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Banking in Latin America

Abstract and Keywords

This article provides an overview of the recent consolidation of banking sectors in Latin America. It then considers the evolution of financial policy and how it has contributed toward the recent consolidation process. It investigates the effects of consolidation on banking sectors. As the subprime mortgage crisis exploded after this article was completed, and since so far its impact on the region has been relatively moderate, the article includes an epilogue discussing perspectives for the three major economies in the region: Argentina, Brazil, and Mexico.

Keywords: banking industry, banking sector, consolidation, financial policy, Argentina, Brazil, Mexico

Introduction

During the 1980s and, even more notably, the 1990s, banking systems in Latin America were deeply transformed. Liberal reforms were widely adopted in the region. Common features of these reforms were the liberalization of interest rates, the attenuation of barriers to entry in the provision of banking services, large-scale privatization of state-owned banks and the facilitation of entry for foreign banks (see Singh, et al., 2005; and Stallings and Studart, 2006). In parallel, but in a largely independent process, liberalization of the capital account of the balance of payments also influenced the evolution of domestic financial systems, since it opened new opportunities of investment for resident wealth holders at the same time in which it made possible for non-residents to buy assets and offer financial services to residents. The downside of such a process, of course, is the increasing exposure of these economies to the volatility of international financial markets.

The joint impact of all these changes was to transform deeply the ways financial systems work in Latin America. In fact, the transformation process is still unfolding, although nowadays in the shape of a sharp expansion of securities markets and (p. 869) also of a fast increasing supply of bank credit to private borrowers, even though it has generally started from very low levels in the region. Among the most visible changes already achieved is the strong process of bank consolidation that has taken place in the period. Of particular interest are the effects of consolidation on competition and efficiency in banking sectors.

This chapter is structured in the following way. After this Introduction, the second section provides an overview of the recent consolidation of banking sectors in Latin America. In the third section, we consider the evolution of financial policy and how it has contributed toward the recent consolidation process. The fourth section investigates the effects consolidation has had on banking sectors with the fifth section offering some concluding remarks. As the subprime mortgage crisis exploded after this chapter was completed, and since so far its impact on the region has been relatively moderate, we have added an epilogue discussing perspectives for the three major economies in the region: Argentina, Brazil, and Mexico.

Banking Consolidation in Latin America: A Quick Overview

Banking crises, financial deregulation, and the globalization of financial services have led to a significant increase in foreign bank penetration of emerging market banking sectors over the latter half of the 1990s. The effects of these developments have been summarized as follows:

global market and technology developments, macroeconomic pressures and banking crises in the 1990s have forced the banking industry and the regulators to change the old way of doing business, and to deregulate the banking industry at the national level and open up financial markets to foreign competition.… These changes have significantly increased competitive pressures on banks in the emerging economies and have led to deep changes in the structure of the banking industry. (Hawkins and Mihaljek, 2001: 3)

Whilst the process of bank consolidation in industrialized and emerging markets has been shaped by the above forces, some specific features have characterized consolidation in emerging markets (International Monetary Fund, 2001; and Gelos and Roldós, 2004). First, cross-border mergers and acquisitions (M&A) have been an important source of consolidation in emerging markets, yet the exception in industrialized markets. Second, consolidation was used to restructure emerging-market banking sectors after financial crises rather than to eliminate excess capacity or improve bank efficiency as in industrialized markets. Finally, emerging (p. 870) market governments actively participated in the process of consolidation, whereas consolidation tended to be ‘market-driven’ in industrialized markets since it represented financial institutions’ response to policies of financial deregulation that were implemented in the 1970s and 1980s.

Bank consolidation has been more advanced in Latin America compared to other emerging markets. National governments actively participated in bank restructuring and implemented substantial bank privatization programs, though in countries such as Argentina and Brazil some large banks remain under state ownership. Since the 1990s ended, the consolidation process—especially in Brazil and Mexico—has become increasingly market-driven (as in industrialized markets). Generally, the desire to enhance competition and efficiency and, in some cases, to restructure public finances formed the background to almost all privatization programs in the region. The role played by foreign banks in the restructuring and consolidation of domestic banking sectors should not be underestimated. The mid-1990s banking sector crises offered foreign banks

a one time set of opportunities to invest in financial institutions and to expand business… A standard response to crises by EME (emerging market economies) government, encouraged by the international financial institutions, was to accelerate financial liberalization and to recapitalize banks with the help of foreign investors.

(Committee on the Global Financial System, 2004: 6)

This has happened in Argentina, Brazil, and Mexico. Foreign banks’ shares of banking sector assets have increased substantially in Latin America, and although foreign bank penetration is not as extensive as in Central and Eastern Europe it is higher than in Asia (see Table 34.1).

In the 1990s, Latin America received record levels of foreign direct investment (FDI). In 1998 alone, the region received an inflow of $76.7 billion which was equivalent to 41 percent of total FDI to developing countries (Economic Commission for Latin America and the Caribbean, 2000: 35–6). The majority of investments were made in banking sectors. Between 1991 and 2005, a total of $121 billion was expended on cross-border M&A involving the acquisition of banks in emerging markets (Domanski, 2005). Of the total, 48 percent was spent in Latin America, with Asia and Central and Eastern Europe receiving 36 percent and 17 percent, respectively. The main source of investment in Latin America came from Spanish banks (46.6 percent of the value of acquisitions made by foreign banks of domestic banks in the region) followed by US (26.5 percent), UK (10.0 percent), Dutch (6.4 percent), and Canadian banks (3.6 percent).

Bank restructuring has increased the level of concentration in regional banking sectors. Whilst banks numbers have fallen—considerably in some countries—the accompanying increases in concentration were not as sharp. Measured by the three-irm deposit concentration ratio between 1994 and 2000, the largest banks in Brazil and Mexico grew their share of deposits to more than 55 percent, whereas (p. 871) the comparative shares of the largest banks in Argentina and Chile remained stable (see Table 34.2). Across the region, concentration of the ten largest banks increased (except Venezuela). Whilst Latin American banking sectors were more highly concentrated (in 2000) than Asian sectors, they were slightly less concentrated than sectors in Central Europe. However, Table 34.2 clearly shows that concentration increased in Latin America whereas it decreased in Asia and Central Europe (albeit with limited exceptions).

Table 34.1. Share of bank assets held by foreign banks'

Countries

1990

20042

Gross Domestic Producy (%)

US$ billion

Central and Eastern Europe

  Bulgaria

0

80

49

13

  Czech Republic

10

96

92

99

  Estonia

97

89

11

  Hungary

10

83

67

68

  Poland

3

68

43

105

Emerging Asia

  China

0

2

4

71

  Hong Kong

89

72

344

570

  India

5

8

6

36

  Korea

4

8

10

65

  Malaysia

18

27

32

  Singapore

89

76

148

159

  Thailand

5

18

20

32

Latin America

  Argentina

10

48

20

31

  Brazil

6

27

18

107

  Chile

19

42

37

35

  México

2

82

51

342

  Peru

4

46

14

11

  Venezuela

1

34

9

9

Notes:

1 Percentage shares of total banking sector assets.

(2) Or latest available year.

Source: Domanski, 2005: 72, based on data from European Central Bank and national central banks.

In countries such as Mexico and Argentina, the rise in the level of consolidation was closely tied to foreign bank penetration. In Mexico, foreign banks had unrestricted access to all sectors of the banking market and became market leaders. Whilst foreign banks came to dominate domestic banks in Argentina—as they increased their market share from 16.1 percent of total bank deposits in November 1994 to 51.8 percent in December 2001 (Fanelli, 2003: 52)—their presence partially wavered after the 2001–2 financial crisis as their market share declined whilst the (p. 872) market shares of private and mainly public-owned banks increased. Domestic private and public banks are market leaders in Brazil. Indeed, privately owned banks responded proactively to foreign bank penetration and became active in domestic M&A (Paula and Alves, 2007). The consolidation process in Chile proceeded more gradually: it has increased because of M&A in Spain (the home country of the parent banks of the two largest banks in Chile); technically, the enlarged Spanish parent has operated its Chilean subsidiaries as individual entities (Ahumada and Marshall, 2001).

Table 34.2. Banking concentration in some selected emerging countries, 1994–2000

Countries

1994 Market share total of deposits (%)

2000 Market share total of deposits (%)

Banks quantity (1994)

Three major banks

Ten major banks

Herfindahl index (1994)

Banks quantity (2000)

Three major banks

Ten major banks

Herfindahl index (2000)

Asia

  Korea

30

52.8

86.9

1,263.6

13

43.5

77.7

899.7

  Malaysia

25

44.7

78.3

918.9

10

43.4

82.2

1,005.1

  Philippines

41

39.0

80.3

819.7

27

39.6

73.3

789.9

  Thailand

15

47.5

83.5

1,031.7

13

41.7

79.4

854.4

Latin America

  Argentina

206

39.1

73.1

756.9

113

39.8

80.7

865.7

  Brazil

245

49.9

78.8

1,220.9

193

55.2

85.6

1,278.6

  Chile

37

39.5

79.1

830.4

29

39.5

82.0

857.9

  Mexico

36

48.3

80.8

1,005.4

23

56.3

94.5

1,360.5

  Venezuela

43

43.9

78.6

979.2

42

46.7

75.7

923.1

Central Europe

  Czech Republic

55

72.0

97.0

2,101.5

42

69.7

90.3

1,757.8

  Hungary

40

57.9

84.7

1,578.8

39

51.5

80.7

1,241.2

  Poland

82

52.8

86.9

1,263.6

77

43.5

77.7

899.7

Source: International Monetary Fund, 2001: 127.

Bank restructuring and privatization ushered in a new wave of cross-border (and domestic) M&A activity. Cross-border bank M&A partially reflects country-specific factors: positively related to shared language (Spanish bank entry: Sebastian and Hernansanz, 2000) and geographical proximity (North American bank entry: Buch and DeLong, 2001); and the availability of access to large, relatively poor countries with widely spaced populations and underdeveloped financial sectors (Buch and DeLong, 2001; and Focarelli and Pozzolo, 2001). M&A can be analyzed in terms of the financial condition of buyers and targets. A recent application to Brazil differentiates between M&A involving domestic-owned and foreign-owned banks. The results suggest that domestic and foreign buyers (p. 873) acquired target banks that had alternative profiles: domestic buyers have tended to buy underperforming banks whilst foreign buyers tended to acquire large, slow-growing institutions; the implication is that foreign banks have used M&A as the vehicle to increase bank size and market share (Cardias Williams and Williams, 2008).

The Evolution of Financial Policy in Latin America

Although the process of transformation of Latin American banking systems has exhibited basically the same features, and took place in roughly the same period, its causes diverged from country to country. Post-1945, Latin American financial systems were typically repressed, and governments across the region attempted from the late 1940s on, with varying success, to accelerate economic growth and transform national social and economic structures. The key to become a developed country was thought to be becoming industrialized as quickly as possible. Inspired by the experiences of Central European countries (cf. Gerschenkron, 1962), Latin American governments, particularly in the largest countries (Brazil, Mexico, Argentina, and Chile) saw in the banking system a powerful instrument to centralize and direct the necessary resources to finance the growth of manufacturing production. Unwilling to rely on the eventual ability of freely operating financial markets to support an accelerated growth process, governments in those countries imposed financial repression (Fry, 1995), which consisted in this case mostly of creating, or enlarging the functions of, existing, state-owned banks, setting maximum interest rates to be charged on loans by private banks (frequently adopted in the context of usury laws), and directing the credit supplied by these banks to sectors considered strategic to enhance economic growth.

This is not the place to assess how successful these initiatives were in promoting growth.1 The region suffered heavily with the oil shocks of the 1970s. The attempts to deal with the effects of those shocks by increasing short-term foreign debt led to the debt crisis of the early 1980s that brought the most important economies of the region to a standstill that lasted so long it became known as the ‘lost decade of economic growth’. As part of the negotiated resolution package for that crisis, practically all countries in Latin America accepted to promote liberalizing reforms, (p. 874) including in the financial sector and thereby ending the financial repression experiment.

Chile was the pioneer in this process (see Stallings and Studart, 2006; and Foxley, 1983). Liberal reforms in the banking markets, including privatization of state-owned financial institutions began right after the 1973 military coup that ousted then-President Salvador Allende. The root cause of financial liberalization in the case of Chile was the radically conservative nature of the military regime led by General Pinochet, which aimed at erasing all and any trace of the policies adopted before. As it has happened in similar experiences, strong liberalization policies created new profitable opportunities for banks which raised their competitiveness. However, financial regulation and bank supervision were deficient either because regulators lacked experience with open markets or because the state was assumed to be an inefficient player in the economic game so no investment in upgrading the skills of regulators and supervisors was made. Inevitably, as has been the general experience, this first wave of liberalization ended up generating a profound banking crisis in the early 1980s. To resolve the crisis, the government intervened heavily in the banking system. On the one hand, banks were allowed to sell to the government their non-performing assets under the obligation of buying them back over time, when the crisis was expected to be over. In addition, tougher bank regulation was adopted to prevent the disorderly expansion of the past from repeating itself.

In the case of Mexico, banking reforms were inspired by less dramatic events (see Avalos and Trillo, 2006; Singh, et al., 2005; and Stallings and Studart, 2006). Mexico had also followed the general pattern set by the largest economies of Latin America in the post-war period of creating strong state-owned banks to stimulate economic development. Room for private banks was very limited and foreign banks were all but banned from operating in the domestic markets. As late as in the early 1980s, foreign banks were still prevented from controlling more than 7 percent of the net worth of the largest banks. The 1982 debt crisis, the ensuing period of economic stagnation, and the conditionality clauses included in the rescue packages negotiated by the Mexican government with creditor banks and multilateral institutions led the Mexican authorities to a change of heart. The government endeavored to promote liberal reforms in the economy, of which banking reform was an important element (see de Vries, 1987). Later, this drive was strengthened by Mexico's adhesion to NAFTA which led to a drastic reduction of barriers to entry to American and Canadian banks. The defining act of Mexico's reforms, however, was the bungled privatization process of 1991, which took place when there were still strong restrictions against foreign participation in the domestic banking sector. Banks were acquired by businessmen inexperienced in the banking business, at prices widely considered to be excessive. The rush to recover their investments and to obtain proits led to a credit boom unrestrained by any kind of proper regulation. Credit was expanded without any attention being given (p. 875) to credit risks. The fast expansion ultimately caused the 1994 crisis, when bank assets were virtually re-nationalized. In fact, the Mexican government, first in 1995, and again in 1996, bought the huge amount of non-performing assets in banks’ balance sheets through a crisis resolution entity created to manage the problem (Fobaproa).2 Contrary to what was done in Chile, however, those assets were not to be reabsorbed by the banking system; rather, taxpayers’ money paid for the losses of banks, since Fobaproa's liabilities were transformed into public debt. The weakness of the banking system led the Mexican government to change the law to allow an increasing participation of foreign banks in domestic markets, including the acquisition of local problem banks. Consequently, the market share of foreign banks in Mexico was over 80 percent in 2000 (Hernandez-Murillo, 2007: 416).

In Brazil and Argentina, the causes of the liberalization process were somewhat more complex, owing to persistently high inflation. In both cases, most (but not all) reforms were adopted as elements of price-stabilization strategies. Until the 1970s, the Brazilian banking system was highly repressed (Carvalho, 1998). Although the presence of private banks was strong, the system was dominated by state-owned institutions. Foreign banks were confined to attending mostly foreign companies, and, as in other countries, prevented from reaching domestic clients (Carvalho, 2000). In the mid-1960s, the structure of the Brazilian financial system had been changed, and a segmented market model, similar to the one set by the Glass-Steagall Act in the US, was imposed. Commercial banks would provide short-term credit and payment services, investment banks should help develop an incipient securities market, specialized institutions would finance the acquisition of durable consumption goods, and public institutions would give financial support to productive investments in manufacturing, agriculture, and construction.

Thanks to loopholes in the legislation, financial conglomerates, with interests in practically all segments of the financial system, and in non-financial sectors as well, emerged in the 1970s and early 1980s. In parallel, the acceleration of inflation after the oil shocks of the 1970s steadily reduced the access of private borrowers to credit markets. Banks were increasingly devoting the resources they controlled to buying public debt issued by the Federal government, unable as the latter was to control its fiscal deficits. Market segments other than deposit taking and public debt buying, and the institutions supposed to operate them, gradually faded and disappeared. Under these circumstances, in 1988, the Central Bank of Brazil passed a resolution adopting the German-type universal banking model in the place of the aforementioned segmented model.3 In the same resolution, interest rate controls were lifted. Financial liberalization in Brazil, therefore, began as the result of the (p. 876) acknowledgment that past regulations had become obsolete rather than being the first step of a well-defined strategy.

In Argentina, similar, up to a point, developments took place in the same period.4 Accelerating inflation, as in Brazil, was the most important problem faced by policymakers at the time. In the late 1980s, the arsenal of instruments to control inflation was fast being depleted, after many failed attempts at price stabilization. Moreover, foreign creditors were demanding implementation of financial liberalization policies as a conditionality clause in the resolution package for the debt crisis of 1982. The Argentine government had little choice but to begin a liberalization process, by freeing interest rates and moving toward a universal bank model, leaving to each financial institution the choice of sectors where to operate.

After 1991, with the adoption of the Convertibility Plan (also known as the Cavallo Plan, named after then Finance Minister Domingo Cavallo), in contrast to the more pragmatic Brazilian experience, a radical liberalization strategy was put in place. A central element of this strategy was the opening of the domestic banking market to foreign banks. As a result, foreign penetration of the Argentinean banking system increased dramatically as it was deliberately promoted by a restructuring and concentration policy, which had been implemented after the contagion of Mexico's Tequila crisis that severely tested both the Convertibility system and the financial sector. Among the ten largest banks in Argentina in December 2000, seven banks were foreign owned, two were publicly owned—the market leaders, Banco de la Nación (Federal) and Banco de la Provincia de Buenos Ayres (provincial)—and only one bank was domestic, privately owned (Paula and Alves, 2007: 97).

The process of privatization of state-owned banks in Argentina illustrated an important change of views that had already taken place in countries, such as Chile and Uruguay. In these cases, privatization was seen not only as a temporary convenience or an unavoidable evil. Liberalization was adopted as a strategy, rather than as an expedient. Bank privatization was conducted as an element, no matter how important, of an overall liberalization process that was expected to help the region to overcome its long-term inefficiencies. The deep crisis of the early 2000s led Argentina partially to repudiate this view. It is still dominant in Chile and Uruguay, even after center-left administrations were elected in the latter countries at the beginning of the new century.

In Brazil, in contrast, this path was explored with caution. In fact, the end of finlation in 1994 caused severe stress in a large number of banks that earned their profits mostly from securing deposits to finance the purchase of public debt, the yield of which was indexed to the rate of inflation. When inflation fell precipitously, after the implementation of the Real Plan in 1994, many banks were revealed to be (p. 877) practically bankrupt. The Brazilian government, to avoid panic, took measures to allow splitting problem banks in two parts: a ‘sane’ one, with healthy assets and its corresponding share of liabilities; and the failed one, with the non-recoverable assets. The sane part was to be sold to other banks; the failed part would be liquidated by the Central Bank.

The same scheme, actually inspired by rules used in the US to deal with the Continental Illinois Bank in the mid-1980s, was adopted in Argentina (De la Torre, 2000). In Argentina and Brazil, panic was avoided, at the cost of pushing bank consolidation forward. In Brazil, the Central Bank decided to invite foreign banks to buy domestic banks that were either being privatized (the banks owned by the States) or facing difficulties that would probably lead them to fail. The decision to allow foreign banks in was made to prevent excess concentration, which was expected to ensue should the leading domestic banks be allowed to buy problem banks. Although, the Brazilian government never lifted the legal restrictions banning the entry of new foreign banks in the domestic system, it allowed ‘exceptions’ to take place while they were needed. Once the economy was stabilized and the stock of problem banks was sold, practically no new foreign bank was authorized into the country. Mexico was the last large country in Latin America to open its market to foreign banks. However, it is also the country where foreign banks were granted the most unrestrained access to domestic markets, leading to an almost complete disappearance of domestic private banks, let alone state-owned banks.

The recent trend toward consolidation is not new to the region. Previously, waves of bank consolidation had taken place in some countries, mostly induced by domestic policies. In Brazil, for instance, in the early 1970s, a strong consolidation process was promoted by the Federal government under the expectation that taking advantage of supposedly strong economies of scale would allow the reduction of interest rates necessary to keep the economy growing as rapidly as it was. Financial repression was still in force, and no increase of foreign participation was envisaged. Increasing efficiency via scale economies should lighten the burden of interest rate control on banks, attenuating the incentives to evade these controls. In any case, Latin American economies are still relatively small. If to the small dimension of these economies one also adds the generally high degree of income concentration, markets for banking services would be even smaller. If scale economies exist in banking, one would expect to find a relatively high degree of concentration in the region anyway.

In the 1980s, and more so, in the 1990s, the push for consolidation came from many sources. Political and ideological factors were very important in the case of Chile in the mid-1970s, to allow banks to decide their own policies, including larger and stronger banks to absorb smaller ones. After the early 1980s crisis, the push for consolidation was strengthened by the assumption that larger banks, especially foreign ones, are capable of managing risk more efficiently, specially if prudential regulation was improved, thereby making the system more stable.

(p. 878) Concerns with systemic stability help to explain consolidation, in one way or another, in nearly all of the region's recent experiences. Many of the regulatory initiatives adopted to strengthen the stability of banking systems contributed to push consolidation forward. The introduction of modern payments systems, the increasing use of ATMs, Internet banking and so forth, also lead to increased consolidation if individual banks have to provide their own equipment and other facilities. Even privatization initiatives were frequently defended with systemic safety arguments, on the notion that state-owned financial institutions increase the risk of feeding dangerous forms of crony capitalism. Consequently, at the turn of the millennium, the most important banking systems in Latin America came to exhibit a relatively similar ownership structure.

Financial Penetration in Latin America

Latin American financial systems are characterized by similar features: financial depth is limited; financial sectors are bank-based since stockmarkets are mostly small and illiquid and corporate debt markets even more so; intermediation margins are high by international standards; banking sector concentration has increased; and bank lending is low relative to overall economic activity. Indeed, the limited access to bank credit and uncertainty about financial stability are factors that have contributed to economic volatility in the region (Singh, et al., 2005: ch. 1).

Whereas Latin American financial systems are deeper than they were a decade ago (Rojas Suarez, 2007: 3), the level of financial depth is low compared to industrialized countries and some emerging market regions (see Table 34.3). There is considerable heterogeneity in financial depth in the region: financial penetration is deeper in Chile and Uruguay (which operates as an offshore financial center) and the largest markets—Argentina, Brazil and Mexico—exhibit only modest levels of financial depth (see Table 34.4). Chile is the only country to have achieved a level of deepening comparable with industrialized countries (Rojas Suarez, 2007). Chile's stockmarket depth (measured as the ratio of stockmarket capitalization to GDP) is greater than Japan's and some European countries such as France, Germany, and Spain (Betancour, De Gregorio, and Jara, 2006). Furthermore, households’ access to financial services in Chile is closest to levels observed in industrialized countries; over 90 percent of households have access to financial services in western industrialized countries compared with 60 percent to 80 percent in Chile, 40 percent to 60 percent in Brazil and Colombia, and 20 percent to 40 percent in Argentina and Mexico (Honohan, 2007).

If financial depth and access to financial services are to increase, the institutional environment which conditions the effective operation of financial intermediaries and financial markets must be developed further. The World Bank Governance Indicators show an improved level of governance in Brazil, Chile, and Mexico (p. 879) (p. 880) between 1996 and 2004, but only Chile achieved a level comparable with industrialized countries (Rojas Suarez, 2007: 25).

Table 34.3. Financial depth by region, 1990s

Region

Number of countries

Credit to private sector (% of gross domestic product)

Credit and market capitalization (% of gross domestic product)

Gross domestic product per capita, 1995 (US$)

Developed countries

24

84

149

23,815

East Asia and the Pacific

10

72

150

2,867

Middle East and North Africa

12

43

80

4,416

Latin America and the Caribbean

20

28

48

2,632

Eastern Europe and Central Asia

18

26

38

2,430

Sub-Saharan Africa

13

21

44

791

South Asia

6

20

34

407

Note: Values are simple averages for the regions for the 1990s.

Source: Inter-American Development Bank (2005: 5) with data from International Monetary Fund and World Bank.

Table 34.4. Financial depth in some selected countries of Latin America, 2003 (percentage of GDP)

Country

Banking system*

Outstanding domestic debt securities

Deposits

Loans

Assets

Argentina

25.3

14.2

44.8

25.2

Brazil

30.6

21.5

74.6

47.2

Chile

38.1

68.5

79.8

52.9

Colombia

19.7

19.7

37.9

Ecuador**

16.8

15.1

22.0

24.8

Mexico

25.5

16.1

52.3

13.9

Paraguay

24.6

17.6

31.7

Peru

14.5

13.7

19.2

7.1

Uruguay

36.4

64.3

82.6

Venezuela**

20.0

8.1

23.9

1.3

Latin

25.2

25.9

46.9

24.6

America***

Notes: In 2003, the supply of credit decreased sharply due to the effects of economic crises in Argentina and Brazil (with a greater decline in Argentina due to the crisis of the convertibility system). Indeed, the credit to gross domestic product ratios of Argentina and Brazil stood at 21.4% and 24.8% in 2000 (see Belaisch, 2003: 4), which was greater than in 2003, but still very low compared to industrialized countries and some other areas of emerging market countries.

* Only deposit taking commercial banks are considered.

(**) “Domestic debt securities data are as of 2000.

(***) Mean values.

Source: Singh, et al. (2005: 64).

The effectiveness of financial liberalization in Latin America may be gauged from the evolution of interest rate spreads. Weaknesses in the institutional environment are offered as a partial explanation for the relatively high, by international standards, spreads observed and the dispersion of spreads across the region (Gelos, 2006). Although spreads have narrowed recently, the continued presence of high spreads has limited the benefits of liberalization.

Across Latin America, credit is not only scarce but costly too. Comparatively speaking, the region has one of the highest interest margins in the world (8.5 percent), above East Asia and the Pacific(5.1 percent) and the developed countries (2.9 percent), yet slightly lower than Eastern Europe and Central Asia (8.8 percent). Table 34.5 points to the negative correlation between private sector credit and interest spread (Singh, et al., 2005: 5–7).

 Banking in Latin AmericaClick to view larger

Fig. 34.1. Banking spread (percentage per annum)

Notes: In Figure 1, the banking spread (ex ante spread) is calculated as the difference between the average lending rate and the average deposit rate, that is, the measurement of the ex ante spread, while net interest (ex post spread) is a measurement of the net yield of bank financial intermediation, according to the revenues actually generated by credit operations and the actual cost of deposit taking, normally calculated from accounting data made available by the bank itself.

Figure 34.1 shows the evolution of interest rate spreads in Latin America from 1993 to 2006. Salient features include the narrowing of spreads over time—although remaining high by international standards—and considerable cross-country variation. Spreads are largest in Brazil (Brazil has some of the highest short-term interest rates in the world), Uruguay, and Peru. Chile has the narrowest spread, comparable with industrialized countries. After 2004, it appears that spreads began to converge (except Brazil, Uruguay, and, to a lesser extent, Peru). Spreads are correlated more with loan rates than deposit rates (especially in Argentina and Peru) meaning that a shock that causes spreads to widen will raise (p. 881) lending rates rather than decrease deposit rates. Finally, spreads are more dispersed across banks than over time (Brock and Rojas Suarez, 2000).

Table 34.5. Interest spread and efficiency by region, 1995–2002

Region

Number of countries

Interest margins (%)

Overhead costs (% of assets)

Credit to private sector (% of gross domestic product)

Developed countries

30

2.9

1.8

89

East Asia and the Pacific

16

5.1

2.3

57

Middle East and North Africa

13

4.0

1.8

38

Latin America and the Caribbean

26

8.5

4.8

37

Eastern Europe and Central Asia

23

8.8

5

26

Sub-Saharan Africa

32

10.6

5.1

15

South Asia

5

4.6

2.7

23

Note: Values are simple averages for the regions for the 1990s.

Source: Inter-American Development Bank (2005: 7) with data from International Monetary Fund and World Bank. Authors’ calculations with data from International Financial Statistics.

One should exercise caution when interpreting the narrowing of spreads. Under competitive conditions with weak bank regulation and supervision, explicit government guarantees, and the absence of political will to liquidate failing banks, poorly performing banks could have raised deposit rates but not passed on the higher funding costs to borrowers for fears that higher loan rates may raise default risk for risky borrowers. In addition, these banks may have tried to grow market share by expanding loans to risky borrowers (Brock and Rojas Suarez, 2000; and Rojas Suarez, 2001). This suggests there may be an inverse relationship between interest rate spreads and banks’ portfolio risk in Latin America, which, if true, is contrary to the observed relationship in industrialized countries. It implies that stronger banks served the ‘better-quality’ customers meaning that poorly capitalized, weaker banks have had to operate with lower spreads in order to compete. Furthermore, weaknesses in provisioning caused spreads to narrow when the loan portfolio (and bank income) deteriorated (Brock and Rojas Suarez, 2000).

Factors influencing bank spreads include microeconomic factors (high operating costs, poor loan quality, high capitalization, and reserve requirements) and macroeconomic factors (interest rate volatility, GDP growth, and inflation). Empirical evidence suggests that microeconomic factors have been the main determinant of spreads in Bolivia; micro- and macroeconomic factors impacted on spreads in Chile and Colombia (Brock and Rojas Suarez, 2000; Barajas, Steiner, and Salazar, 1998; and Barajas, Steiner, and Salazar, 2000); macroeconomic factors were more important in determining Brazilian spreads that were particularly high at large banks due to market power (Afanasieff, Lhacer, and Nakane, 2002); neither micro- nor macroeconomic factors adequately explained the evolution of spreads in Argentina and Peru (Brock and Rojas Suarez, 2000). A comparison of spreads in Latin America with the industrialized countries found that the main difference is the effect that non-performing loans have had on spreads, with deteriorating loan quality associated with narrower spreads in Latin America. It is suggested that this feature was indicative of inadequate loan-loss provisioning, or that banks with large amounts of bad loans lowered spreads in an attempt to grow out of difficulties (Brock and Rojas Suarez, 2000).

Besides the generally low level of credit identified in Table 34.3, the pattern of credit growth in Latin America has been marked by boom and bust cycles, particularly in economies with the lowest amounts of bank credit to GDP. Credit had expanded sharply across the region in the early 1990s, in part due to increased capital inflows, but it collapsed in many cases after the mid-1990s banking crises and remained subdued for many years. Only after 2004 has credit begun to recover, due to stronger economic growth, easier global monetary conditions, and progress in bank restructuring. Credit growth has been particularly strong in Argentina and Brazil (Jeanneau, 2007: 6–7). Yet, in most Latin American countries, the unstable macroeconomic environment has been a critical factor in holding back financial system development and generating a high volatility of credit growth. For example, high short-term interest rates used to combat inflation or defend the exchange rate has added to banks’ funding costs and increased loan-default rates (Singh, et al., 2005: 70–1).

There are legitimate concerns that the composition of bank portfolios probably led to some crowding out of private sector credit. This was because of banks’ tendencies to hold high proportions of government securities in their portfolios, which possibly reflected historical patterns of behavior associated with hyperinflation. In the late 1990s, banks replaced non-performing loans with sizable portfolios of government securities in Argentina, Mexico, and Venezuela. More recently, and due to fiscal consolidation (in Argentina, Mexico, and also Brazil), the amount of government securities in banks’ portfolios has declined.

Banking Sector Heterogeneity and Dollarization

The observed heterogeneity across Latin America's financial systems results from a variety of different historical and institutional features. Financial sector penetration (depth) of the economy is highly variable but unrelated to country size and per capita incomes. The relatively large economies of Argentina and Mexico have smaller banking sectors than implied by their levels of economic development, (p. 883) which can be attributed to long-lasting effects of financial crises. As a result of the 1990s Tequila crisis, the ratio of Mexican bank assets to GDP fell from a historical high of almost 70 percent in 1994 to between 32 percent and 35 percent from 2000 to 2005 (Sidaoui, 2006: 287). Estimates imply that private sector credit should be around 50 percent of GDP given the economic size of Argentina, rather than the observed 1990s average of 20 percent (Inter-American Development Bank, 2005: 6). Uruguay has one of the most internationalized and open financial systems in the region with the banking sector performing the role of regional offshore financial center. Owing to its longer track record of greater macroeconomic stability, sustained economic growth, and earlier financial sector reform, Chile has achieved a more even pattern of credit growth.

Latin American financial systems are characterized by varying degrees of dollarization with the conspicuous exception of Brazil and Venezuela (see Singh, et al., 2005). In several countries, relatively large shares of bank deposits and loans have been denominated in US dollars: the average dollarization ratio across 1998 to 2004 shows that over 75 percent of total banking sector deposits were foreign currency denominated in Bolivia, Peru, and Uruguay whilst the ratio was approximately 60 percent for Paraguay (see Table 34.6). In these countries, informal dollarization has been developed partially as a response to the hyperinflation of the 1980s (in Bolivia and Peru), when confidence in the value of domestic currencies was severely undermined.

Table 34.6. Dollarization ratio* in selected countries in Latin America (percentage)

Countries

1998

2000

2001

2004

Argentina

58.4

66.6

2.9

11.0

Bolivia

93.1

93.8

92.1

90.5

Brazil

0.0

0.0

0.0

0.0

Chile

6.2

0.0

11.5

13.0

Colombia

0.0

0.0

0.0

0.0

Costa Rica

44.4

44.9

48.0

48.0

Ecuador

100.0

100.0

Mexico

8.0

5.6

4.7

3.4

Panama

100.0

100.0

100.0

100.0

Paraguay

47.5

61.6

68.5

61.9

Peru

76.5

76.9

73.2

68.9

Uruguay

90.6

91.6

93.6

90.0

Venezuela

0.0

0.1

0.2

0.1

South America

21.4

23.2

27.5

27.0

Note:* Total foreign currency deposits in the domestic banking system/total deposits in the domestic banking system.

Source: Bank for International Settlements (2007: 68).

(p. 884) In Ecuador, full dollarization was implemented for price stability purposes in 1999. Elsewhere, economic policies that stimulated the dollarization of the domestic economy were adopted. In 1991, Argentina implemented its currency board regime that guaranteed the full convertibility of dollars and pesos; financial intermediation increasingly became dollar-denominated until the regime collapsed in 2002. In contrast, other countries (Brazil, Chile, Colombia, Mexico, and Venezuela) have avoided dollarization, by either prohibiting most holdings of foreign currency deposits, or imposing prudential constraints on such holdings. Prohibition has had the adverse effect of shifting deposits and loans offshore; consequently, financial-system vulnerability increased because of greater liquidity and solvency risks (Jeanneau, 2007: 7–8).

The Effects of Banking Consolidation

Market Structure, Privatization, Foreign Bank Penetration, and Bank Performance

Bank privatization of state-owned banks dramatically altered the market structure of domestic banking sectors.5 Privatization has transformed the governance structure of domestic banks as new, private owners (domestic and foreign) assumed control of banks. Generally speaking and across the region, state-owned banks had served political and social purposes and they shared certain characteristics: weak loan quality, underperformance, and poor cost control. Indeed, privatization was deemed to be a cheaper option than restructuring and recapitalization. The outcomes of bank privatization have varied across countries. For Argentina and Brazil, the evidence suggests that privatized bank performance improved (p. 885) post-privatization (Berger, et al., 2005 for Argentina; Nakane and Weintraub, 2005 for Brazil). In stark contrast, the 1991 privatization program in Mexico failed in the mid-1990s with the onset of the Tequila crisis.6 The crisis revealed deep-seated problems in the banking sector which had been masked by weak property rights and ineffective bank regulation that failed to prevent imprudent behavior by newly privatized banks. Bank privatization failed to the tune of a bailout costing an estimated $65 billion (Haber, 2005). Yet, unlike in Argentina and Brazil, the 1991 Mexican program disbarred foreign banks from entering the auctions. Beginning in February 1995, a post-Tequila second round of restructuring and privatization liberalized the treatment of foreign ownership of domestic banks and was completed in 1996 (with effect from 1997). This lead to a large-scale transfer of bank ownership from domestic to foreign hands: foreign banks held 5 percent of banking sector assets in 1995 that leapt to 82 percent by 2003 (Haber, 2005). In 2007, two of the three largest Mexican banks were owned by foreign banks.

One must be cautious when interpreting the apparent positive outcome of bank privatization. The observed post-privatization improvements in bank performance may reflect selection bias. In order to raise the viability of state-owned banks to prospective buyers, bank balance sheets were sanitized and healthy banks were privatized whilst bad banks were funded using public funds (for further details on the privatization of Argentina's provincial banks, see Clarke and Cull, 2000). Certainly, statistically significant differences in the balance sheet structures of privatized and non-privatized state banks are reported for Argentina (Berger, et al., 2005). Similar transfers were carried out in Brazil. The utilization of the bad bank model can be expected to have influenced post-privatization bank performance.

Bank privatization assisted foreign bank penetration in Latin America as foreign banks acquired large, domestic banks. For policymakers, foreign bank entry was expected to raise competition leading to efficiency gains and banking sector recapitalization. Foreign bank entry increased banking sector capitalization in Mexico between 1997 and 2004 by more than $8.8 billion—equivalent to 42 percent of total banking sector capital in 2004 (Schulz, 2006). Country-level evidence suggests bank efficiencies improved at the same time as foreign bank penetration increased. Arguably, this is too general a claim since there are caveats to consider. First, one should distinguish between the performance of existing foreign banks and domestic banks acquired by foreign banks—mainly large banks purchased via cross-border bank M&A. We refer to the latter as foreign bank acquisitions. Second, it is difficult to disentangle the effects of foreign bank entry from other (p. 886) liberalization effects that could have affected bank efficiency. Finally, many studies use proxy measures of efficiency like the ratio of overhead costs to assets; there is limited evidence where econometric estimates of bank efficiency were employed (Berger, 2007).

One exception reports there were inter-country differences in bank cost efficiencies with very small and very large banks more inefficient than large banks. Cost inefficient banks tended to be small, undercapitalized, relatively unprofitable, less risk averse, facing unstable deposit bases and intermediating less. Country-level factors also determined bank-level cost efficiencies: countries with higher rates of economic growth, denser demand for banking services, and lower levels of market power achieved better cost efficiency performance (Carvallo and Kasman, 2005).

It is very difficult to identify the separate effects of bank privatization and foreign bank entry on bank condition and performance. One study reported little difference in the performances of privately owned domestic banks and foreign-owned banks, though the former did outperform state-owned banks (Crystal, Dages, and Goldberg, 2002). Foreign banks achieved higher average loan growth than domestic banks (in Argentina, Chile, and Colombia) with loan growth stronger at existing foreign banks compared to acquired foreign banks. It is suggested that management at foreign bank acquisitions focused on restructuring the former domestic banks and integrating operations with the parent (foreign) bank. This implies that foreign bank acquisitions adopted a defensive strategy toward market share and growth until the integration process was completed. The cautious nature of foreign bank strategies explains why foreign banks, and foreign bank acquisitions in particular, had better loan quality than domestic-owned banks, although stronger provisioning and higher loan recovery rates translated into weaker profitability at foreign banks. Foreign banks were relatively more liquid, have relied less on deposit financing, and realized stronger loan growth during episodes of financial difficulty than domestic banks. The available evidence suggests that foreign banks have achieved a greater efficiency in intermediation because they were better able to evaluate credit risks and allocate resources at a faster pace than their domestic-owned competitors (Crystal, Dages, and Goldberg, 2002).

In Argentina, foreign banks typically entered the market via cross-border M&A rather than ‘de novo’ entry. The targets of foreign banks tended to be the larger and more profitable domestic banks. On average, foreign banks achieved better loan quality and were more highly capitalized and profitable than domestic banks (Clarke, et al., 2005). The effects of the governance changes on bank performance are summarized by Berger, et al (2005): state-owned banks underperformed against domestic and foreign banks due partly to poor loan quality associated with directed lending and subsidized credit. The privatization of provincial banks realized efficiency gains as the amount of non-performing loans fell and profit (p. 887) efficiencies increased. However, the improvement in profit efficiency may simply reflect selection bias since cost efficiencies were consistent before and after privatization. M&A activity involving domestic banks and foreign bank entry were reported to have had little effect on bank performance (Berger, et al., 2005).

These findings do not generalize to Brazil. Foreign banks operating in Brazil have faced difficulties in adapting to the peculiarities of the Brazilian banking sector, which remains dominated by private domestic banks (Paula, 2002). Incidentally, the empirical record offers no support for the hypothesis that foreign banks are either more or less efficient than domestic banks (Guimarães, 2002; Paula, 2002; and Vasconcelos and Fucidji. 2002). This is unsurprising in the light of evidence that the operational characteristics and balance sheets of domestic and foreign banks are similar (Carvalho, 2002). Hence, the expected benefits of foreign bank entry have yet to materialize in Brazil, because foreign banks have witnessed and graduated toward similar operational characteristics of the large private domestic banks (Paula and Alves, 2007).

Market Concentration and Competition Effects

The recent consolidation process has increased concentration in Latin American banking sectors. Whereas the expectation of policymakers has been that higher concentration would lead to more competition and efficiency improvements, there was the possibility that competitive gains would not materialize, and instead bank market power would increase. The latter implies that the evolution of highly concentrated market structures could limit the deepening of financial intermediation and the development of more efficient banking sectors (Rojas Suarez, 2007). Since a non-competitive market structure often produces oligopolistic behavior by banks, the suggestion is that further consolidation could incentivize banks to exploit market power rather than become more efficient.

It is an empirical matter to determine if bank consolidation (more concentration) has raised competition and banking sector efficiency, or instead realized market power gains for banks. Some degree of market power can check bank risk taking, and there are trade-offs between increased competition and financial stability. One difficulty when considering the relationship between consolidation and competitive conditions is the measurement of competition. The literature commonly employs the H statistic showing the sum of the elasticities of bank revenue with respect to input prices (Panzar and Rosse, 1987). Using this approach, banks in Latin America were found to operate under monopolistic conditions, consistent with results from industrialized countries and other emerging markets.

Importantly, the recent increase in consolidation has not weakened competitive conditions (Yeyati and Micco, 2007; Yildirim and Philippatos, 2007; and Gelos and Roldós, 2004). Despite this general finding, there are country-level features of note and some inconsistencies between studies. For instance, there is agreement that banking sector competition increased in Argentina and remained constant in Mexico from the mid-1990s to the early 2000s. On the contrary, competitive conditions in Brazil and Chile are reported to have changed little (Gelos and Roldos, 2004) or weakened (Yildirim and Philippatos, 2007).

In general, the literature rejects the notion of collusion between banks, but evidence from Brazil suggests that banks possessed some degree of market power (Nakane, 2001; and Nakane, Alencar, and Kanczuk, 2006). Other Brazilian evidence has illustrated the complexities associated with identifying competition effects. Whereas the banking sector has operated under conditions of monopolistic competition, this finding cannot be generalized across bank ownership and size. Whilst small banks and state-owned banks operated under the above banking sector conditions, large banks and foreign banks behaved competitively. This implication is of markedly different competitive conditions in local markets and the national market (Belaisch, 2003). In local markets, privately owned banks were more procompetitive than state-owned banks, although the latter entered markets which the former did not service (Coelho, de Mello, and Rezende, 2007). Small and large banks have also faced different competitive conditions in Argentina and Chile (Yildirim and Philippatos, 2007). Lastly, evidence from Colombia finds increased competition reduced banks’ market power (Barajas, Steiner, and Salazar, 1998).

At first sight, greater competition brought about by the changes in the banking industry in the 1990s has not weakened bank safety. As one can see from Table 34.7, capital coefficients have been comfortably above the Basel 1988 minimum of 8 percent of risk weighted assets everywhere. Even if one considers the higher floor of 11 percent, as suggested in the twenty-five Core Principles for Effective Banking Supervision, all countries in the Table would be in compliance.

One should read these data with some care, though. It is true that the 1990s and the 2000s witnessed a widespread effort at modernization of regulatory and (p. 889) supervisory methods and institutions everywhere in the region. Nevertheless, in part the data may be hiding one important source of fragility which is the dependence of the banking industry, at least in some of the largest economies, on the supply of credit to the government. Public debt securities tend to benefit from zero risk weighting (and thus do not require any capital to cover credit risk) adding one more incentive to banks to accumulate them, instead of private credit. As a result, in countries like Argentina, Brazil, or Mexico, high capital coefficients may not necessarily translate into higher defences against insolvency, but, in fact, to higher dependency on Treasury policies.

Table 34.7. Bank regulatory capital-to-risk-weighted assets

Country

2002

2003

2004

2005

2006

Brazil

16.6

18.8

18.6

17.9

18.9

Chile

14.0

14.1

13.6

13.0

12.5

Colombia

12.6

13.1

13.8

13.2

12.2

Mexico

15.7

14.4

14.1

14.5

16.3

Peru

12.5

13.3

14.0

12.0

12.5

Venezuela

20.5

25.1

19.2

15.5

14.3

Note: No data for Argentina is provided.

Source: International Monetary Fund, Global Financial Stability Report (September 2007).

In the discussion so far, no attempt has been made to disentangle the impact of foreign bank entry on competition. A priori greater foreign bank penetration was expected to increase competition and to offset the potential rise in domestic bank market power resulting from higher concentration. Consistent with expectations, there is cross-country evidence that suggests the increased foreign bank penetration raised the level of competition (Yildirim and Philippatos, 2007). An alternative view claims that increased concentration had little effects on competition and financial stability. Rather, foreign bank entry caused competitive conditions to weaken (Yeyati and Micco, 2007). The intuition for this claim is that foreign banks typically acquired domestic banks that were under duress and consequently operating with relatively high interest margins. For new foreign owners, the franchise value of high margins and the time needed to transform the fortunes of their acquisitions can explain why increased foreign bank penetration was associated with weaker, rather than stronger, competition. Whilst this apparent feature was inconsistent with policymakers’ objectives, the franchise value of the high margins disciplined banks’ risk taking because of fears that the increased bank profitability of the period could be dissipated away. In short, although foreign bank entry may have weakened competition it appears to have had a beneficial effect on banking sector stability (Yeyati and Micco, 2007).

Foreign bank entry raises the threat of increased competition which conditions the behavior of domestic banks and reduces their market power (Claessens, Demirgüç-Kunt, Huizinga, 2001). The evidence suggests this has happened in Latin America: greater foreign bank penetration has caused lower interest margins and profits at domestic banks (Yildirim and Philippatos, 2007). Individual country studies offer a richer interpretation of events. Evidence from Colombia suggests that foreign bank and domestic bank behavior began to evolve differently following the announcement (in 1990) that financial liberalization policies were to be implemented (Barajas, Steiner, and Salazar, 2000). This study was able to control for other liberalizing reforms that affected bank behavior—for instance, it differentiated between foreign bank entry and the entry of new domestic institutions, and it controlled for the opening of the capital account as well as improvements made to bank regulation and supervision. Whereas foreign bank entry did condition domestic bank behavior by reducing excess intermediation spreads over (p. 890) marginal costs, the effect of new domestic entrants on bank behavior was greater, reducing non-financial costs and interest spreads. The Colombian evidence implies bank behavior reflected the degree of market power of banking groups; since foreign banks had relatively little market power they were more able to adapt to changes in competitive conditions (Barajas, Steiner, and Salazar, 2000).

In Mexico, the lower administrative costs of foreign banks released downward pressure on administrative costs across all banks, which improved bank efficiency (Haber and Musacchio, 2005). Others have suggested that the impact of foreign bank entry on bank efficiency was limited because the low level of competitive intensity in the banking sector abated pressures for banks to improve operational efficiency (Schulz, 2006). Evidence from Argentina and Brazil has reported there was no significant difference in the behavior of foreign and domestic banks; both types of bank reacted similarly to the macro-institutional environments (Paula and Alves, 2007).

Consolidation and the Allocation of Credit

The governance changes resulting from bank privatization and foreign bank penetration raised concerns in relation to the supply of bank credit. Three concerns were voiced: first, that increased foreign bank penetration would affect the stability of bank lending; second, foreign bank entry and/or new private ownership of banks might lead to a reallocation of credit toward certain geographic or product market segments; and third, given the governance changes, would bank credit be responsive to market signals.

Foreign bank penetration has raised foreign banks’ share of total banking sector loans in Latin America. Foreign bank lending has tended to concentrate in specific market segments, mostly the commercial loans markets (including government and interbank sectors) in Argentina, Colombia, and Mexico (Dages, Goldberg, and Kinney, 2002; Paula and Alves, 2007; and Barajas, Steiner, and Salazar, 2000). In these countries foreign banks limited their exposure to the household and mortgage sectors. In Chile, household credit has dominated foreign banks’ loan portfolio increasing from 18.4 percent to 27 percent of total foreign bank loans between 1990–9 and 2000–5 (Betancour, De Gregorio, and Jara, 2006). In Argentina and Brazil, foreign and domestic banks competed in loans markets and shared loan portfolio characteristics (Dages, Goldberg, and Kinney, 2002; and Paula and Alves, 2007). However, foreign banks in Argentina weighted the loan portfolio toward relatively less risky loans (Dages, Goldberg, and Kinney, 2002), which was not the case in Brazil where no distinction was found between interest rates charged by foreign banks and domestic banks. This gave rise to claims that variations in pricing occurred within the foreign bank and domestic bank sectors rather than between the two sectors (Carvalho, 2002).

(p. 891) Foreign banks have become an important source of finance for specific customer segments. Indeed, they have achieved higher loan growth (better quality and less volatile) than domestic banks (especially vis-à-vis state-owned banks) (Dages, Goldberg, and Kinney, 2002). Foreign banks—and also private domestic banks—are responsive to market signals: in particular, lending is procyclical and sensitive to movements in GDP and interest rates, which is indicative of transactions-based activities. The finding of higher loan growth and lower volatility at foreign banks—even during crisis periods—implies they were important stabilizers of bank credit (Dages, Goldberg, and Kinney, 2002).

After being granted unrestricted access in 1997, foreign banks came to dominate the Mexican banking sector quicker than they had done in other countries: in 1997, foreign banks supplied 11 percent of bank credit, which grew to 83 percent in 2004 (Haber and Musacchio, 2005). During this time, a ‘credit crunch’ occurred and private sector lending fell by 23 percent in real terms between December 1997 and December 2003 (Haber, 2005). It appeared foreign bank penetration had altered bank lending strategies, but this was not the case because the acquired foreign banks had begun to reduce private lending before acquisition. Prior to the 1991 bank privatizations, the ratio of commercial bank loans to GDP was 24 percent and rose to 26 percent in 1996; subsequently, it declined to 14 percent in 2003 (Haber, 2005). Furthermore, the behavior of foreign bank acquisitions, pre-and post-M&A, differed little from domestic banks. In brief, the ‘credit crunch’ was driven by factors affecting all banks and unrelated to foreign bank entry.

In Argentina, bank privatization and foreign bank entry raised fears of a reallocation of bank lending. Initially, fears arose because the acquirers of the privatized provincial banks tended to be small, wholesale banks based in Buenos Aires who were expected to raise deposits in the provinces and allocate resources more in the centre (Clarke, Crivelli, and Cull, 2005). State-owned bank lending had been geographically diversified though concentrated more in the public sector with fewer manufacturing loans. Other concerns were that the volume of bank credit would decrease post-privatization because the transfer of non-performing loans to bad banks meant the size of the privatized provincial banks was smaller than pre-privatization (Berger, et al., 2005). Since foreign banks had mainly located in Buenos Aires and tended to finance large-scale manufacturing and utilities firms in that province, commentators questioned foreign banks’ commitment to diversify lending to the provinces (Berger, et al., 2005).

Temporarily, privatization and foreign bank entry disrupted credit in the 1990s. Disruptions were most pronounced in provinces that had privatized banks; credit levels fell but quickly returned to pre-privatization levels once privatized banks increased in size. Privatization did not affect the lending of private domestic or foreign banks. For foreign bank acquisitions, lending increased in importance and as a ratio of total assets, with loans growth allocated more toward consumers than manufacturing (Berger, et al., 2005). Fears that foreign banks would concentrate (p. 892) their lending in Buenos Aires did not materialize. Foreign banks entered provincial markets, aggressively in provinces which had privatized their banks. In contrast, the newly privatized banks decreased lending relative to total assets to control risk through more prudent lending (Berger et al., 2005). In summary, foreign bank penetration caused an increase in provincial lending because foreign banks offset changes in lending of domestic banks (Clarke, Crivelli, and Cull, 2005).

Consolidation and Interest Rate Spreads

Finally, we review the effects that foreign bank penetration and market concentration have had on the evolution of bank interest rate spreads and on the process of financial intermediation. The effects were determined by comparing the spreads charged by foreign banks and domestic banks and the evidence comes from several countries (Argentina, Chile, Colombia, Mexico, and Peru). Generally speaking, foreign banks have operated with lower spreads compared to domestic banks (especially ‘de novo’ foreign banks), but the main impact of foreign bank penetration has been the inducement for all banks to reduce costs rather than a marked decline in spreads. Concentration, on the other hand, could offset the apparent benefit of foreign bank penetration, since higher concentration could raise operational costs and thereby widen spreads especially for domestic banks (Martinez-Peria and Mody, 2004).

Conclusion

The last two decades have witnessed deep changes in the operation of the banking sector everywhere, but without a doubt these changes have been particularly strong in Latin America. In these twenty years, financial repression was eliminated or drastically attenuated from Mexico to the Southern Cone. The role of state-owned banks was streamlined either by privatization or by increasing specialization in the provision of financial support to special groups of borrowers, such as, small and medium-sized firms, as in the case of Mexico. In a few countries, however, and most notably in Argentina and Brazil, a large sector of state-owned banks survived the financial liberalization process and went on to become leaders in their domestic banking sectors.

A common feature of the financial liberalization process in the whole region was the increasing presence of foreign banks in domestic markets. Led by US and Spanish banks, foreign institutions have aggressively taken advantage of the (p. 893) relaxation of restrictions on the operation of foreign banks in practically the whole continent.

Liberalization, privatization, and foreign bank entry combined with larger macroeconomic policy changes and strategies to generate a process of consolidation in the banking sector of all countries in the region. Consolidation was actively supported by local government policies aiming at taking advantage of possible economies of scale and scope in the production of banking services. Nevertheless, the results of these efforts are still to appear more clearly, although there is some evidence of efficiency improvements in bank operations in the region.

In the major countries of Latin America, banks faced important difficulties in adapting to the new context of financial deregulation and liberalization. Serious banking sector crises took place in Chile, which pioneered the liberalization process, Argentina, also in the early stages of liberalization, and Mexico. In Brazil, banks suffered strong pressures resulting from the joint impact of deregulation and price stabilization processes in the mid-1990s, forcing the government to create a special crisis-resolution program. Argentina suffered another banking crisis in 2001, connected to the balance of payments crisis that put an end to the Convertibility Plan.

In sum, practically all of the changes in the book have been implemented in the region since the late 1980s. Interest rates are currently market-determined everywhere but Venezuela, where controls still subsist. Privatization advanced strongly everywhere, except Brazil, where the leading banks were kept in the hands of the Federal government. Directed credit was reduced or eliminated across the region, again with the partial exception of Brazil, where a Federal development bank (BNDES) is practically the only provider of long-term credit. Monetary policy in all parts of Latin America is implemented through open-market operations.

The results of the process have been relatively disappointing, given the high expectations that surrounded the liberalization process in the late 1980s. The jury is still out, of course, given the relatively short time during which these changes have been in place and the turbulence that characterized some periods in the 1990s. There is some evidence of improvement in many cases, but still not enough to generate enthusiasm. Banking crises and stresses, however, have not led to reversals in the financial liberalization process so far. On the contrary, most countries in the area have been investing in building regulatory and supervisory institutions while adhering to modern regulatory paradigms, such as the Basel accords. If the assumptions underlying the process of financial liberalization are in fact true, better results should begin to show in the short term in the form of lower cost of capital, wider access to finance, better allocation of resources, while, of course, maintaining a reasonable degree of financial stability. It is a tall order, but financial liberalization promises no less.

(p. 894) Epilogue: The International Financial Crisis and Latin American Banks

Arguably the economies and financial systems of Latin America are better placed to withstand the effects of exogenous shocks emanating from international financial market distress than at any other time in the recent past. Since 2003, Latin America has enjoyed ‘an unprecedented cycle of economic growth with macroeconomic stability … while inflation has fallen and fiscal positions have improved … This period of economic growth was supported by an exceptionally favorable external financing environment’ (Bank for International Settlements, 2008b: 2). In many regional economies, current account surpluses have replaced deficits, which together with increasing foreign direct investment and growth in remittances have allowed a substantial accumulation of international reserves. Consequently, external borrowing and debt have fallen, aided by important changes in financial structure—for instance, the development of local currency bond markets. In addition to a reduction in vulnerability over time, Latin American economies are relatively less vulnerable than emerging markets in Asia and Central and Eastern Europe. However, there is concern that, in spite of the improvements, Latin America is vulnerable to a slowdown in the US economy, and also to changes in the positive market sentiment the region has enjoyed since 2003 as global economic conditions worsen (Bank for International Settlements, 2008b).

The current global financial crisis initiated with the collapse of the subprime mortgage market in the US, in 2007, did not have a strong immediate impact on banking markets in the main economies in the region. Although there has been fast-paced growth in securitization in Latin America, the market is relatively nascent, although issuance of domestic asset-backed securities increased fivefold from 2003 to 2006. In 2006, the value of issues of domestic asset-backed securities in Latin America was $13.6 billion, with activity concentrated in Brazil and Mexico (40 percent and 32 percent of total), followed by Argentina (18 percent). Mortgage-backed securitization accounted for 21 percent of market activity in 2006 (Bank for International Settlements, 2008a). The scanty evidence available so far, however, suggests that Latin American banks were not significantly exposed to the US subprime mortgage market as such, contrary to what happened in Europe. As a result, they were spared the credit and market value losses that plagued banking systems in the US, Europe, and, to some extent, Asia. One of the apparent lessons of the crisis, that the survival of independent institutions, particularly those dealing with securities markets, such as investment banks, may be under threat, when compared to universal banks would not be a problem to the region, since its banking industry has long been converted to the universal bank model.

(p. 895) One possible source of transmission of the crisis into Latin American financial markets would be through a retrenchment of claims on the region by international banks. Though the latest official data (see Bank for International Settlements, 2008c) report nominal growth in claims by international banks on Latin America of nearly 30 percent between June 2007 and June 2008—with three-quarters of claims on Brazil and Mexico, respectively—the effects of the crisis began to be felt from the middle of 2008, and mostly in the form of a drastic cut in access to foreign credit and securities markets, which was an important source both for domestic borrowers and for banks operating locally. With this in mind, we next review developments in the region's three largest banking markets in 2008.

Argentina

Argentina's banking sector, like its Brazilian and Mexican counterparts, so far has not suffered a direct impact of the global financial crisis. After the dramatic fall of loans to the private sector during the Convertibility Plan's crisis—from around 20 percent of GDP in 2001 to 8 percent of GDP in the second half of 2003—a slow and gradual credit recovery developed in Argentina: total credit to the private sector over GDP reached 12 percent in October 2008, well above the minimum 7.5 percent of GDP registered in 2004. In October 2008, total loans to the private sector (in pesos and in foreign currency) grew 2.8 percent, accumulating an increase of 22.2 percent in the first ten months of 2008, pushed up mainly by state-owned banks (an increase of 40 percent in the same period of 2008). The credit boom, however, has been losing strength: the annual rate of growth of credit fell from 40 percent until June 2008 to 30.1 percent in October 2008. In terms of the risk of default of outstanding loans, the Argentine financial system seems to be in a reasonably safe position: non-performing loans reached 2.9 percent of total credit to the private sector in September 2008 compared to 3.5 percent in September 2007.7

In October 2008, the demand for foreign currency from the private sector increased (private savings in foreign currency increased, on average, by 3.1 percent (Asociación de Bancos Privados de Capital Argentino, 2008: 8), which caused a decrease in the value of peso-denominated private sector deposits of 1.6 percent. Data released by the Central Bank (Banco Central de la República Argentina, 2008), however, shows some recovery of peso deposits in November.

At least until October 2008, banks were significantly liquid. The bank-liquidity indicator—defined by the pesos in cash in banks, reserve deposits in pesos in BCRA, and reverse repos with the Central Bank as a percentage of total deposits in pesos—was, on average, 21 percent in October 2008, above the average for the last (p. 896) three years, which was 18.9 percent. On the other hand, Argentine banks’ Basel coefficients have been around 17 percent since the beginning of 2006, far above the minimum international standard (Banco Central de la República Argentina, 2008:10).

In spite of the situation of sufficient liquidity at local banks, the call-money market loan rate registered an increase of 3.9 percentage points and averaged 13.1 percent in October. As a result, the cost of credit (both in wholesale and retail markets) increased along with the rates paid on deposits. This upward trend was a consequence of the increase in the rate established by BCRA for repo transactions, and also of more risk-averse behavior by banks in the context of the global financial crisis and of the risk of a prolonged global recession.

Faced with the volatility of the international financial markets, and in order to avoid bank liquidity problems due to a reduction of deposits and the increase of the cost of credit, BCRA has adopted some preventive measures: it stipulated a bimonthly period to carry out the position of minimum cash in pesos in October and November (Communication A4858); and, with the intent to lower the cost of loans, it admitted in a transitory way (as from December 2008), to take into account the totality of cash kept in financial entities (in pesos and in foreign currency) in order to integrate the minimum cash (Communication A4872).

In summary, as of the end of 2008, there were no significant credit, liquidity, and solvency problems in the Argentine banking sector. However, some concern is related to the future of the Argentine economy owing to the fall of the international demand for, and prices of, commodities in international markets. The still subdued decline in domestic industrial output is also a cause for concern. In the third quarter of 2008, the economy grew by 6.5 percent, the lowest rate of growth since 2003, and the outlook in the near future is not optimistic. Under such conditions, it is likely that banks will adopt a more procyclical behavior and reducing the supply of credit for both households and firms.

Brazil

Since 2005 there was a credit boom in Brazil, in part pushed by the economic growth: total credit to private sector over GDP grew from 23.5 percent in January 2005 to 38.0 percent in September 2008. Available data show that, as of October 2008, bank credit was still growing vigorously. The monthly survey published by the Central Bank of Brazil,8 indicated that total credit had expanded 26.8 percent in the first ten months of 2008, compared to the same period of 2007, when credit had already been growing very quickly. All three segments of the banking system expanded strongly in 2008: state banks’ credit grew 30 percent, private domestically (p. 897) owned banks expanded credit in 26.4 percent, and even foreign banks’ credit supply grew 22.7 percent. A widespread feeling of credit rationing prevailed in the period though, leading the federal government to take many initiatives toward easing the pressure felt by borrowers. Required reserves were drastically reduced, public banks were allowed to give support to private institutions, new sources of liquidity were opened, including through the use of international reserves to support the supply of trade credit to exporters. Banks tended to explain the sensation of credit rationing by the virtual closure of domestic as well as international securities markets, which supposedly strongly increased the demands for bank credit, beyond their capacity to meet them.

Another important effect of the crisis could be said to be psychological in nature. Some measure of panic seems to have spread throughout the economy as a reflex of the news coming from the US and Europe. Middle-sized banks suffered some loss of deposits, which tended to be shifted to larger banks, particularly public banks, which always benefit in bouts of panic. It is widely expected that, as a result of such movement, a new consolidation wave will take place in the near future, as mid-sized and small banks lose access to resources and are forced to look for stronger partners to merge. In addition, the Brazilian government has proposed measures to allow public banks to buy threatened institutions. So far, however, only one important merger took place, whereby the second-largest private bank in the country, Itau, merged or acquired (the details of the deal remain fuzzy) the fourth-largest private bank, Unibanco. It is unclear, however, to what extent this merger is already a precocious answer to the crisis or just another move in the complex competitive picture of the Brazilian banking sector. Itau had long been striving to beat Bradesco, which was the largest private bank in the country for decades, and this was finally possible with this merger or acquisition of Unibanco.

In any case, other than additional moves toward consolidation, there does not seem to exist signs as yet of further changes in the structure of the industry in Brazil. Current indicators of fragility remain within safe intervals, although the current crisis should feed some caution in dealing with such data. Non-performing loans have actually decreased in 2008, to 2.9 percent of total credit in October, down from 3.3 percent in January. Provisions, consequently, have also remained stable, at levels above 5 percent, which, in principle, are more than sufficient to absorb expected losses. Basel coefficients also remain significantly above required minimums, although the same caveat applies.

Mexico

Over 2008 (from January to October) domestic financing by commercial banks to the non-bank sector increased by 6.47 percent to $160 billion. On average, domestic bank loans accounted for approximately 97 percent of domestic financing (with the (p. 898) remainder sourced from commercial bank agencies and loans related to restructuring programs). In terms of private and public sector lending, on average, the former received over 83 percent and the latter roughly 17 percent of bank loans. Public sector bank lending has fallen to 13.95 percent in October 2008 from 18.4 percent in June; correspondingly, private sector bank lending grew by 10.85 percent during 2008.

The composition of bank loans has altered over 2008 with the share of consumer credit in bank lending decreasing from around 26 percent to just over 18 percent by October. Concomitantly, bank lending to corporations and self-employed businesses grew from 38 to nearly 43 percent of bank financing. Mortgage lending remained relatively stable (at around 15 percent) whilst loans to non-bank financial intermediaries had doubled to over 10 percent by September and October.

The stock of non-performing loans (NPL) has increased by 9.87 percent in 2008, which is roughly comparable with the observed growth in private sector bank lending. On average, the quality of the loan portfolio as measured by the ratio of NPL to total loans was 2.25 percent, with above-average observations since July. The bulk of NPL are concentrated in the consumer credit sector and mostly in the credit card segment. Yet, the stock of NPL in consumer credit fell by 8.49 percent to account for 54.35 percent of total NPL by October. However, a more-worrying trend seems to be emerging in the mortgage lending and business lending segments, as stocks of NPL increased by 30.48 and 56.06 percent, respectively. As at October 2008, NPL in the mortgage loans sector accounted for more than 20 percent of total NPL (from February's 16 percent); the comparative figure for business loans is 24.58 percent (from 17 percent in January).

Arguably, the situation outlined above is understandable given that interest rates have revised upwards over 2008. For instance, the twenty-eight-day interbank equilibrium interest rate (TIIE) was 8.6835 percent on 30 December 2008 compared with 7.925 percent one year earlier, whilst credit card interest rates reached 41.78 percent in November 2008 compared with 31.6 percent a year previously. Although rates on fixed rate peso-denominated mortgages have been gradually easing since the end of 2004 to a recent low of 12.10 percent in April 2008, there is the beginning of an upward trend, with rates reaching 12.64 percent in November 2008. In spite of these tensions, the Mexican commercial banking sector is well capitalized with a capital adequacy ratio of 15.18 percent at the end of October 2008, albeit slightly down on January's 17 percent.

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                                                                                                                                                        Notes:

                                                                                                                                                        (1) Higher growth rates were in fact achieved, although at the cost of the emergence of some important disequilibria.

                                                                                                                                                        (2) The ratio of non-performing loans to total loans is estimated to have reached 52.6% by December 1996 (Hernandez-Murillo, 2007: 421).

                                                                                                                                                        (3) Universal banks are called multiple banks in Brazil.

                                                                                                                                                        (4) Decisions concerning financial liberalization in Argentina since the late 1980s are listed (in Portuguese) in Studart and Hermann (n.d.) and are reproduced and discussed in Carvalho (2008). For an overview of the process, see OʼConnell (2005).

                                                                                                                                                        (5) In Argentina in the early 1990s, each province had its own bank which often dominated the local financial sector. Provincial state-owned banks held between 40% and 70% of banking sector assets in each province. In 1993, 25 provincial banks held an assets market share of 21.6% of the Argentinean banking sector with a further 23.3% of assets held by nine state-owned national and municipal banks. By 1999, the remaining 10 provincial banks and five national and municipal banks held 13% and 18.5% of total assets, respectively (Clarke, et al., 2005). In Brazil in 1994 there were 32 public sector banks holding 51.53% of total banking sector assets. In 2002, 14 public sector banks held market share of 35.01% (Nakane and Weintraub, 2005). In Colombia, state-owned banks held a 55% asset market share in June 1991; following liberalization this share stood at 10.3% in June 1998 (Barajas, et al., 2000). The Mexican authorities responded to the 1982 debt crisis by nationalizing the banking sector and implementing a restructuring program involving M and A. By 1991, at which time it had been decided to return the 18 state-owned banks to private ownership, they controlled around 70% of banking sector assets (Montes-Negret and Landa, 2001).

                                                                                                                                                        (6) For details of the new owners of the 18 privatized banks, see Hoshino (1996). The bank auction process is described by Haber (2005). It is suggested that some new bank owners lacked suitable experience and that this was a contributing factor to the problems which befell the banking sector in the mid-1990s (Hoshino (1996); Montes-Negret and Landa (2001); Haber (2005)).

                                                                                                                                                        (7) Asociación de Bancos Privados de Capital Argentino (2008) based on data from Central Bank of the Republic of Argentina.

                                                                                                                                                        (8) Available on its website ‹http:www.bcb.gov.br›.