Latin American Capital Markets

THE IMPACT OF THE MACROECONOMIC ENVIRONMENT ON CAPITAL MARKETS 101The high leverage liability structure of the banking industry could allow thedevelopment of liquidity problems in solvent banks, through a contagion effect. Thefailure of one bank could induce depositors of other banks to believe that their institutionsare also weak, thus promoting a sudden withdrawal of funds and creating liquidityproblems in the system. If the increase in interest rates paid to retain depositsis translated into higher interest rates paid by borrowers, then an insolvency situationcould emerge, and the failure of the first institution could spread to a second one andeventually to the rest of the system. Under these circumstances, deposit insurancecould minimize such externalities, but, unfortunately, it has other important side effects,in particular, the moral hazard problem.In many countries, the government subsidizes deposit insurance. Governmentsponsoreddeposit insurance has been a widespread practice in Latin America. Mostcountries in the region have had banking crises in the past two decades, and the governmenthas always bailed out depositors and, many times, shareholders.This policyinhibits market discipline and precludes the investors and supervisory authoritiesfrom using this instrument to improve the efficiency of financial markets.The experience of Paraguay in the mid-1990s provides an example of thebanking industry's preferred status regarding regulations and government support.Paraguay, like most small countries in Latin America, relied on banks to tap resourcesto finance all types of business concerns, with stock exchanges playing almost no role.This was mainly the consequence of the banking crisis resolution schemes used in thecountry. During the early 1990s, the country liberalized its banking sector allowing theentrance of new entities. Many new banks and nonbank financial companies had lowcapitalization and inexperienced management. A system of loan risk classification wasintroduced, but never enforced. A banking crisis erupted in 1995, when two largebanks were unable to meet their clearing debts.The central bank intervened and tookover the management of these two banks. By mid-1995, the central bank had intervenedand taken over the management of four banks and six finance companies.Further investigation by the Superintendence of Banks revealed that morebanks and finance companies had been involved in fraudulent operations and mismanagement.They had false records and loans related to their owners. Most of thebanking system was working with deposits and loans that bypassed taxes and regulations.In fact, there was a huge informal financing market The banking crisis put all thisout in the open.The central bank guaranteed all the deposits and bought the bad portfoliosof distressed banks in 1996.The technology used by the monetary authorities tomanage the crisis created moral hazard problems; financial investment in the bankingsystem was fully protected, and bank loans could be rescheduled or borrowers bailedCopyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub