Banking Crises in Latin America: Can Recurrence Be Prevented?

Leaving aside war, banking crises in developing countries, in general, and in Latin America, in particular, may stand as the major man-made catastrophe in recent history. The destruction of real and financial wealth that systemic banking crises entail is so large that there is little wonder that financial intermediation in Latin American remains shallow and well below the levels reached by industrial countries. Among developing countries, Latin American stands out for the frequency, depth and costs of its banking crises. The recent example of the crisis in Ecuador is a case in point. While estimates for the costs derived from a recent major natural disaster, El Nino, amount to about 11% of GDP, the cost associated with the banking crisis that erupted in 1998 has been estimated to reach 17% of GDP.Research and efforts to identify the causes of banking crises and to design crisis-prevention mechanisms have not been in short supply. Turning to the causes of banking crises, the list of culprits has been growing after every spur of crisis. For example, while the Latin American crisis of the 1980s brought emphasis on the need for appropriate macroeconomic fundamentals, especially on the fiscal and monetary policies, the Mexican crisis of 1994 identified the lack of appropriate regulatory and supervisory frameworks in the context of financial liberalization as key contributors to crises. By 1997, the East Asian crisis popularized the role of “contagion” in crisis generation. The recent financial crisis of emerging markets, triggered by financial turbulence in East Asia, led a number of analysts to claim that weak domestic banking systems (resulting from regulatory and/or macro problems) may not be the only source of financial problems. Lacking complete information about the capabilities of a country’s banking system to deal with external shocks, market concerns about the stability of one country’s financial system can result in deteriorated perceptions about the soundness of other countries’ financial systems. “Contagion” derives in banking crisis through two channels. First, deteriorated perceptions about a country’s creditworthiness result in reduced access to international capital markets. The slowdown in economic activity that follows leads to deterioration in loan portfolios as borrowers’ capacity to pay is closely related to the growth of domestic output. Second, if concerns about a country’s creditworthiness extend to domestic residents, bank runs may occur as depositors anticipate the erosion in the quality of bank loans.The design of mechanisms for banking crisis prevention has followed hand in hand the pattern of identification of causes. Therefore, while the 1980s and early to mid-1990s witnessed efforts to improve domestic regulatory and supervisory frameworks by individual countries separately, the post Asian crisis saw the establishment of the Financial Stability Forum (FSF) by the G-7 countries to specifically promote international stability by engaging the cooperation of governments, markets and international organizations in the process of financial supervision and surveillance. While recognizing that effective domestic regulatory frameworks are essential, a new ingredient for crisis prevention is the design and implementation of better-coordinated global regulatory and supervisory frameworks. This paper adds an additional item to the list of crisis avoidance mechanisms. While recognizing that efforts both at the domestic and global levels to strengthen financial systems are not only desirable but indispensable, the paper claims that the process of banking crisis resolution tells a lot about the capacity of a financial system to avoid future crises. To the popular say: “prevention is the best cure”, I add that: “a good cure goes a long way in preventing recurrence.” As the paper will show, countries with successful programs of banking crisis resolution have been able to maintain financial soundness for extended periods of time. Conversely, countries where the resolution of crises ended in bank disintermediation show a pattern of recurrent eruption of crises. The underlying reason is simple: A successful bank-restructuring program sets up the right incentives for avoiding excessive risk-taking by banks. Because an adequate resolution process improves the public confidence in the capacity of the authorities to deal with future problems, the banking system becomes more resilient to future adverse shocks and contagion.The rest of this paper is organized as follows. Section II assesses whether the main characteristics of banking systems in Latin America during the 1980s were significantly different from those in the 1990s and early 2000s. Section III identifies features of the region that distinguish Latin American banking crises from crises in industrial countries. Having characterized banks and banking crises, the next two sections deal with the experience of crisis resolution in the region. Section IV defines principles for successful execution of restructuring programs. This section also illustrates how different constraints faced by regulators in industrial and developing countries affect the application of principles. Section V uses the framework presented in Section IV to evaluate a number of banking crisis experiences in Latin America. This section demonstrates that the regulators’ willingness to adhere to basic principles of effective crisis management explains to a large extent the sharply contrasting outcomes between countries. Section VI concludes the paper.