Argentina - Financial sector review

Report No. 17864-AR Argenti na Financial Sector Review September 28, 1998 Argentina, Chile and Uruguay Country Management Unit Poverty Reduction and Economic Management Unit Latin America and the Caribbean Regional Office  Currency Equivalents Currency Unit: Peso (As of May 1998) US$1 = ARG$1 Fiscal Year January I - December 31 Glossary of Acronyms ADR American Depository Receipts AFJP Private Pension Funds BASIC Bonds, Audit Control, Superintendency, Infonnation and Rating Agencies BCRA Cenitral Bank of the Republic of Argentina CAMEL Capital, Assets, Management, Earnings, Liquidity CEDEAR Argentine Certificate of Deposit CNV National Securities Commission CPI Consumer Price Index GDP Gross Domestic Product IMF International Monetary Fund INDEC National Statistics & Census Institute LIBOR London Interbank Offer Rate MAE Electronic Open Market MCBA Buenos Aires (city) MERCOSUR Southlern Cone Common Market MERVAL Capital Market Index MRP Minimuum Relative Profitability NPL Non Performing Loanis OECD Organizationi for Economic Cooperation & Development SAFJP Superinitendency of Pension Funids SEDESA Deposit Insurance Agency SEFC Superintendency of Financial Institutions USA Uniited States of America VAT Value Added Tax YPF Oil Company Vice President: Shahid Javed Burki, LAC Director: Myrna Alexander, LCC7C Lead Economist: Paul Levy, LCC7A Task Maniager: Paul Levy, LCC7A  COUNTRY DATA - ARGENTINA AREA POPULATION DENSITY 2766.9 thous. sq.km. 34.7 million (mid-1995) Country density 1991 11.7 hab.per sq.km 1.4% annual growth Rural density a/ 16.9 hab. per sq.km of arable land POPULATION CHARACTERISTICS a/ HEALTH bI Crude Birth Rate (per 1000-1995) 19.8 Populabon per physiian (thous.) 0.4 Crude Death Rate (per 1000 - 1994) 7.5 Population per hospital bed (thous.) 0.2 Infant Mortality (per 1000 live births .1994) 22.0 INCOME DISTRIBUTION bi DISTRiBUTION OF LAND OWNERSHIP % of natonal income, highest quintle 51.0% % owned by top 10% of land owners % of national income, lowest quintle 5.0% % owned by smallest 10% of land owners ACCESS TO SAFE WATER (1993) ACCESS TO ELECTRICITY (1989) % of population - urban 73% % of population 95% % of populabon - rural 17% NUTRITION a/ EDUCATION Calore intake as % of requirements 119.2% Adult literacy rate % (1980) 95% Per capita protein intake (grams per day) 99.7 Pnmary school enrollment % a/ 100% GNP PER CAPITA IN 1997 dl 8,770 GROSS DOMESTIC PRODUCT IN 1997 el ANNUAL GROWTH RATES (% constant prices) USS Bill. % (current prices) of GOP 196S-73 1973-80 1980-9B 1997 GDP atmarketpnces 325.0 100.0 4.3 2.2 1.5 8.6 Gross Domestic Investment 65.3 20.1 6.8 4.3 1.3 26.5 Gross National Savings 54.0 16.6 2.5 2.3 1.5 7.1 Current Account Balance -9.5 .2.9 Exports of Goods & NFS 29.3 9.0 -4.7 14.1 6.3 9.1 Imports of Goods & NFS 34.9 10.7 0.6 13.3 7.8 27.1 OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 1995 Value Added (constant prices) Labor Force f/ V.A. Per Worker Arg $ Thousand % of Total Thousands % Arg $ Agiculture 1,010 7.4 2,973 12.0 340 Industry 5,056 37.0 7,780 31.4 650 Services 7,588 55.6 14,023 56.6 541 Total GDP at Factor Cost 13,654 100.0 24,776 100.0 551 GOVERNMENT FINANCE g/ Federal Govemment Provinclal Govemment Million Pesos % of GDP Million Pesos % of GDP 1997 1997 1996 1996 Current Revenues 53,838 16.6 Current Revenues 27,658 9.2 Current Expenditures 55,056 16.9 Current Expenditures 25,462 8.5 Capital Revenues 736 0.2 Capital Revenues 316 0.1 Capital Expenditures 3,795 1.2 Capital Expenditures 4,150 1.4 Surplus 4,277 -1.3 Surplus -1,829 -0.6 at For the period 1982-1935. bl For the period 1970-1976. rJ For the period 1987-1992. dt Current US dollars. Estimated using Bank Adas methodology. el Current US dollar estimates, calculated from data in constant Arg S 1986. f Calculated by applying 1980 census shares to 1994 population. g Cash Basis in current Pesos, includes Centra Administration, Social Security and net balance of Public Enterprises. Capital revenues includes privatzabon incomes.  COUNTRY DATA - ARGENTINA MONEY,CREDITANDPRICES 199 19" 196" 199 1997 (Mllons of P0s0; end of period) Money and Quasi Money 29,479 33,248 32,817 38.026 44,709 Domestic Bnk Ceditto Publ Sector 9,020 9,426 8,157 9.137 1028" Domesc Bank Cr to PrvaFt Sector 42206 50,581 50,568 58,045 64,022 Money andiuasci Moneya% ofGDP 114 11.8 11.7 12.7 13.8 Wholesae Prce lndex(Apr IN99llWO) bS 106.4 108.8 115.9 119.5 119.7 Annual peentage thanga In: General Whiotasale Price Index dV 1.8 2.3 8.5 3.2 01 BankCredtloPublicSector -0.9 4.5 -13.5 12.0 12.4 Bank Credit to Pdrvb Sector 256 19.8 0.0 10.8 14.2 MERCHANDISE EXPORTS (Averag 1991-1997) a BALANCE OF PAYMENTS ac 1993 994 1995 1996 1997 US$ Mn. % of Total Primary products 4304.6 24.1 Manuf. of agricuttural origin 6493.8 36.3 EMxor of Goods, NFS 15,572 18,437 23,824 27,037 29,318 Manuf. of indusrial origin 546.3 26.2 Imports of Goods, NFS 20,728 25,616 23,808 27,910 34,899 Fuels 2049.5 11.5 Resource Balnce .5,158 -7,179 18 -873 -5,581 Total Morchandise Export 17894.2 100.0 Interest Payrmnts (not) -1,081 .1,136 -1.054 -1,326 -1,784 Other Factor Pamnts (net) -1,848 -2,122 -2.182 -1,922 -2,435 Total Public Debt Outstanding & DOsbured (End 199S) bi USS Mn. NotCurrentTrandferm 411 320 432 334 346 BalanceonCurrentAccount -7,872 -10,117 -2,768 -3,787 -9,454 Total 97105 IBRD 5316 Capitol Account 10,938 10,218 783 7,203 12,549 IDB 4756 IMF 6279 Pdvate Sector 7,849 5,274 -5,175 -2,011 5,983 Bilaterals 10162 Public Sector 3,089 3,944 5,958 9,214 8,588 Bonds 88841 Comnercial Banks 1751 Changes in Gross Reserves (+ i nrease) 3,266 101 -1,985 3,418 3,095 DEBT SERVICE RATIO, 1996 55.3% RATE OF EXCHANGE itRDIlDA LENDING, DECEMBER 31,1996 (Mn. US$) bl USS 1- Arg.$ I IBRD IDA Outstnding & Disbursed 5316 at Source: Minitry of Econormy bV Source: INDEC c/Averae indx for th year. dV Based on th average Index for the year.  Table of Contents EXECUTIVE SUMMARY ............................................................; 1. THE FINANCIAL SYSTEM IN THE CONTEXT OF THE CONVERTIBILITY PLAN ............................................................1 ARGENTINA'S REFORM AGENDA ............................................................................1 THE FINANCIAL SYSTEM AND THE CONVERTIBILITY LAW . .................................................................. 2 The 1994/95 Challenge ........................................................................... 5 Aftermath to the Crisis ........................................................................... 9 LESSONS OF EAST AsIA ........................................................................... 10 INTERNATIONAL INTEGRATION AND REGULATORY COORDINATION ..................... ............................... 16 ENDNOTE ........................................................................... 17 2. THE BANKING SECTOR ........................................................... 18 CURRENT CONDMONS .1....................... 18 Structural Change: Overview and Implications ........................................................ 18 Recent Developments ........................................................ 21 Assessing Current Problems ........................................................ 23 BANKCING SYSTEM: AN EVOLUTIONARY PROCESS ......................................................... 28 STRUCTURAL CHANGE: IMPROVING SYSTEM STABILITY ....................................... ................. 32 Foreign-Owned Banks ........................................................ 32 Privatization ......................................................... 35 Consolidation ........................................................ 37 IMPROVING THE REGULATORY AND SUPERVISORY FRAMEWORK ...................................................... 39 Regulation ........................................................ 41 Liquidity Requirements and Capital Standards ...................... .................................. 42 The Role of Subordinated Debt ........................................................ 44 Contingent Repo Facility ........................................................ 45 Central de Deudores ........................................................ 48 Bank Regulation: International Comparisons ........................................................ 53 Supervision ........................................................ 54 FURTHERING INSTITUTIONAL/STRUCTURAL CHANGE ............................. ........................... 58 Failure Resolution Mechanisms ........................................................ 58 Liability of BCRA Personnel in Failure Resolution .................... ............................. 60 Bank Governance ................................................. 60 3. CAPITAL MARKETS ................................................. 62 EQUITY AND BOND MARKETS ..................6.2.......................... 62 Introduction .................... 62 Recent Performance .................... 63 The Equity Market .................... 63 Bond Market .................... 67 The "Co-movement" of Argentine Equity and Bond Prices .............................................. 69 Conclusions and Policy Issues ............................................. 72 INSTITUTIONAL INVESTORS AND SECURITIES MARKETS ......................................... 77 Introduction ............................................. 77 Pension Funds .............................................. 78 Insurance Companies ............................................. 87 Mutual Funds ............................................. 91 APPENDIX .............................................. 97  EXECUTIVE SUMMARY 1. The Convertibility Plan has proven to be Argentina's most successful economic program in decades, and its achievements, durability and continued public support is a testament to its success. The challenge of sustaining a stable and growing economy and reducing poverty are priorities that are setting an ongoing reform agenda for Argentina. This report reviews one dimension of that reform agenda, that of the financial markets. THE FINANCIAL SYSTEM iN THE CONTEXT OF THE CONVERTIBILITY PLAN 2. The financial markets have developed significantly since the beginning of the Convertibility Plan. Nevertheless, further financial deepening is necessary for overall economic development, and to sustain the symbiotic relationship existing between the financial system and the Convertibility Plan. While external shocks, which in extreme cases, as prescribed by the Convertibility Plan, can lead to the demonetization of the economy and challenge the financial system, the health of the financial system might also challenge the viability of the Convertibility Plan. Whichever is the nature of the shock, it is critical for the sake of the Convertibility Plan to have a strong financial system, a requirement that emerging and developed countries alike are currently painfully experiencing. The strict rules of the Convertibility Law, however, have, in general, played a constructive role in preventing external crises from damaging the Argentine economy by instilling discipline on individual banks, and the banking system as a whole. 3. Despite serious prior efforts to strengthen the financial system, the 1994/95 crisis increased the urgency for reform, since the financial system came close to the point of collapse. As a result, following the crisis, Central Bank authorities took a number of measures to build on the growing strengths of the banking system both from the regulatory and supervisory perspectives and to increase the liquidity in the system, actual and contingent. Given the importance of systemic liquidity for a country that has limited access to a lender-of-last-resort and variable access to international credit, the authorities have now amassed an arsenal of options which can provide liquidity equivalent to over 40 percent of deposits in the system (through obligatory liquidity requirements, the contingent repo facility, and the use of rediscounts which could back a third of the monetary base with foreign denominated public bonds). Measures taken The main focus of this report is the review of the cvolut ion of Argentina's financial system, particularly since the tequila crisis of 1995. It poses the question of whether it is stronger or weaker than before that crisis, and identifies future challenges. Contributors to this report were Messrs./Mrnes. P. Levy (task managcr, systemic issucs and institutional framework), G. aprio, R. Cull, C. Caloiniris (banking system, systemic issues), I. Gutierrez (supervision), M. Miller (small and medium enterprises); D. Vittas (capital markets, institutional investors), S. Schmukler (capital markets). Discussions with Mr. S. Alber, and analytic support by Mr. D. Lederinan, enhanced the report. The report benefited from a veiny constnmctive and open dialogue with the Central Bank, including its President, Dr. P. Pon, the report's main official counterpart Dr. A. Powell, the Superintendent and Vice-superintendent of Banks, Messrs. M. Ortiz and J. Boizico, and other C.B.R.A. directors and staff. The Bank mission benefited from discussions with Messrs. A. Quiroga at the Ministry of Economy, A. Hall at the CNV, H. Domeniconi at SAFJP, F. Susinel at Banco Hipotecario, the Superintendency of Insurance, and SEDESA.  - ii - since 1995 have been instrumental in deflecting the critical early stages of the recent Asian crisis. 4. Increasing the system's access to a lender of last resort, however, works in two directions. While it strengthens confidence in the banking system's ability to absorb shocks, and in that they might succeed in preventing them from occurring in the first place, they also increase the discretion of economic authorities in affecting monetary aggregates, which the Convertibility Law had successfully constrained. 5. Lessons of E. Asia miggest that (a) capitalflows could be dangerous when the regulatory structure of the financial system cannot enswure their efficient use--in Argentina, regulation is stronig and the suibordinated debt system utilizes market information toflag inefficient use of capital; (b) property and asset market bubbles can occur even with low inflation. Argentina has set uip a system to track lending, and if need be, since the convertibility law does not pernmit countercyclical monetary policy, preferably use fiscal measures to cool the economy; cad (c) diversified foreign bank entry can make the banking system more efficient catid more robust to shocks--Argentina is moving aggressively ini that direction. 6. Growing international integration could lead the Argentine financial system to evolve and resemble regional US financial markets, which have thriving financial sectors despite company listings in New York. A strategic decision couild be taken to support measures that pronmote international integration and consequently enhance financial efficiency and improve financial internmediationi, without undue concern over the changing structure of the domestic financial market. 7. There is a need to address problems arising from lack of coordination across financial regulatory agencies. Argenltine authorities could examine the advantages of creating an umbrella body that could promote coordination amonlg susch agencies, without losing the benefits of specialization. THE BANKING SECTOR 8. In recent years the banking sector in Argentina has gone through a number of changes. In particular, since the Tequila crisis, substantial consolidation, privatization, increased entry by foreign institutions, and tightening of regulation and supervision have taken place. The fast expansion of the financial system has been taking place in the midst of a restructuring process, which saw the number of financial entities in the banking system cut by a third. Based on current policy to treat foreign capital in a similar vein to domestic capital, the continuing diversified entry of solid foreign banks should strengthen the system further, reducing systemic risks. 9. Relative to domestic banks, foreign ones are larger, are growing more rapidly, and have much higher portfolio quality than domestic ones (either public or private). There is, however, variation in the quality of the private domestic banks, and it is the smallest ones (but certainly not all small banks) that appear to pose the greatest risks of  - iii - failure. From a systemic perspective, private domestic banks may not pose that great a threat.' The public banks pose the biggest problems, though the main issue with such banks is the misallocation of resources associated with nonperforming loans. Their portfolio quality is low regardless of size, and this could probably worsen after more rigorous audits. 10. From a systemic perspective, it is encouraging that the weakest banks, both public and domestic private, tend to be smaller. In addition, the smaller, weaker banks also tend to have lower ratios of liquid to total assets. The combination of weak portfolios and low liquidity implies that these banks are most vulnerable to exogenous shocks. The portfolio quality results are also reflected in 1997 profitability figures. Concerns over the low profitability of the banking system appear to be structural, reflecting more the problematic state of public banks and small banks, with the ten larger banks having a return to equity of 15.3 percent in 1997. 11. The findings of this report lead to recommenedations for the continuing restructuring of the banking system, including: (a) Efforts should continue to reduce the presence of public banks in the system, including national, provincial and municipal banks. While posing a lesser systemic risk, they introduce significant misallocation of resources to the econcomy, distort due to their size the efficient functioning of the entire banking system ('including the interest rate structure and the entry of private banks in the provinces), and pose a fiscal burden. If a financial crisis is associated to a fiscal crisis, public banks could create a systemic risk as well; (b) restructure more aggressively smaller, weak private banks, which due to their relative large number--but small overall share of the market--are a constant source of insecurity to the system; (c) to improve merger qcuality, consider restricting bank acquirers to A -rated banks; and (d) improve access to finance for small and medium enterprises by strengthening the legal protectiotn cafforded to lenders in secured transactions, strengthening the judicial system 1s ability to address commercial cases, implementing changes in the tax trealmenit of leasing, which deter that industry's development, and continuing to improve infornation on7 borrovers' credit history. Regulatory Framework and Supervision 12. The Central Bank has introduced a very sound framework of prudential regulations, some of them novel and experimental, aimed primarily at the systemic risks facing the banking system. These are market-oriented regulations which attempt to complement oversight responsibilities of the banking system through investors, auditors and rating agencies (Argentina's home-grown BASIC program). On supervision, the overall structure is sound, and incorporates many of the current international best 1 We recognize, however, that contagioii could conceivably iiake individtial bank runs worse. Still, the size of the weaker private domestic banks relative to the large foreigu, public, and private domestic ones suggests that such contagion would have to affect banks that appear quite healthy at the moment to have serious systemic consequtenices.  - iv - practices. Central Bank efforts in strengthening banking supervision and its regulatory framework have been successfuzl and commendable. However, since the 1995 crisis, some areas of the supervisory process have been overwhelmed by the need to devote substantial resources to crisis management, and there is a need to renew the process of supervisory institutional development, and to improve implementation of the existing legal and institutional framework. 13. In an experimental international comparison of regulation of various banking systems in Latin America and E. Asia by using extended CAMEL standards, Singapore, Argentina, and Hong Kong stand out as having the strongest banking regulations. Across virtually all categories, Argentina dominates the East Asian countries that have been beset by financial crises. Thus, whereas no banking system is ever immune to sufficiently large shocks, the Argentine regulatory system appears to be among the most robust, as it needs to be given the constraints on official intervention that is part of the Convertibility Plan. 14. Findings in this report suggest the followi7ng recommendations: (a) the supervisory process wouild be greatly strengthened if the implementation of adopted strategies by the Superintendency flirther enhaniced in.spectors' ability to assess individual banking risks and provide advance warning of emerging problems, before they became critical. Efforts underway to strengthen supervisory personnel would facilitate this process; (b) to improve failure resolution1 mechanisms, the Central Bank should consider the arguments for and against separating the functions of the Central Bank, the Superintendency, and SEDE,S.A. While the current structure facilitates information flows anid co-ordinactioni of decision makinig, separation could reduce moral hazard in. crisis resolution, and.facilitate better coordination with other regulatory entities, particularly oti non-banking financial institutions. (c) SEDESA should reconsider the "least cost resolution" principal that provides a mechanism for multiple bailouts; (d) pass legislation protecting public of ficials in the exercise of their public duties, to facilitate the restructuring of the bantking systenm;(e) sub/ect publicly owned banks to the same supervisory rigor and regulatory enforcemlent as private banks; (G) improve the quality of internal anld external audits; antd reliability of banking data management systems, by applying better incentives and penalties, to obtain a more accuracy picture of portfolio quaclity; anid (g) strengthen guiidelinies for proper bank governance, affecting owners, macagenment, and outside directors. 15. On bank regulation, (h) to strentgthen the effectiveness (of subordinated debt requirements the Central Bank might want to consider using them for preventive purposes; as high yields on subordinated debt could act as "triggers" for more intensive examination of such banks. Additionally, the Central Bank might consider making explicit how excessive batik risk ('as indicated by high yields on subordinated debt) will be penaclized by the authorities5 Penalties could, for example, take the form of limits on subordinated debt yields (which would trigger limits on the growth of lending as subordinated debt yields reach excessive levels), or alternatively penalties or punitive requirements that rise with the level of market yields (e.g., capital requirements, deposit insurance premia, or reserve requirements); (i) standbys  - v - purchased by individual banks may be superior lo the B(,IRA repo facility as a form of reserves, since the repo facility protects against a smaller cla.ss of risks than do standbys, and because it spreads the cost of protection throughout the financial system (rather than rewarding low-risk bcaniks with lower costs of protectionJ. Hence, the repo facility is not a perfect substitute for individual bank reserves and standbys. That is not to say, however, that there is no role for the B(7Ri?A repo facility reserves since the Central Bank may create econonmies of scale, reducinig costs and strengthening the signaling effect; (j) to mitigcate privacy concerns in the functioning of the Central de Deudores, some limits on the public disclosure of credit in?formation - i.e., perhaps limiting information disclosure of the detailed credit histories of individuals to financial institutions anid authorized ratings agencies - may be desirable; and (k) consider the eventual privatization of the Central de Deudores functions. CAPITAL MARKETS 16. The Argentine capital markets have developed in recent years, but still lag behind the banking sector. Additionally, market capitalization and trading volumes are below levels attained in other developing countries. Despite this lag, prospects for capital markets growth are excellent, particularly in view of the rapid evolution of institutional investors, which could turn out to be the defining factor in the development of the capital markets. 17. In the Argentine equity market, both market capitalization and trading activity are concentrated in big companies. These companies are also the ones that trade ADRs in New York, where their trading activity is substantially higher than in Buenos Aires. Although the volume of outstanding stocks has increased, the number of listed companies has declined. This trend intensified the concentration of the Argentine equity market. A further development of the local market is needed to .facilitate the issuance of equities and bonds by new companies, in order to make second-tier companies less dependent on the banking sector. Despite the considerable progress of recent years, several challenges persist. The first challenge is to increase the numnber of listed companies. The Bolsa has already simplified the listing process and has substantially reduced the cost of listing, but much remains to be done to persuade the owners of family groups about the net benefits of public listing. Another alternative would be to facilitate the participation of smaller com1panies in international markets, consistent with the ongoing financial integration of Argentina in international financial markets. 18. The bond market has been developing, with the public sector continuing to play the dominant role in that market. The private sector increased its absolute participation significantly relative to the previous year only in 1997. Moreover, in 1997, new sectors started to issue bonds. 19. The authorities have adopted rigorous and strict rules on insider trading, insider reporting and self dealing in a clear policy to strengthen market integrity, although compliance mechanisims should be strengthened. There has also been a substantial  - vi - increase in authorized corporate bond issues as well as in securitized instruments, while new markets for CEDEARs and financial futures and options are under development. 20. The authorities need to improve corporate disclosure by introducing consolidated group accounts and to strengthen corporate governance by assigning a greater role to indepenidenrt directors. Similarly, the quality of external audits and ratings needs to be uipgraded by raisinrg stanldardv, imposing sanctions on auditing firms that fail to qualify misleading reports, and, if necessary, removing the requirement for compulsory ratings. The regulation (?f capital market intermediaries would also require tighleitng, with improved market surveillance to prevent trade allocations and increased capital requirements to better protect small investors from fraud and gross negligence. 21. The Argentine capital markets are very sensitive to external shocks. The sensitivity increases during market downturns, and it may reflect the growing integration of large companies in world markets. Greater transparency and disclosure of information on the strengths of local individual companries might reduce such sensitivity. Market sensitivity amlong Argentine stocks cani al.so be reduced by encouraging listing by new firms. 7his will increase the scope for di versifrcation and enable internationial investors to discriminate ietter hetween Argentine companies and those from other emerging countlries. Institutional Investors 22. Institutional investors are a major emerging force in the Argentine financial system. Pension funds, insurance companies and mutual funds collectively mobilize nearly 7 percent of GDP. This constitutes a fundamental change in the structure of the financial system and reflects both reforms in the legal and regulatory environment and stable macroeconomic conditions. 23. Pension Funds The growth of pension funds has stimulated financial innovation and financial deepening. The strong regulatory framework has ensured a smooth launching of the new pension system with no casualties during the Tequila and Asian crises of 1995 and 1997. Despite these positive features, the private pension fundss are faced with several challenges. These include low effective coverage (about 45 percent of eligible workers contribute regularly), the high marketing costs and account switching, the high concentrationt of the sector, the strong links between pension funds5 and affiliated insurance companies. and the regulation and riskiness (f investments. The liberalizatiotn of pension investments from u/nduily restrictive rules is recommended, including allowing pension fitds to invest in rated mutual finds that specialize in foreign securities without requiring the rating of uinderlyinig securities. 24. Insurance Conmpanies. Despite the deregulation of the early 1990s, which replaced premiums and product controls with solvency monitoring, put into liquidation the state reinsurance company, privatized the largest insurance company, opened the market to greater competition, and the more recent boost from the implementation of  - vii - pension reform and the new insurance law covering workers compensation, the insurance sector continues to suffer from high fragmentation and operational inefficiencies. 25. The insurance sector appears to be lagging behind the growth and modernization of other types of institutional investors. The main challenges facing the insurance industry are the consolidation of the sector, through mergers and closures, introduction of a rating system, creation of an insurance inforniation bureau, structural improvements in autonmobile insurance, and establishment of a consuimer complaints office. Despite these challenges, insurance companies are expected to be major beneficiaries of pension and other reforms and of the continuing economic recovery. 26. Mutual Fundv. The development of the mutual funds industry was held back by the macroeconomic instability of recent decades, the inadequacy of the regulatory framework, and the high level of intermediation costs. Mutual funds also suffered from the requirement to place 80 percent of their assets in equities, which prevented the development of money market and bond funds that could provide greater competition to deposit banks. 27. The main policy issues facing the mu/tulcal f,ind indlustry include: improved investor edcucation; greater transparency, especially qffees and expenses; relaxation of some unduly restrictive rules (suich as the 75 percent investment rule in MERCOSUR securities); and expanditng their scope (e.g. by allowing 'funds /fjunds').  1. THE FINANCIAL SYSTEM IN THE CONTEXT OF THE CONVERTIBILITY PLAN ARGENTINA'S REFORM AGENDA 1.1 Seven years have passed since Argentina adopted the Convertibility Plan.' This has been Argentina's most successful economic program in decades, and its achievements, durability, and continued public support is a testament to its success. Inflation, the scourge of Argentina for decades, has been defeated, and economic growth during these seven years, despite the sharp 1995 setback, averaged an annual 6.25 percent. Productivity has been increasing thanks to the broad liberalization of the economy, and the initial consumption-led boom matured in recent years into a healthy pattern of investment- and export-led growth. While poverty has declined since the inception of this plan, unemployment remains an issue of concern, highlighting the need for continued reforms. 1.2 The Argentine experience so far pertains mostly to the so-called "first generation reforms" that often follow a sustained period of economic decline. The reform strategy in Argentina centered in changing macroeconomic rules, reducing the size and drastically narrowing the scope of the state by dismantling institutions that promoted protectionism and statism. The effort to severely curtail an inefficient state apparatus, particularly in the conduct of monetary policy under the Convertibility Plan, was the result of the prior discrediting of the state. By narrowing the scope of the state, greater responsibilities were given to the market, where fundamental market rules prevailed, and the discretionary powers of the authorities were minimized. However, the task of enhancing the institutional capacity of the state is still not finished; the difficult task of creating or rehabilitating indispensable public sector institutions lags behind.2 1.3 The challenge of sustaining a stable and growing economy and reducing poverty are priorities that are setting a reform agenda for the next several years for Argentina. This agenda, of "second generation reforms", calibrated in the context of globalization of financial markets, trade, investment, information, and technology know-how, comprises the following five broad policy areas': I For definition and assessmuent see "Argenitina; The Convertibility Plan: Assessment and Potential Prospects" 1996, World Banik report. 2 See "Latin America's Journey to the Market: From Macroeconiomiiic Slhocks to Institutional Therapy", Moises Naim, 1995, Initerniationial Center for Ecoiiomliic Growth, Occasional Paper 62. 3 See "Argenitiina; Second Generation Reformis" World Banik draft report, 1997.  - 2 - (a) Efficient Factor Markets (Financial and Labor Markets) (b) Enhanced Regulatory Environment (c) Quality Public Administration and Governance (d) Fiscal Strengthening, and (e) Investment in Human Capital 1.4 In this report, we review one dimension of this reform agenda, that of the Financial Markets. Clearly, the above five policy areas are very closely interconnected. Both the reduction in poverty, which is a priority for the Argentine Government, and economic growth, would benefit from, or more likely critically depend on, reforms in the above five areas. Furthermore, it is essential to maintain the gains achieved under what we called first generation reforms, since in their absence the whole edifice could be in jeopardy. THE FINANCIAL SYSTEM AND THE CONVERTIBILITY LAW 1.5 The nature of the Convertibility Law (see Box 1), which made the Central Bank into a currency board by mandating a 100 percent international reserve requirement for high-powered money, creates special challenges for the financial system. Actually, the challenge points in two directions, given the symbiotic relationship of the Convertibility Law with the financial system: while external shocks, which in extreme cases, as prescribed by the Convertibility Plan, can lead to the demonetization of the economy and challenge the financial system, the health of the financial system on its own may also challenge the viability of the Convertibility Plan. Whichever is the nature of the shock, it is critical for the sake of the Convertibility Plan to have a strong financial system, as other countries, developed and developing, are currently painfully realizing. 1.6 The inherent rigidity of a currency board, which denies the use of discretionary monetary or exchange rate policy, has contributed to building the credibility of Argentina's stabilization program. At the same time, such rigidity reduces the ability of the Central Bank to provide the functions of lender-of-last-resort and other monetary operations, which, in times of crisis, might facilitate the stabilization of the banking system.4 Furthermore, unlike Hong Kong's currency board, which counts on significant 4 In the case of Argentinia, the Central Bailk can serve the limiled functioni of a "classical" lender of last resort, throtuglh the use of dollar denomiiinated public bonids wlhiclh can be increased to constitute up to a third of monetary base (from about zero percent now), plus the use of the "repo facility" discussed later. What the Central Bank canniot do, is become a "fiscal" lender of last resort, which other entities in the Government could theoretically provide, to a limited extent, as was the case of BNA in the 1995 crisis. For furthler discussioni on currenicy boards, see "Tlhe LOLR function under a Currency Board; The Case of Argentinia" by Caprio, Dooley, Leipziger, and Welslh, 1996, "Bank Soundness and Currency Board Arrangenicmcts: Issues and Expericnce" IMF Paper on Policy Analysis and Assessmenit, 1997, and "Cturrenicy Board Arrangemients; Issues and Experiences", INT Occasional Paper 151, 1997.  -3 - Box I The Convertibility Plan The Convertibility Plan, one of Argentina's most successful economic programs, gets its name from the Convertibility Law, but it represents a much wider set of measures aiied at the complete and permianent adjustmenit of the economy. The main pillars of the Convertibility Plan are: (a) Monetary Reform, through thc Conivertibility Law, subsequenitly supplemented by the new Charter of the Central Bank; (b) Fiscal Reform, initially throughi a sharp improvement in the administration of the tax system and later through a redefinitionl of tax instrumenits and rates: (c) State Reform, through a successful plan of privatization and deregulation of factor and product markets; (d) Social Security reform, allowing for a new capitalization mechaniisimi operated by the private sector, (e) Trade Reform, throughi the eliminiation of export taxes and most quantitative restrictions on imports, and the reduction of the level and range of import tariffs. While these are radical reforms, the recent history of hyperitilation., governmental confiscation of private financial assets, and extreme economic instability meanit that only such a radical program would be credible to the Argentine public. The Convertibility Law The Convertibility Law of April 1991, fixes the r atc of the Austral at 10,000:1 to the dollar. On January 1992, the Austral was replaced by the Peso at the fixed rate of 1: 1 to the tJS dollar. The law also established that the monetary base could not exceed the dollar valtie of international reserves, and prohibited all indexation in the goods and labor markets. The Convertibility Law, in practice, made the Central Bank into a Currency Board by mandating a 100 percent international reserve requirement for highi-powered moniey. I'his has lent strong credibility to economic management, with monetary policy becoming broadly endogenious. T'he Central Banlk Charter permits a maximum of 33 percent of reserves backing the monetary base to be in dollar-denominated govenmment bonds (e.g., BONEX). Issuing base money against such bonds allows the Central Bank to regulate short run fluctuations in market liquidity through swaps. T'he Central Bank can additionally exert discretion through the use of variable bank licluidity requireimients, and excess interinationial reserves. To ensure the full reserve backing, othier conditionis were set on the behavior of the monietary authorities through the new Charter of the Central Bank. This Charler, approved by Congress on September 1992, established the independence of the Board of Directors, all of whom are ratitied by Congress and provides fixed termis of tenlure fur the appointees, includinig the president. This Plan also encourages prudent fiscal maniagement, since there is no significant scope for monietizinig fiscal deficits. Additionally, the Charter dictates that the Central Bank cannot take any new interest earning liabilities, and it cannot reminerate reserve requirements (liquidity requiremenits are remiLnerated by the Govermilenit). 'I'hese measures eliminiate the possibility of generating a quasifiscal deficit through the servicing of Central Bank debt. Consisteint with the restrictions for gcnerating Central Bank liabilities other than those used to acquire interilationial reserves, the Cliarter does not allow the Central Bank to guarantee commercial bank deposits, i.e. deposit insurance (a privately funded and limited deposit insurance fund was established in 1995). This substantially reduces the role of the Central Bank as a lender of last resort, both for the peso and for the domestic dollar deposits system. Nevertheless, in an emergency the Central Bank can provide, for Iimited time, liquidity up to 100 percent of a bank's capital. Under the convertibility system, internationial reserves are backinig the monietary base, and cannot be considered as precautionary reserves. There are no restrictions in capital tlows, and variations in interniational reserves have a direct impact on the economy through changes in the money supply and the real interest rate. An important feature of the coivertibility Plan is its bi-monietary nature, whicih permlits the use of foreign exchange for market transactions, or the holding of foreign exchanige denominiiated liquid assets in the domestic finaicial system. Dollarization has contributed to enhanicinig the credibility of exchanige rate policy, siice is redLices vulierability under a fixed exchange rate, because portfolio shifts from domestic to foreign currcncy denominiiated deposits, or vice versa, would not necessarily involve a reduction in total domestic bank deposits. Under a dollarized system, where fractional reserve requirement are in ctfect, the lender of last resort function becomes more challenging, since part of the liabilities of the bankinig system are dollar denominiiated, and the Central Bank cannot print dollars to fulfill that function. In a crisis, high bank reserve requiremcints, excess iitcrinational reserves or a foreign lender of last resort are needed to fulfill that function.  -4 - excess reserves for use in case of crisis, Argentina's access to such reserves has historically been quite limited.5 As a result, with a monetary base that is susceptible to movements in capital flows, interest rates become a major adjustment variable, moving abruptly and substantially. 1.7 Large fluctuations in interest rates have a direct impact on the banking system through the changed valuation of its assets and liabilities, and indirectly through their impact on real economic activity. Prolonged rises in interest rates punish more severely weakest banks first, leading often to insolvency and contagion of other banks which under other arrangements would not be as susceptible to a crisis. However, both the exchange rate and monetary policy rigidities of the Convertibility Law, and the resulting limitations to the lender-of-last-resort function (see Box 1), have played a constructive role in preventing crises by instilling discipline on individual banks and the Argentine banking system as a whole. 1.8 The flexibility of factor markets in absorbing an external shock is crucial in a currency board arrangement, since in the absence of such flexibility, adjustments to the economy are more difficult to materialize, resulting in excessive swings in economic activity, higher unemployment, and other economic dislocations, such as bankruptcies. That applies to both financial markets and labor markets. Argentina's market liberalizing efforts have been significant under the Convertibility Plan, particularly in goods and services, both domestic and international, but have lagged in the crucial areas of labor markets, and partially in the financial markets. While financial markets have enjoyed open competition and foreign entry, as well as unimpeded capital movements, an important part of the financial system remains in the public sector, injecting an unnecessary degree of rigidity and inefficiency in the system (reviewed in Chapter 2 of this report). Greater flexibility in factor markets will be crucial for reducing the costly side-effects of capital movements under a currency board arrangement. 1.9 The above suggests a course of action to which the economic authorities in Argentina are keen in implementing. They have taken concrete steps to: reduce the substantial presence of the public sector in the financial system; facilitate the restructuring of the private banking system; strengthen banking supervision and regulation; and increase actual and contingent liquidity of the banking system to mitigate the limitations of the lender-of-last-resort function. 1.10 As will be explored later in this paper, the Asian crisis is an example of random shocks that can impact the Argentine economy. Judging from the capital markets' reaction to unfolding events, the course of the shocks' transmission has been multifaceted, affecting Argentina, either directly via higher interest rates and altered trade flows, or It should be noted tlhat, while Hong Kong has ample excess reserves in relation to its monetary base (in Dec. 1997 international reserves were 3.5 times the monletary base), Argentinia has better coverage tlhan Hong Kong of M3 (albeit due to lower level of developmenit of Argentina's financial markets). In December of 1997, the ratio of interniationial reserves to M3 was 27.4 percent for Argentinia, and 25.6 perccnt for Hong Kong.  - 5 - channeled through the perceived vulnerability of a major trading partner like Brazil, or that of Hong Kong's currency board (as a testing ground of the stability to the currency board arrangement). Whether the transmission of a shock is direct or indirect, the common element is the challenge to the economy in adjusting to that shock, with its limited degrees of policy freedom in Argentina's Convertibility Plan. Such concerns are typically reflected in the financial markets, which are the most efficient discounters of perceived changes in economic prospects. The ability of the financial system to accommodate such changes is an important link to the economy's ability to absorb shocks, and the strength of this link is the subject of this report. The traditional risks of a pre-electoral period are also currently present in Argentina, although the authorities have control over the magnitude of that potential shock. 1.11 While the Convertibility Plan have severely tested the financial system, vulnerabilities of the financial system could also test the Convertibility Plan. Although measures taken by the economic authorities in Argentina to strengthen the financial system make that possibility increasingly remote, banking failures could themselves test the strength of the Convertibility Plan. In a reverse sequence of the tequila crisis, a banking run (that could be externally induced) could result in a currency run which exhausts the political limits of dollarization, putting in peril the continuation of the Convertibility Law. In either of the two scenarios, the strength of the financial system is key, and the Argentine authorities are aggressively taking steps to that effect. The 1994/95 Challenge 1.12 The challenge of the currency board to the financial system became evident during the tequila crisis. Argentina's crisis in 1994/95 began as an exchange rate crisis, not a banking crisis. Initially, Argentine banks experienced outflows from peso-denominated accounts and inflows into dollar-denominated accounts, reflecting a concern about the maintenance of convertibility. Such concerns were related to political uncertainty leading to the May 1995 Presidential elections, recent slippages in fiscal and current account balances, rapid growth in credit, and the absence of an IMF program6. As long as confidence in the financial system was maintained, the Government could deal with the currency run through the dollarization of the financial system. In that sense, the presence of a bimonetary system played a constructive role during the crisis, by providing an alternative to outright capital flight. 1.13 By March of 1995, the shrinkage in domestic money related to outflows of capital (and lack of access to international credit) had produced significant increases in credit risk within the banking system, and the character of the crisis changed from a run on the peso to a run on both the peso and the banking system. The structural conditions of the banking sector--which were characterized by the absence of a deposit insurance, limited nature of a lender of last resort, and a segmented and inefficient financial system, as well see "Maintaining Finanicial Stability in Global Economiiy" Remarks by Pcdro Pou in a Conference sponsored by the Federal Rescrve Bank of Kansas, 1997.  - 6 - as memories of previous financial crises that ended in asset confiscation (either outright confiscation, or devaluation of assets through inflation or currency depreciation)--fiueled a systemic run on deposits (mostly by domestic residents). Controlling for the systemic run on the banking system, evidence suggests that in the absence of deposit insurance and the limited nature of lender of last resort, depositors imposed discipline on banks through flight to quality (depositors reallocated deposits from weaker banks that were offering higher interest rates to foreign banks and the ten largest domestic retail banks).7 Simultaneously, interbank market access shrank down to top private sector banks and the interbank rate increased sharply, pushing several solvent but illiquid institutions to the brink of failure. 1.14 For the first four months of the crisis prior to the May Presidential elections, Argentina suffered a massive liquidity shock, with bank deposits declining by 18 percent, and liquid international reserves by 30 percent, as access to the international financial markets was cut off (with the exception of multilateral lending). Under the Convertibility Plan, where the monetary base has to be fully backed by international reserves, capital outflows resulted in the demonetization of the economy. However, the credit squeeze in the economy was moderated by the reduction in reserve requirements, and the increased used of dollar denominated bonds as part of international reserves.8 This demonetization affected both the performance of the financial system, but also, as expected, real economic activity, leading to a sharp recession. From a policy perspective, given that bank reserve requirements were less than 100 percent, M2 at that time was about 3.5 times the stock of international reserves, under the Convertibility Law the Central Bank had more limited resources than other countries to confront a run against bank deposits (being a weak "lender of last resort"). 1.15 By the end of May, 1995, forceful action both by the Government (cutting the fiscal deficit and obtaining support for its new economic program by multilateral organizations) and the Central Bank (through skillful management of liquidity to the financial system, including lowering remunerated reserve requirements, and the extension of credit through swaps and rediscounts) reinstated confidence on the peso and the banking system's solvency. Additional measures included the establishment of a privately managed limited deposit insurance scheme, the establishment of fiduciary trust funds to facilitate the privatization of provincial banks and the restructuring of private 7 See "IInforiiiationi and Bank Runis; Evidence from a Contemiiporary System witlhout Safety Net: Argentiina after the Tequila Slhock" by Liliana Sclimliaclher, May 1997, mimiieo; and "Contagioni, Banks funidamiienitals or Macrocconoiniic Slhock? An Empirical Analysis of the Argentinie 1995 Bankinig Problems" by D' Amalo, Gnibisic, and Powell (BCRA, Working paper No. 2, 1997). In this paper, controllinig for banik and macro futndamientals, there is still evidence of some conitagioni effect. 8 While the credit cunclh was mitchi less proniouniced (a declinie of 3 percent) thlan ithe contraction in deposits (a decline of 18 pcrcent), thle impact on small and mediuiiii enterprises may lhave been mucl larger than prime borrowers, wlho switclhed from the interniationial to the local financial market. See Guillenno Calvo's "Argentinia's Expericnce after thle Mexican Crisis", in "Currenicy Boards and External Sliocks", the World Bank, 1997.  - 7 - The 1994/95 Finanicial Crisis Initial Shock * Domestic minii-crisis following failure of bond trading houise shakes confidenice and causes banks to cut lines to these "liayoristas." * Tequila effect shakes conifdcnce in LA and investors re-evaliate Argentinie exposure. * Stock and bond markets suffcr large losses. * Banks call in loans extended to dealers and provincial banks, now largely insolvenit (due to earlier mismaniagemiienlt). Aftershock * Growing fiscal concerins and lack of IMF agreemenit comipotiuid concerins. Dollarization increases, and selective deposit withidrawals begin, mostly from small banks -- $2b. in two weeks. Liquidity crisis forces banks to cut credit lines. BCRA persuades top 5 banks to provide $250m. in safety net. * BCRA establishes second net via rcserve requirciiiemet reductioni for top 25 banks, yielding $790m. Continuing Crisis Uncertainty over teie May national elections' outcomiie furilier weakens confidence. From late- February, bank nms become a generalized run on the system (for first two wveeks of March). Cumiulative deposit losses reach 16 percent or $8b. * Interbanik interest rates skyrocket. * BCRA extends extraordinary liquidity assistance above limits of bank capital and for longer than 30 days, totaling $1.7b. rediscounits and $300m. repos. * Some banks fail. Freefall Stops * Interinationial package (IMF, IBRD, IDB), fiscal measures, plis domestic and international bond issues restore confidenice. * Strong comimiitiimenit to convertibility maintained, althouigih reserve level falls by $5bn. . Deposit insurance (limited, privately financed) annotiliced. . Dual bank restnmcturinig funids to privatize provincial banks and restnimcture private banks established with aid of multilateral banks. * Fiscal strengtilnicig plans aninouiniced. Outcome * Bank consolidation as 28 cooperative and 5 wholesale banks close. * Provincial banks moribiuind, fifteen in process of privatization/closure. * Top 10 private banks increase market shiare as deposits begin to returni. * Crisis ends wilh $8b. deposit outflow hiavinig becn covered by reserve loss ($4b.), BCRA liquidity ($2b.), loani reductions ($1b.) anld foreign loans ($1b.).  -8 - sector banks. These measures facilitated the return of deposits to the banking system, which, by early 1996, reached their pre-crisis levels. 1.16 The Mexican crisis, being the first true test of the Convertibility Plan, brought to light important lessons for Argentina: (a) as for any emerging country, it highlighted the importance of a sound banking system supported by strong prudential regulation and banking supervision, and weaknesses related to the absence of a dollar lender of last resort in an increasingly dollarized system, particularly when government access to international credit is interrupted (although the absence of a full safety net was a strong incentive for responsible behavior by the banks). Increased capital mobility, while welcome in remonetizing the Argentine economy has also made the economy more vulnerable to external shocks, and the banking system the agent of transmission of financial crises; (b) reemphasized the need to sustain sound macroeconomic policies--just before the crisis there was a slippage in the fiscal accounts and a growing current account deficit-- and consequently the credibility of the Convertibility Plan; (c) highlighted the extent of the real economy's vulnerability to volatile capital flows under a currency board, particularly in view of rigidities in factor markets (labor markets in particular), and (d) the Mexican experience highlighted the difficulties in changing the exchange rate regime during periods of crisis, particularly in a highly dollarized economy where the majority of private sector liabilities, government debt, and banking credit is in US dollars. It was a widely held belief in Argentina during the crisis, and rightly so, that a devaluation of the currency would have had much worse consequences than the ensuing recession, undermining as it would the edifice of the Convertibility Plan. As a consequence, no serious proposal was raised during the crisis to abandon the currency board. (e) lessons for the banking system underline the need for substantial liquid assets, to withstand sharp liquidity shocks and the lack of access to international credit. Some contagion effects were observed9 and hence a limited deposit insurance scheme was introduced to li-nit that problem among depositors. Other relevant experiences include: time deposits proved more fickle than sight deposits, and banks with no sight deposits suffered acute liquidity problems; banks with standardized loans and good 9 See D'Ainato, Grubisic, and Powell (1997) Contagioni, Banks Fundamiientlals or Macroeconomic Shock? An Empirical Analysis of tile Argentinie 1995 Baikinig Problemis (BCRA, Working paper No. 2, July).  - 9 - documentation marketed loan portfolios easier; market risk capital requirements were seen as an important complement to the high counterparty risk capital requirements that had already been implemented. 1.17 In turn, Argentina's reaction to the crisis sent strong signals to markets about its long-run credibility--especially its financial sector decisions (a) to remain with the currency board (despite rapid decline in the money supply and high unemployment), (b) to allow some banks to fail and some bank depositors to lose money, and (c) to react to the crisis by tightening market discipline over banks and moving to strengthen the credibility of the currency board (for example, by moving bank and Central Bank effective 'reserves' offshore). It might be of interest also to note that throughout the Convertibility Plan, even at the worst moments of the 1995 crisis, the Convertibility Law (in particular its mandated coverage of high powered money by international reserves) was never breached. While at the height of the crisis usage of dollar denominated bonds reached its legal limitations as a share of total reserves, following the crisis the usage of bonds was quickly reduced as signal of strength of the Convertibility Plan. Aftermath to the Crisis 1.18 Despite serious prior efforts to strengthen the financial system, the 1994/95 crisis increased the urgency for reform, since the financial system came close to the point of collapse. As a result, following the crisis, Central Bank authorities took a number of measures to build up on the growing strengths of the banking system both from the regulatory and supervisory perspectives (which also mitigate the need for lender-of-last- resort functions), and increasing the liquidity in the system, actual and contingent. 1.19 Among the specific measures taken are: (i) the increase in liquidity requirements; (ii) the establishment of a contingent repo facility with international banks covering about 10 percent of all domestic deposits; (iii) the privatization of a significant number of provincial banks; (iv) the 100 percent coverage of monetary base by international reserves (although backing by foreign denominated bonds is authorized under the Convertibility Law, none is currently used); (v) the strengthening of an information clearing house (Central de Deudores) at the Central Bank, to make credit risks more transparent; (vi) the obligation of banks to issue subordinated debt to other banks for 2 percent of their deposits as proof of banks' creditworthiness; (vii) the continuing r eform of the banking supervisory process; (viii) the reform of bankruptcy laws; and  - 10- (ix) the continuation of a precautionary IMF program, which can be seen as an implicit lender-of-last-resort instrument in case of crisis. 1.20 Given the importance of systemic liquidity for a country that has limited access to a lender-of-last-resort and variable access to international credit, the authorities have now amassed an arsenal of options which can provide liquidity equivalent to over 40 percent of deposits in the system, of which 20 percent are from the obligatory liquidity requirement on banks, 10 percent from the contingent repo facility with foreign banks, and the rest from rediscounts that can be provided from backing a third of the monetary base with dollar denominated public bonds. 1.21 The adoption of the above measures have been instrumental in deflecting the critical early stages of the recent Asian crisis. Despite the decline in equity values, and the initial brief dip in reserves and bond values, the financial markets recovered swiftly. Depositors have maintained their confidence in the domestic banking system and continued the strong expansion in deposits, although some increase in dollarization took place (at the end of 1997, dollar deposits accounted for 53.3 percent of total deposits), and early in the crisis, larger banks captured more deposits, mostly in dollars. Banks also decelerated their rate of credit expansion, and interest rates, after a sharp initial increase, regained pre-crisis levels. LESSONS OF EAST ASIA 1.22 The turbulence and spread of financial crises in the East Asian 'miracle' economies -- and in Japan -- has raised concerns about the stability of financial systems in many countries, as well as inquiries as to the lessons of this experience. Although these episodes will doubtless spawn research for several generations of economists, this section will dwell on some preliminary lessons, and also compare Argentina and East Asian economies on a variety of macro-financial indicators. As will be seen in Chapter 2, Argentina compares quite favorably in terms of banking regulation. Thus the popular recommendation following the Asian crises, that these countries tighten up their prudential regulatory framework, already has been effectively pursued in Argentina. 1.23 In summarizing the lessons of East Asia, it is important to recognize that not all the crises were the same. In Thailand, the finance companies have been the greatest source of problems; these companies were weakly regulated, were given positive inducements to grow rapidly, and in some cases were related to commercial banks. In Indonesia, although some banks were weak or insolvent, foreign exchange mismatches directly on the part of the corporate sector were the channel through which the crisis spread. And in Korea, although banks had long been burdened with a high level of nonperforming loans, the excessive leveraging of corporate sector was the weakest link, one that became apparent as firms lost competitiveness. Non-bank financial intermediaries in Korea were much less problematic, and indeed helped improve the functioning of the financial system since the 1 980s while the banks were hampered with problem loans.  - 11 - 1.24 Notwithstanding these differences, there were a number of similarities.'0 Thailand, Indonesia, and Korea all lost some competitiveness from the Chinese devaluation of 1994 and the slide of the yen in 1996-97, and were negatively affected by weak domestic demand in Japan. As seen in Chart 1, by the end of 1996, the real exchange rate in Indonesia, Malaysia, and Thailand had appreciated by 30-40 percent since the early 1990s, though has risen most significantly in the Philippines, thus far not in crisis, and not in Korea (not shown), which has had a serious crisis. Still, the notion that macro fundamentals were not an issue in East Asia clearly is incorrect. In contrast, in the case of Argentina, between the beginning of the Convertibility Plan and December 1997, the trade-weighted real exchange rate has appreciated by only 13.1 percent. Furthermore, structural changes in the economy, associated with the Convertibility Plan, led to significant increases in productivity, which in conjunction with the reductions in tariffs, have improved the economy's competitiveness, moderating the impact of the currency's real appreciation. Actually, the appreciation occurred mostly in the early years of the Plan, when inflation was higher than international inflation. Since mid-1994, the peso has been experiencing a real depreciation, only to be reversed in 1997 with a 3 percent appreciation (following the dollar's appreciation). Chart I Real Exchange Rate Appreciation 1990=1 00 180 160 140 120 8c ~~~~~~~~~~Mexico 80 60 .. 1990 1991 1992 1993 1994 1995 1996 1997 1997 1997 Q1 Q2 Q3 10 For fuller discussions, sec The World Bank, Global Development Finance, Chapter 2, March 1998; Paul Kngnain, "What lhappened lo Asia, uiiiieo, January 1998, and G. Corsetti, P. Pesenti, and N. Roubini, "What Caused the Asiaii Currency and Finanicial Crisis,' miinieo, Janiuary 1998.  - 12 - 1.25 In most of the Asian crisis countries, it appears that risk capital was low in the banking system, even relative to stated minima (Chapter 2) and that the quality of capital was low. Depositors enjoyed implicit and then explicit guarantees in Thailand, where even finance companies' depositors were fully covered; in Korea, where explicit global guarantees were given in mid-1 997; and in Indonesia, when the survival of private banks began to be doubted, there was a prompt run to the state banking system, where deposits are considered fully insured. Implicitly, foreign loans to private firms were also considered to be a liability of the government, as suggested by the low spreads on emerging market debt until the spring of 1997, and were part of a large inflow of capital that the domestic financial system was in a poor position to intermediate effectively, as seen in the low comparative scores of their regulatory systems (Table 2. 