Latin American Capital Markets

100 VALERIANO F. GARCIA AND LUIS ALBERTO GIORGIOchange in the banking system.Traditionally, the lending function of banks was based onequity rather than on debt.The Chicago plan for banking reform would move bankscloser to the major world nonbank financial intermediaries associated with large firms,such as General Electric, General Motors, and other financial giants. These entitieshave shown more resilience and less vulnerability than banks have.Garcia, Maino, and Fretes-Cibils (1998) argue that fractional reserve requirementscan actually do more than just multiply. In any ordinary business, the natureh ofliabilities is no different from that of assets.The authors show that in the case of a fractionalreserve banking business, the nature of assets is different from that of liabilities:assets are credits, whereas liabilities are money. Due to the system of fractional reserves,banks create money (credit) by means of credit (money) and, vice versa, eliminatingcredit (money) eliminates money (credit). In this system, money and credit arethus inextricably interwoven.Coupled with other factors, such as poor macroeconomic policy and weakcorporate governance, the fractional reserve requirement scheme could create acontagious effect on the banking system, promoting a crisis, affecting the availability ofsavings to be invested in capital markets, and reducing demand for resources due tothe lack of projects to be financed. Most economies in Latin America have gonethrough this sequence of events, confronting costly and lengthy banking crises. For example,in Argentina in 1980-82, the cost of the crisis was 16.6 percent of GDP; inChile in 1981-88, it was 45.5 percent of GDP; in Mexico in 1994-95, it was 9.6 percentof GDP; and in Uruguay in 1981 -85, it was 41.7 percent of GDPThe lender of last resort and the deposit insurance facilities. The central bank has thefunction of lender of last resort, which allows the monetary authority to lend to abank whenever the market is not willing or able to do it.This should be a short-term,high-interest-rate, liquidity facility that complements the role of the interbank lendingmarket If the lender of last resort function were used as a substitute for the interbanklending market, it would create a preference for the banking system over capitalmarkets, allowing banks to rely on a source of liquidity not available to other financialinstitutions.The lender of last resort function of the central bank and the deposit insuranceschemes are natural consequences of the system of fractional reserve requirements.Because of fractional reserve requirements, the banking system is subject tosystemic risk Under fractional reserve requirements, banks lend a multiple of their reserves;consequently, they can never have the necessary liquidity to sustain a run ondeposits, and some sort of liquidity support has to be put in place.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub