Financial systems and development

etary and fiscal policy and in some cases have led
to further macroeconomic instability.
Box 5.2 Bank solvency and liquidity
Resource misallocation
A bank is solvent if the value of its assets is greater
The rising proportion of nonperforming loans has
than the value of its liabilities to depositors and
other creditors; "net worth" is the amount by
limited the volume of credit that banks can extend which assets exceed liabilities. The larger a bank's I.
to new clients. Moreover, credit allocation has of- net worth, the larger its cushion against insolten
become perverse, with banks extending more vency-that is, the larger the fall in asset values
rather than fewer loans to their least solvent cli- that the bank can sustain and still be solvent.
ents, especially to large borrowers. New loans to Bank supervisors try to ensure that banks have
troubled firms might have been justified if the adequate capital, which is often defined as some
minimum fraction of total or risk assets. If the
loans had been used to restructure the ailing enter- required capital-to-assets ratio is 5 percent, for ex- K
prises or if the firms had not been insolvent but ample, a bank with $100 million in assets and $98 |
merely illiquid. But much new lending has simply million in liabilities (hence a net worth of $2 mil- 5
financed the servicing of prior loans or prolonged
lion) would be instructed to find $3 million of adthe
lives of nonviable firms. By channeling addi- ditional capital to bring net worth up to $5 million.
tional funds to borrowers unable to make profit- Many banks in developing countries are insolvent
able use of the resources already at their disposal,
and unable to earn the large sums needed to relenders
heeegain solvency; the negative net worth of some of
lenders have delayed the process of adjustment.
these banks is many times their capital.
Credit misallocation caused by financial distress
A bank is liquid as long as it can meet day-tohas
been more pronounced in some countries than day operating expenses and withdrawals. Because
in others. In some countries losses built up gradu- it is highly leveraged, a bank can remain liquid
ally as banks, complying with government direc- long after becoming insolvent. That some countives,
continued to lend to unprofitable sectors. In tries have not experienced runs does not signify
other countries, however, loan portfolios deterio- that their banks are sounder than banks in countries
where runs did occur but merely that they
rated rapidly, especially in the highly indebted
are more liquid. Public ownership of banks, imcountries
following the shocks of the early 1980s. plicit or explicit deposit guarantees, periodic pro-
With a large proportion of their clients suddenly in vision of liquidity to weak banks, and macrodifficulty,
bankers had to extend additional credit economic stability make depositors less likely to
to their most troubled borrowers to stave off their withdraw funds from insolvent banks and thereby
own bankruptcy. Thus borrowers took on new helpthosebankstoremainliquid.
debt to service old debt, domestic as well as for- - ___ _ __ ,,, , _
eign. In countries that experienced acute financial
distress, a growing share of credit has gone toward
debt service instead of investment. Figure 5.1 firms and intermediaries have been under great
shows that, in a select group of countries, the ratio financial stress.
of new credit to investment rose after 1980.
The use of new lending to cover interest pay-
Widespread distress increases the demand for ments, together with the high real interest rates in
credit and therefore exerts upward pressure on some countries, has inhibited investment and thus
real interest rates. During the 1980s real interest production. Gross investment in developing counrates
in several developing countries have often tries fell from an average of 25.1 percent of GNP in
been extremely high, far exceeding the return on 1978 to 21.7 percent in 1986. The decline has been
investment. Although various explanations for particularly steep in the seventeen highly indebted
high real interest rates have been offered (includ- countries, where gross investment fell during the
ing expected devaluation, unexpectedly low infla- same period from 25.0 percent of GNP to 17.5 pertion,
tight monetary policies, heavy public sector cent, a level barely adequate to maintain the existborrowing,
and the reduced availability of foreign ing stock of capital. Although reduced aggregate
savings), the main reason firms were willing to demand and increased macroeconomic instability
borrow at real interest rates much higher than their are the principal causes of the decline in investreturn
on capital was to avoid bankruptcy. The ment, domestic financial distress has been a concountries
in which real lending rates have been tributing factor.
highest (Argentina, Chile, Colombia, Costa Rica, The financial system's reduced ability to direct
Turkey, and Uruguay) are all countries in which credit toward profitable borrowers has under-
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