Latin American Capital Markets

THE IMPACT OF THE MACROECONOMIC ENVIRONMENT ON CAPITAL MARKETS 99Financial Policy DistortionsMonetary authorities implement monetary and financial policies using instrumentssuch as fractional reserve requirements on deposits, lender of last resort facilities, anddeposit insurance schemes for bank deposits. When employed in stable and competitivefinancial environments (for example, in the United States), these instruments donot impose constraints on the development of capital markets. By contrast, in mostLatin American and Caribbean economies, these instruments severely affect the flowof funds into the market.Fractional reserve requirements. Central banks use legal restrictions to grant banks theability to use part of their liabilities (demand deposits) as a means of payment. Thispreference differentiates banking institutions from other financial intermediaries. Ifbanks were not required to hold 100 percent reserve requirements over quasimoney,the system would create something unique to the banking sector, that is, itwould transform money into credit.When receiving any kind of deposit, banks are required to hold only a fractionof those reserves; the rest can be lent.This has important implications because itcreates a multiplier, incrementing credit (and money) by a multiple of the monetarybase. Initially, the banking system can create real debt (credit) without the correspondingreal savings. Therefore, the system of fractional reserve requirements implies asubsidy to the banking sector This subsidy encourages the artificial expansion of thebanking system and negatively affects the development of the equity market. In thelong run, it reduces the effectiveness of both the debt and equity markets. The levelof fractional reserve requirements is an inverse measure of the regulatory subsidy tothe banking system.During the 1930s, a group of economists—mostly, but not solely, affiliatedwith the University of Chicago 1 —launched a proposal for an alternative banking reform—the100 percent reserve plan. 2 They suggested basing the financial system onequity, raising reserve requirements on sight deposits to 100 percent, thereby separatingthe creation of money from the creation of credit. Elimination of the subsidy byraising reserve requirements on sight deposits to 100 percent would imply a drastic1 This plan was formulated in the 1930s; it was associated with Hart, Simons, Mints, and (later) Milton Friedman.2 Simons (1947) cites the Bank Charter Act of 1844 for the Bank of England (known as The Peel's Act) as the originalsource of the Chicago plan.This separated the Bank of England into money issuing and lending departments andimplemented the proposal of Ricardo's "Plan for the Establishment of a National Bank" (1824).Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub