Latin American Capital Markets

114 VALERIANO F. GARCIA AND LUIS ALBERTO GIORGIOof unsustainable reserve losses.The country's massive depreciation led to a crisis in itsfinancial system that is still not fully resolved.Avoid Taxes and Regulations That D/stort Markets in Favor of Bank Debt FinancingMost countries have tax systems that favor bank debt finance over equity. On the supplyside, depositors do not pay taxes on the interest they receive on bank deposits. Ifinstead of holding bank deposits, they hold equity or business debt, they have to paytaxes on those returns. On the demand side, a firm that obtains bank credit can includeit as a cost of capital and reduce its tax payment. If the same firm taps the stockexchange, it cannot include any dividends as a cost of capital. In addition, minimum reserverequirements, lender of last resort facilities, and deposit insurance schemes createsubsidies and preferred status for the banking industry against capital markets.Separation of the functions of banks as payment system administrators and savingsinvestmentintermediaries (that is, the narrow banking approach) could minimize thenegative impact of bank debt financing on equity financing.Avoid Crowding Out by the GovernmentGovernments have a critical responsibility in creating the framework for capital marketdevelopment. For example, the government could adopt crucial steps for the establishmentof a yield curve as a benchmark, thus promoting fiscal discipline. However;more often than not, governments in developing countries end up making the marketsthat they have created a captive source of funds. The high-benchmark, riskadjustedinterest rate displaces private instruments.The new capital markets give thegovernment the opportunity to increase expenditures because it has a new venuewhere more financing can be found.The only way to avoid this trap is by having thegovernment run fiscal balanced budgets.Segment the Stock ExchangesThe segmentation of stock exchanges must be designed to give breathing room tosmall and medium enterprises and accommodate investors' risk preferences. As Bottazziand Da Rin (2000) point out, the opening of EuroNM is not simply a source offinance, but also an institution that can select and support entrepreneurs and promisingprojects. Innovative entrepreneurial firms are typically credit constrained.They donot possess assets that can be used as collateral because they mainly rely on intangi-Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub