

Indonesia (1992) Open Open No South Korea (mid-1980s) Closed Open

Turkey (1994) Open Open Yes

Sri Lanka (early 1990s) Closed Open Yes

Williamson and Mahar, (1998, p. 53).

Capital Account Liberalization and Financial Crises

June 7th 2007 7

Microeconomic Factors:

1. Mismatches between assets and liabilities.2. Government interference. 3. Weaknesses in the regulatory and legal framework.4. Premature financial liberalization.

Capital Account Liberalization and Financial Crises:

Macroeconomic Factors

1. External shocks 2. The Exchange Rate Regime3. Openness4. Financial Repression5. Domestic shocks6. Lending booms

Deposit Runs

June 7th 2007 8

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.

80

100

120

140

160

180

200

220

t-7 t-6 t-5 t-4 t-3 t-2 t-1 t t+1 t+2

Chile 1981 Philippines 1981

South Africa 1985 Turkey 1985

Venezuela 1994

Source: BBVA from IIF data

Terms of Trade Index (100=first year of financial difficulties[t])

Maximum decrease of the terms of trade in the “t-7” to “t+2”

period:

Chile 1981: 20%Philippines 1981: 41%South Africa 1985: 53%Turkey 1985: 35%Venezuela 1994:

34%

June 7th 2007 9

Macroeconomic Factors: External Shock

Capital outflows induced by an increase in world interestDrop 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.

0

2

4

6

8

10

12

14

16

18

20

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

10-year Treasury Note Federal Funds

Interest rates in the United States (in %)

Source: BBVA

June 7th 2007 10

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 highUnder 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.

Macroeconomic Factors: Exchange Rate

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.

June 7th 2007 11

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

0.02

0.04

0.06

0.08

0.1

0.12

0.14

No crash, no SS (1815 events) Crash but no SS (317 events) Crash and SS (18 events)

Fit

ted

Op

en

ne

ss

0.55

0.56

0.57

0.58

0.59

0.6

0.61

0.62

0.63

0.64

0.65

Op

en

ne

ss

Fitted Open

Open

Macroeconomic Factors: Opennes

Source: Calvo, Izquierdo & Mejia (2003); Edwards (2004a,b)

June 7th 2007 12

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)

Macroeconomic Factors: Opennes

Sudden Stops (SS1) and Currency Crises (Crash) by level of openness

34

127

52

292

0

50

100

150

200

250

300

350

SS1 (86 events) Crashes (419 events)

Nu

mb

er

of

Ep

iso

de

s

> Mean open

< Mean open

Source: Calvo, Izquierdo & Mejia (2003); Edwards (2004a,b)

June 7th 2007 13

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 system2. Weak accounting standards3. Government directs credit4. Financial institutions nationalized5. Inadequate government regulation

June 7th 2007 14

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.

0

2.000

4.000

6.000

8.000

10.000

12.000

14.000

ene-

93

feb-

93

mar

-93

abr-

93

may

-93

jun-

93

jul-93

ago-

93

sep-

93

oct-

93

nov-

93

dic-

93

ene-

94

feb-

94

mar

-94

abr-

94

may

-94

jun-

94

0,00

0,10

0,20

0,30

0,40

0,50

0,60

0,70

0,80

0,90

Money market interest rate (in %)Exchange rate vs USD (r.h.s.)

Interest and exchange rates in Brazil (1993-1994)

Source: IFS (IMF)

June 7th 2007 15

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 creditrisks is harder when the economy is expanding because borrowers may be at leasttemporarily profitable and liquidBoom is often accompanied by asset price bubbles (stock market, real estate).

Macroeconomic Factors

Source: Credit Stagnation in Latin America. Adolfo Barajas and Roberto Steiner 2001

Absolute Deviations in the Credit-GDP Ratio with Respect to Trend

June 7th 2007 16

Micro Factors: Balance Sheet Mismatches

1. Bank assets and bank liabilities: differ in terms of liquidity, maturity, and currency of denomination.

2. Maturity and currency mismatches: more acute in a context of rapidly increasing bank liabilities (capital inflows).

3. Maturity mismatch and sequential service constraint: create the possibility of self-fulfilling bank runs.

4. Large, unhedged foreign-currency positions (banks and their customers): increase risk of default on existing loans and overall financial vulnerability to adverse (domestic or external) shocks.

5. Lending in foreign currency by banks to domestic borrowers transforms currency risk into credit risk.

Emerging countryFirst year of

financial difficulties [t]

External mismatch of deposit banks in [t]*

Argentina 1995 -9%Brazil 1994 -7%Chile 1981 -30%

Indonesia 1992 -2%Mexico 1994 -22%Turkey 1991 3%Turkey 1994 9%

Venezuela, Rep. Bol. 1994 11%Source: BBVA from IFS (IMF)*(Foreign Assets-Foreign Liabilities)/Total Assets

Developed countryFirst year of

financial difficulties [t]

External mismatch of deposit banks in [t]*

Australia 1989 -6%France 1991 -4%Italy 1990 -9%

New Zealand 1989 -12%Source: BBVA from IFS (IMF)*(Foreign Assets-Foreign Liabilities)/Total Assets

June 7th 2007 17

If lending decisions remain subject to government discretion: It will encouragereckless behavior by bank managers; poor quality of loan portfolios. Liberalizationwill not improve credit allocation or deepen financial markets.

Micro Factors: Government interference

0

20

40

60

80

100

120

140

160

180

200

-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}

Dep

osit

ban

ks c

laim

s on

pri

vate

sec

tor

(% o

f G

DP)

Source: BBVA based on IMF and World Bank

Financial system and governance (2005)

June 7th 2007 18

Weak legislation against concentration of ownershipWeaknesses in the accounting, disclosure, and legal infrastructure: hinder theoperation 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'screditworthiness and the market value of collateral.

Micro Factors: Weak Regulatory and Legal Framework

0

20

40

60

80

100

120

140

160

180

200

0 1 2 3 4 5 6 7 8 9 10

Legal rights index (0-10)

Deposit

banks c

laim

s o

n p

rivate

secto

r

(% o

f G

DP)

Source: BBVA based on IMF and World Bank

Financial system and legal framework (2006)Banking Default Rates 2006

0

2

4

6

8

10

12

14

16

18

20

Arg

enti

na

Braz

il

Colo

mbi

a

Peru

Uru

guay

Mex

ico

Vene

zuel

a

Chile

Phili

ppin

es

Indo

nesi

a

Thai

land

Mal

aysi

a

Sri L

anka

Indi

a

Hon

g Ko

ng

Kore

a

LATAM = 2,5

ASI A = 9,3

Source: GFSR - I MF

%

June 7th 2007 19

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 20

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.

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.

Route of a classic financial crisis

June 7th 2007 21

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– excessive bank lending growth– excessive capital inflows– an overvaluation of the currency– a fall in foreign exchange reserves

→ these trends reverse after the crisis!

Can these indicators predict a financial crisis?

banking crisis

currency crisis

Empirical evidence of twin crises

June 7th 2007 22

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.

Early warning signals

June 7th 2007 23

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

Are financial crises only due to bad fundamentals?

June 7th 2007 24

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 ana. 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, ‘self-fulfillers’ as a liquidity crisis

Combination of both embodied in third generation models of currency crisis

What have we learned?

June 7th 2007 25

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.

What have we learned?

June 7th 2007 26

Financial Reform and Vulnerability:

How to Open but Remain Safe?

José Luis Escrivá

Chief Economist - BBVA Group

June 7th, 2007