10). 1.26 Although the Asian crises are now recognized as more financial crises than currency crises, it is important to note that systemic financial crises usually involve corporate finance difficulties. That is, the problem usually traces to imbalances in at least some corporate balance sheets. Thailand, Korea, and Indonesia all featured excessively high levels of short term debt, though comparable data are difficult to obtain for the maturity structure of domestic corporate debt. Short-term exposure to BIS reporting banks, however, is available and was quite high in Thailand, Indonesia, and Korea (Table 1.1), whereas this figure was relatively low in Argentina and Chile. Interestingly, all three countries also saw sharp expansions of lending by Japanese banks in the late 1980s and early 1990s, and then very sharp retrenchments -- as much as 50% to 60% reductions -- in this lending since 1993-4, according to BIS data. It is conceivable that the term structure of corporate debt began shortening as Japanese banks, thought to be suppliers of longer- term loans, pulled out. Table 1. 1 Foreign Short-term debt to reserves levels, mid- 1997 (Percent) Short-term debl/totil debt Short-term debt/reserves Indonesia 24 160 Korea 67 300 Thailand 46 107 Malaysia 39 55 Philippines 19 66 Argentina 23 44 Brazil 23 69 Chile 25 44 Colombia 19 57 Mexico 16 126 Source: Bank for International Settlements, International Financial Statistics, World Bank.  - 13 - 1.27 Excessively high leverage, a reliance on short term debt, and property bubbles were featured in these economies.1" Consistent with (and encouraged by) the real exchange rate appreciation of their currencies, there was a sharp increase in investment in non-traded goods, especially construction, and it became clear in 1997 that much of the new office space -- in Bangkok and Jakarta by early 1997, 5-8 times the capacity of the early 1990s -- was a misallocation of resources. Although credit growth in Argentina has accelerated in recent years, with the re-intermediation of the financial system, no signs of anything like the booms in East Asia has yet been seen. 1.28 One way to summarize the many possible determinants of banking crises is through the model of Demirguc-Kunt and Detragiache (1997), who do a multivariate logic analysis of the likelihood of a banking crisis, based on the following indicators: * macro (growth, change in terms of trade, real interest rate, inflation, depreciation of the exchange rate, and government surplus/GDP); * financial (M2/ foreign exchange reserves, credit growth/GDP, bank cash/bank assets, and private credit/GDP; and * institutional indicators (GDP per capita, the presence or absence of explicit deposit insurance, and an index of law and order, which is a proxy for the ability to enforce contracts). 1.29 This model performs quite well in predicting crises, explaining about 70% of the crises that occurred, and only predicting a crisis when none occurred in 15% of the cases. Chart 2 shows, with the model estimated only with data up to 1996, how the likelihood of a crisis was rising in Thailand since the early 1990s. Chart 3 shows the corresponding model estimates for Argentina, and as is evident, the likelihood of a crisis there in 1997 was quite low.12 In addition to favorable macro developments, the high liquidity of the banking system and still-modest credit risk, in the form of credit to the private sector, help to keep the probability of a banking crisis low, in sharp contrast to the clear warning signs in the case of Thailand. To be sure, no model can predict crises with 100% accuracy, but this model, which out-performs any to date, confirms the significant improvements in Argentina and makes a banking crisis less of a concern in the near term. 1.30 Several lessons are evident from the East Asian experience. First, capital inflows are dangerous when the regulatory structure of the financial system cannot ensure, or at least make it likely, that the inflows will be well employed. Were rankings of financial regulation routinely available, it would at least raise warning flags if capital were routinely going to countries with weak financial sector regulation. When it comes to monitoring Thlese problems also were secni in Malaysia and, to a lesser extent, in (lie Plhilippines, economies that also liave been affccted by currecncy and equity price declines, tlhouglh as yet few significant problems have been cvident in their banking systeiims. Like Argentinia, botlh counitries saw financial crises in the 1980s; in the case of (le Plhilippinies, the crisis was quitc severe and re-intermediation had only beguin O0i a significant scale in tlhe last 4-5 years. 12 The horizontal line indicates wlhen tlie likelilhood of a crisis lias risen to 70%.  - 14 - banks, it is important for authorities to utilize market information as much as possible, as market participants may know when banks are increasing their real estate exposure even if official data do not reveal it. The subordinated debt system put in place in Argentina should function well in this regard, as uninsured debt holders will have a good incentive to monitor the banks. Chart 2 Thailand 0.16 - ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~~~~~~ ~ ~ ~ ~ ~ - - - - --~~.... .. .. . . - . - . . ..- ...._ __....._ 0.14 0.12 0.1 0.08 0.06 0.04 0.0 1991 1992 1993 1994 1995 1996 Chart 3 Ang:hrnAl Crdsis ProbaWiRlhs 0.16 0.14 0.12 0.1- 0.08 0.06 0.04 0.02 1991 1992 1993 1994 1995 199S 1991  - 15 - 1.31 Second, experience from East Asia (and Japan, the United States, and Scandinavia) demonstrates that property and asset market bubbles can occur even during times of relative stability in consumer prices. Even if the data suggest that banks are not lending into a real estate boom, it often turns out that loan classification data are misleading. Setting up a reporting system to track lending -- as Argentina has done -- and then assessing penalties for mis-reporting, is important if authorities are to monitor the linkages between banking and real estate. This also suggests that authorities have to be willing to slow down their economies when they see signs of real exchange rate appreciation coupled with asset market booms -- even if consumer price inflation is modest. In the case of Argentina, where the convertibility law makes countercyclical monetary policy problematic, fiscal measures to cool the economy are preferable. Also, in the case of Argentina, deflation of asset prices took place during the 1994/95 regional financial crisis, mitigating the scope for adjustment in the recent crisis. 1.32 A third lesson is that foreign bank entry can play a role in both making the banking system more efficient and more robust to shocks, but it is important to diversify the sources of entry. When a real negative shock hits a country, both local and foreign financial institutions will react the same, qualitatively: if they anticipate it, they will reduce lending in advance, whereas with an unanticipated negative shock, once the shock is past, both will want to expand their lending to compensate for the lower value of domestic assets in their portfolio. However, if the local institution is more concentrated in domestic assets than the foreign entity, then the hit to its capital may be sufficiently large that it would have to cut back all lending. So in this case having foreign institutions may be stabilizing. However, if a negative shock hits the foreign financial institution in its own country -- lower real estate prices in Japan, say -- then the foreign bank may pull back from lending in the developing country, and this could have significant negative effects.'3 Moreover, foreign regulators could pressure their banks to pull back from overseas lending to aid clients in their domiciles. Over a cycle, these effects may well balance out if domestic and foreign shocks are distributed evenly. Admitting foreign banks from a variety of countries -- as has occurred in Argentina, although diversification has to be observed -- will help to increase the benefits of foreign entry while minimizing its potential costs. Peek and Rosengreni (1997) founid evidence that Japancsc banks, whio had large positions (23-44% of the real estate lendinig businiess) in Califorinia. Illinois, and Ncw York, substantially reduced their lending in the wake of lower rcal estate and stock prices at hoiue, and that this had significant negative effects on thcse local miarkets. Thcsc effeccts occurrcd in very different markets, and notwithstanding miarkedly differcuit leiding bchavior by US and other foreign banks. Thus it is overwhelminigly likely that thc effccts were indecd attributable to the decrease in the supply of loans by the Japanese bank, rather than to lower demand, and econometric work corroborates this finding. If the Japanese banks reduced lending in the United States, they may well have done the same elsewhere, meaning that it is quite possible that, having expanded ilicir lending rapidly in East Asia in the late 1980s and early 1990s, thcy retrenclied therc in 1995-97 in order both to re-balance their portfolios and to help out key Japanese clients, and thereby miay have played a role in the E. Asian crises. The point here is not to single out Japanese banks but rather to reveal how foreign shocks are transmitted when banks are based in different countries.  - 16 - INTERNATIONAL INTEGRATION AND REGULATORY COORDINATION 1.33 Two issues of strategic importance are likely to emerge as major policy concerns in the years to come. Both issues are already evident in the current functioning of the financial system but their importance is expected to grow over time. The first concerns the growing integration of the Argentine financial system with world financial markets and especially with US markets, while the second concerns the problems encountered in the regulation of financial conglomerates and the need for closer coordination among different regulatory agencies. 1.34 Local institutions are concerned that greater financial integration would constrain the growth of the local market. Because of the currency board and free capital movements, there is already a high degree of integration, even if this is not properly registered and measured. The use of ADRs by 14 large Argentine companies and the high volume of trading in New York for these shares are manifestations of integration. The migration of this business to New York heightens the concern of local institutions. Similarly, following the adverse experiences during the period of hyperinflation, many Argentine households and corporations have become used to obtaining financial services from offshore financial centers or from US financial institutions. For households, such services include maintaining bank deposits, purchasing insurance, and even investing in US mutual funds. Against this trend, one can mention the increased presence of foreign banks and other foreign financial institutions in the local market, the stimulus to financial innovation and efficiency provided by them, and the training and promotion of Argentine professionals to senior positions of their local subsidiaries. 1.35 Such developments could cause the Argentine market to evolve over time and resemble regional US financial markets (e.g. Texas, Florida, or California), which have thriving financial sectors, despite the fact that companies list in New York or Washington. Local markets cater to the needs of medium and small firms as well as to the needs of households. Although regional US financial markets also conduct a lot of financial business with non-Americans, most of their financial business is with local firms and resident households. The Argentine authorities would need to assess and publicize effectively the benefits of greater integration. A strategic decision would need to be taken to support measures that will enhance efficiency and promote further integration, without fearing that in the long run this will lead to a major contraction of the local financial market. Examples of practical implications of such a strategic approach would be to allow mutual funds to invest freely outside Mercosur, to change the investment regulations of pension funds to treat securities in Mercosur, Chile and the US as domestic equivalents, to allow pension funds to invest in rated mutual funds that specialize in foreign securities without requiring the underlying securities to be also rated, to encourage smaller firms to seek listing on US markets, and to develop the information and legal infrastructure that would enable smaller firms to tap sources of collateralized finance in Argentina or other markets.  - 17- 1.36 The second point concerns the coordination across regulatory agencies. There is a need to address the problems that could arise from lack of coordination such as potential inconsistencies in regulations and supervisory failures. International experience suggests that a unified agency may also face serious problems such as the possibility of favoring the dominant segment of the financial sector (e.g. banks) at the expense of new or peripheral segments and the failure to appreciate the operating characteristics and regulatory/supervisory requirements of different segments. Pending the gaining of greater experience from the proposed new systems in the UK and elsewhere, the Argentine authorities could examine the advantages of creating an umbrella body that could promote coordination without losing the benefits of specialization. An umbrella body approach would also avoid the political problems of turf fighting. END NOTE 1.37 The prudential measures taken since 1995, and their impact, will be analyzed further in this report. Such measures, however, work in two directions. While they strengthen confidence in the banking system's ability to absorb shocks, and in that they might succeed in preventing them from occurring in the first place, they also increase the discretion of economic authorities in affecting monetary aggregates, which the Convertibility Law had successfully constrained. As the credibility of economic authorities and institutions rises in Argentina, the adoption of incremental degrees of policy freedom may be reconsidered, in the future. This has been the experience in Hong Kong, which by amassing significant excess international reserves through consecutive fiscal surpluses, is in the position to conduct discretionary monetary policy (and act as lender of last resort), while at the same time running a credible currency board. In the absence of such conditions, however, Argentina's measures taken after the tequila crisis may be considered a preferred alternative. 1.38 While this report focuses on financial markets, the strength and flexibility of other factor markets, such as labor markets, are imperative in strengthening the ability of the Argentine economy as a whole to absorb external shocks. Given the close interconnection between the Convertibility Plan and the health of the financial system, advancing in the "second generation reform agenda" mentioned in the beginning of this section, is an imperative complement to the important efforts underway to strengthen the financial system.  - 18 - 2. THE BANKING SECTOR 2.1 In recent years the banking sector in Argentina has gone through a number of changes which we summarize below in Sections 1-3. In particular, since the Tequila crisis, substantial consolidation, privatization, increased entry by foreign institutions, and tightening of regulation and supervision have occurred. In light of those changes, this chapter concludes that the banking system is relatively robust to external shocks, as confirmed by its recent strong performance in the midst of the 'Asian flu.' Section 4, in particular, examines the recent changes on banking regulation and supervision and notes that a 'CAMEL' review of bank regulatory systems rates Argentina quite favorably compared with other Latin American and Asian systems. 2.2 Notwithstanding this considerable progress, there remain challenges that confront the banking system. Section I attempts to summarize the current situation and quantify the risks and costs imposed by remaining problems. For example, the likely misallocation of resources from state-owned banks, as suggested by their high nonperforming loan ratios, is lowering economic growth. We estimate, therefore, the short-term costs of privatizing these entities. Despite the costs, continued bank privatization, plus the consistent application of prudential supervision to the state-owned banks, will be required to improve the overall health of the banking system. Although many countries need to move slowly on privatization while they are improving financial regulation and supervision, Argentina has made substantial progress in each area, and political considerations remain the main barrier. 2.3 A sufficiently large shock can result in a financial crisis in any country, but the recent changes in the structure and regulation of the Argentine financial system make this less likely, both in comparison to Argentina's past and relative to most emerging market countries today. As noted in the introduction, moreover, the lack of policy freedom associated with convertibility may have compelled authorities to make many of these improvements. In reviewing those changes this chapter explains how they reduce the likelihood of crises or lessen their severity when they do occur (Section 4). Future structural changes may also reduce systemic risks. We examine, therefore, whether recent legal and institutional changes such as the creation of bank failure resolution mechanisms are sufficient to support the needed structural changes (Section 5). CURRENT CONDITIONS Structural Change: Overview and Implicationls 2.4 The fast expansion of the financial system has been taking place in the midst of a restructuring process. That process has left Argentina with substantial foreign presence in its banking sector. Thirty-seven foreign-owned banks have 43 percent of total assets, 37  - 19- percent of total deposits." By developing country standards, these figures are high. Levine (1996) reports that foreign banks typically do not comprise more than ten percent of the banking sectors of developing countries. 12 2.5 By contrast, the forty-nine remaining private domestic banks hold only 23 percent of total assets, 25 percent of total deposits. Moreover, the smallest twenty-five private domestic banks comprise only about 2 percent of system assets. In December, 1994 private domestic banks had roughly 45 percent of the system's assets and deposits. Foreign acquisitions and closures are responsible for the steep decline. Public banks have also declined in number and in market share, though not as steeply. In December, 1994 they comprised 40 percent of system assets, 37 percent of system deposits. Eighteen remaining public banks now hold 3 1 percent of system assets, 35 percent of deposits. Recent bank privatizations are largely responsible for the dip. Twelve privatized banks now comprise about 4 percent of system assets and deposits. 2.6 Structural changes have benefited the sector as foreign banks are, on average, better performers than domestic banks. They tend to be larger than all but the remaining public banks, and they have higher ratios of net worth to total liabilities and normal loans to total loans (Table 2.1). They do, however, have ratios of operating income to administrative costs that are very similar to those for private domestic banks. 3 The loan share data from Cull (1998) and these results on efficiency and portfolio quality suggest that foreign-owned banks in Argentina are pursuing lending seriously and that they are doing it at least as efficiently as domestic ones. 14 2.7 Portfolio quality data in Table 2.1 also indicate that, among the domestic banks, the publicly owned ones are the worst performers. They have much lower percentages of normal loans in their portfolios. On the other hand, they do have a higher ratio of net Results in this sub-sectioni and those that follow rely oni a quarterly panel data set provided by BCRA. Using otlher BCRA data sourccs we identified banks as being either foreign-owned, public, private domestic, or privatized. Non-banik fiiancial institutionis wenit into a catch-all category called "other." This classification should help us in analyzing the structural changes that have taken place in recent years. In some cases we were uniable to classify an entity, or data were not available for an entity over all quarters. We may, tlherefore, sliglhtly understate the numiiber of banks in a certain category for some indicators. Comparisonis with BCRA docuLmienits suggest, however, that such understatements are small, anid that minior corrections would not alter the assessments that follow. 12 Ross Levine, "Foreign Banks, Finiancial Developmenit, and Economiiic Growtlh," in Claude E. Barfield, ed., International Financial Mlarkets: Harm0onization Vlersus Competition, Washington DC: The AEI Press, 1996. 13 Claessens, Demirgiiq-Kunit, and Huiziniga in "How does foreigni entry affect the domestic banking market?" (1997) find that the ratio of operating overhcad to total assets is higlher for foreign-owned banks thani for domestic ones in low incomiie and lower middle incomiie countiries. The reverse is true in upper income counitries. Tlhey argue that a possible explanationi miglht be that foreign banks have higlh overhead costs if they have to overcome large inforiiiationial disadvantages, but lower overhead costs (as a percentage of assets) if they engage mostly in wholesale transactions -- as is the case in many developed countries. 4 Conclusions also hold up wheln the samiple is sub-divided by year, so these disparities are not merely due to foreign banks arriving late in tlhe period (1997) wheln bankinig coniditions may have been better.  - 20 - worth to liabilities than the privatized banks. Clarke and Cull (1 997a) find, however, that the net worth of public banks was overstated prior to their privatization and that audits conducted prior to privatization resulted in a substantial reduction in net worth. In fact, the audits often revealed these banks to be technically insolvent. While relatively low, the net worth figures for privatized banks are probably more reliable than for other banks and are, in any event, at acceptable levels. In addition, their average portfolio quality is relatively high. Table 2.1: Size and Performance By Type of Bank Type Deposits Net Worth to Total Operating Inicomiie to % Normal16 Liabilities'. Adminiistrative Costs (Loans) (%/) -(%) Avg. Median** Median** Avg. 1995-97 Foreign 381,941 17.0 1.24 90.8 Priv Domest 286,502 16.1 1.23 75.5 Public 765,173 11.6 0.94 56.4 Privatized 148,065 8.8 1.21 86.8 Total * 411,121 14.8 1.20 73.8 1997 Foreign 673,479 12.5 1.27 91.2 Priv Domnest 344,526 14.0 1.27 76.2 Public 1,331,292 13.4 1.09 62.3 Privatized 187,270 8.6 1.20 89.5 Total 547,431 | 12.8 1.23 79.4 * Averages across all four baik types. Non-banks exclUtded fronm calculations. Because each banik- is weighted equally in the calculationis, the average nomial loan percenitage and net worth to liabilities ratio are iiiuch smaller than if these two figures were calculated from]l a consolidated balance sheet for all banks (as BCRA does when it produces system-wide figures). ** A hanidfil of observations have strong etThcts on the mean1 values ifor these variables. The mediani corrects these measurement errors. 2.8 The portfolio quality results are also reflected in 1997 profitability figures -- profits through December imply a 3.9 percent annual return on capital for public banks, and 7.8 percent for private banks. Table 2.2 makes it clear, moreover, that improved profitability for the total system since 1995 is largely attributable to the private banks, especially the ten largest ones. Concerns over the low profitability of the banking system appear to be structural, reflecting more the problematic state of public banks and smaller banks. Taxes '5 Capital adequacy ratios typically have risk-weiglhted assets in the denomiinlator. Because we use total liabilities, the figtires in this table mlay be muchi lower than the capital adequacy ratios for banks that have relatively few risky assets on their balanice sleets. This is likely to be the case for the privatized banks as a relatively higlh share of their incomle is generated fromii government services (rather than lending). The figures for the privatized banks are, however, influenced somewhat by a handful of observations witli values below zero. Perhaps we have mis-identified banks as being privatized before the process was comlplete. The negative valies may reflect the problems of the old public provincial bank portfolio. If we elimiinlate Ihose observations, t(le figure for privatized banks is in line with those for the other groups. 16 Normal refers to those loans rated in BCRA's top category, EiEn situaci6ni normial/ Cuinplimiento nonnal." There are six categories. Were we to incltude those in categories two and three ("Con riesgo potencial" and "con problemias"), the estimates of performiing loans would, for exainple, surpass 95 percent for most foreign-owned banks. See "Informaci6n de Entidades Financieras," SEFyC, B.C.R.A., October, 1997 for details  - 21 - on financial intermediation, and regulatory costs such as the cost of the legal liquidity requirement, and cost of deposit insurance, which are argued as a cause of low profitability, are small compared to the high level of operating costs and cost of loan recovery and provisioning.'7 Table 2.2: Profitability by Banki Type, 1995-97 Bank Type December, 1995 December, 1996 Dccember, 1997 Public Return on Equity (%) -0.43 2.80 3.89 Retum on Assets (%) -0.09 0.51 0.69 Private Return on Equity (%) 0.03 5.49 7.79 Return on Assets (O) 0.00 0.61 0.76 Top Ten Private Return on Equity(%) 10.81 14.04 15.30 Return on Assets (%) 1.29 1.47 1.37 Total Banking System Return on Equity (%) -0.21 4.21 5.98 Return on Assets (%) -0.03 0.58 0.74 Source: "Itiformaci6n de Entidades Financieras," SEFyC, B.C.R.A., April 16, 1998 (www.bcra.ar) 2.9 The portfolio quality data suggest that the most serious threats to the banking system are posed by the remaining public banks and the smaller private domestic ones (although it should be emphasized that not all small private domestic banks are weak), and that foreign entry has contributed to a healthier financial system overall. Indeed, since the Tequila Crisis, the banking sector has apparently become more efficient. For example, the re-intermediation of the banking sector, coupled with increased foreign presence (or competition) and the removal of weaker banks (see below) has led to greater efficiency in terms of deposits per branch or per employee, and improved measures of operating income to costs. Recent Developments 2.10 Despite the Asian crisis, Argentina's banking system continued to expand at a fast pace during 1997, reflecting the remonetization of a growing economy (1997 GDP growth of 8.4 percent). With international reserves at the Central Bank expanding by 28.4 percent through 1997 (for the entire financial system--including reserves held abroad-- international reserves grew by 37.1 percent), the broader monetary aggregate (M3) reached 25.6 percent of GDP, up from 21.9 percent at the end of 1996.18 17 For 1995-96, IMF staff have estinialcd costs of taxes oni financial interiiiediationi (0.8 percent), legal reserve requiremlenit (0.2 percent), and deposit insurance (0.3 percent), whichi suilii to 1.3 percent, compared to 10. percent in operating costs, and 5.3 percent in costs of loan recovery and provisioninig. In Argentina--Recent Econoimiic Developlmienlts, IMF, Jani. 1998. 18 Figures in this sub-sectioni are takeni from, B.C.R.A., Gercncia de Ailisis Econ6nmico e Informaci6n, "In.formaci6n Monietaria y Financiera," Decemiber, 1997. Addinig a very rough guestiiiate of dollars in circulationi, M3 could be about 29 percent of GDP.  - 22 - 2.11 Overall deposits increased by 30.2 percent in 1997. While by year-end dollar deposits had expanded by 30.9 percent, and peso deposits by an approximately equal rate of 29.6 percent, by mid- 1997 (prior to the Asian crisis), peso deposits were growing faster than dollar deposits, while during the crisis months the system experienced, as could be expected in times of uncertainty, a sharp dollarization. At the end of 1997, dollar deposits accounted for 53.3 percent of total deposits. During the crisis, larger banks captured more deposits, mostly in dollars. 2.12 A combination of growing deposits and increasing liquidity requirements contributed to 45 percent growth in liquid reserves during 1997. While private deposits continued to expand throughout the year, with the exception of a small dip in December (overall deposits expanded in December), credit expansion felt the impact of the crisis. Credit expansion to the non-financial private sector was expanding on a 12-month basis by 18.1 percent in September but, by year-end, it had decelerated to a 15.1 percent annualized growth rate, half the rate for deposits. 2.13 The impact of the crisis was reflected in interest rates as well, starting in October 1997. In the interbank market, peso rates rose by approximately 200 basis points, to 8.5 percent be end-1997. Dollar rates rose less, widening the spread between peso-dollar rates (an indicator of devaluation risk), from imperceptible rates in September, to 135 basis points in December. Prime lending rates rose significantly higher between September and November, but started decelerating in December. 2.14 It may still be early to assess the impact of the recent crisis on the quality of bank portfolios (in the 1994/95 crisis it took a full year for the non-performing loans in the system to reach their peak). As of September 1997, for the system as a whole, non- performing loans reached 15.2 percent of loans.'9 However, adjusted for provisioning, non-performing loans were only 4.3 percent of all loans. Non-performing loans, adjusted for provisioning, accounted for 21.5 percent of banking equity. Disparities between private and public banks are, however, striking. Non-performing loans for private sector banks reach 11.1 percent of loans, while for public sector banks that ratio rises to 22.3 percent (keeping in mind that the first real audit of BNA and Banco Provincia are not yet completed). 2.15 The fast expansion of the financial system has been taking place in the midst of a restructuring process. Compared to December 1994, the number of financial entities in the banking system by end-1997 rank from 205 to 142. The number of public banks declined from 33 to 20, mainly thiough privatizations of provincial banks, while the number of private banks declined from 135 to 96 (mainly through mergers and acquisitions). Non-banking entities declined from 37 to 26. The number of branches has been reduced from 4,286 to 4,077 and - - number of persons occupied in the banking system was diminished form 122,760 to 109,058. 19 Totals for the financial systeiii inclutde noni-banik finaiicial instittlionis. Non-perfonning is what BCRA refers to as "cartera irregular," whiclh inclutdes categories 3,4,5, and 6 of the new rating system and 4,5, and 6 fromii thc old syscim (morc tlhani nintety days late).  - 23 - Assessing Current Problems 2.16 Although the rise of foreign and privatized banks has meant improved performance and stability in the banking sector and improved access to credit in many provinces, about 55 percent of total banking assets and liabilities still reside with private and public domestic banks.20 It is important to assess the systemic risks that they pose. Percentile breakdowns by type of bank for five variables -- assets, liabilities, loans, share of normal loans, and the ratio of net worth to liabilities -- appear in Table 2.3. Foreign banks are included as a means of comparison. The size profile of foreign banks is more similar to public banks than to private domestic ones, which tend to be somewhat smaller. Table 2.3: Percentile Brealkdown, Size and Performance Characteristics, By Type of Bank, June 1997 Bank Type Assets Liabilities Loans % Normal* Net Vorth/Liabilities Foreign 1% 13,554 928 0 78.8 .04 25 % 143,904 122,736 95,894 89.5 .10 50% 732,038 666,886 233,634 92.8 .12 75% 2,077,171 1,987,985 650,769 97.6 .19 99% 8,169,123 7,241,889 4,277,751 99.0 21.1 (n=37) (ni=37) (ui=37) (ni= 14) (ni=37) Public 1% 14,164 10,360 3,751 27.4 -.01 25% 145,626 130,247 79,491 46.9 .09 50% 430,143 357,222 331,132 69.7 .12 75% 2,083,314 1,515,871 968,750 76.4 .25 99% 15,200,000 13,300,000 8,770,519 86.3 1.6 (n= 18) (n= 1 8) (1n= 18) (1n= 1 0) (n= 18) Dom. Priv. 1% 4,635 4,910 9,080 30.4 -.06 25% 118,961 95,014 43,938 69.5 .10 50% 260,427 235,992 143,005 76.4 .14 75% 521,331 469,546 307,034 82.2 .23 99% 10,000,000 9,007,398 5,754,787 94.7 .66 (n=49) (ni=49) (ni=49) (n=29) (n=49) Total** 1,073,961 935,469 605,226 80.5 .17 Nonnal refers to those loans rated in BCRA's top category, "'En situaci6n nornial/ Cumiplimiento nonnal." There are six categories. *** Averages across all four bank types (including privatized, which are not broken down separately in the table). Non-banks excluded from calculations. Because each bank is weighied equally in the calculations, the average normal loan percentage and net worth to liabilities ratio are much small 'han if these two figures were calculated from a consolidated balance sheet for all banks (as BCRA does when it AdLces system-wide figures). 20 See Cull (1998) (Section 1) for data on total nomiiiial asscts and liabilitics by bank type over time.  - 24 - Barriers to Finanice for Small and Medium Enterprises Small and medium-size enterprises (SMEs) Lease Finance- The leasing industry is very Argentina face severe credit constraints. Bank underdeveloped and does not provide a financing is beyond the reach of most small significant source of non-bank finance for SMEs firms and when it is available, the high in Argentina as it does in many other countries. interest rates and strict conditions of the loans In 1997, the Argentine industry wrote leases discourage borrowing. As a result, SMEs valued at approximately $250 million tend to rely on relatively expensive trade the potential market is estimated to be in the finance, self-finance or on retained earnings billions. The tax treatment of leasing is the for their credit needs. This has serious major deterrent to the industry's development. economic consequences since SMEs produce Specifically, financial corporations dedicated to more than two-thirds of value-added in leasing, which are the motor behind developmen manufacturing and commerce and over 80 of the industry in most countries, are at a percent of employment in these sectors. significant disadvantage with respect to Weaknesses in the legal and institutional commercial bank-operated leasing ventures due infra-structure for financial transactions to the treatment of value-added taxes (IVA). As contribute to the high cost and difficulty of a result, investments by leasing firms have not obtaining credit for small businesses. The occurred on any meaningful scale and the most important of these problems are: industry's growth is greatly diminished. In addition, problems in the legal basis for leasing Secured Transactions A fundamental legal have retarded entry into the industry. problem is the relatively weak protection Information - Information on past borrower afforded to lenders. The treatment of secured behavior, such as that recorded in a credit transactions provides a clear example of how bureau, is limited in Argentina. Private the legal system handicaps credit operations. credit information registries exist, but the data The law narrowly defines what constitutes they contain rented and the data acceptable collateral and who can be a they contain iS fragmented and the quality of accetabl colaterl an whocan e adata is uneven. The Central de Deudores created secured creditor, so that many common types dt suee h eta eDuoe rae of c crit, such as accounts receivable by the Central Bank is intended to improve this of crdit, uch s accuntsreceiablesituation by expanding the scope and access of financing, are not adecluately protected under data available to banks. Still, use of credit the law. The process of seizing secured assets . '. can take years of court battles so lenders scorig and other data analysis technques, s typically only accept real estate or liquid hampered by data quality and limited historical instruments as collateral. As a result, credit information. secured by movable goods represents only a Bank - Business Relationships The banking small fraction of financing in Argentina, community has not invested resources in compared with approximately 40 percent cultivating relationships with SMEs, due in part the United States, where the legal to the legal, judicial and information environment provides lenders more rights. they face. The specialized services and attention Judicial Systern- Problems in the legal that small firms require, however, can system are compounded by lack of eficiency provide profitable business opportunities for and transparency in the courts. Fewer than 50 banks who are organized to provide them. A percent of cot n nercial court cases are change in banking culture, and in the attitude of prentsofv comrial outh ase ar SMEs vis-a-vis their banks, is necessary to resolved within 12 months and the median inres bakcei o hetr time for closure is approximately three inrease bank credit to the sector. Many commercial court judges lack adequate training in business law, having come from other legal backgrounds. The deficiencies in the legal framework exacerbate these problems - there is a backlog of cases relating to seizure of assets, bankruptcies and contract violations. Figures from the 1994 National Economiiic Cciisis.  - 25 - 2.17 Three-quarters of the foreign banks have shares of performing ("normal") loans above 90 percent and ratios of net worth to liabilities above 10 percent. Although the private domestic banks and the public banks match the foreign ones with respect to net worth (at least for the top three quartiles), their shares of performing loans are much lower. Normal loans do not comprise more than 90 percent of credit for any public bank. For half of them, less than 70 percent of their loans are performing; for a quarter of them, less than half are performing. At all points of the distribution, private domestic banks have slightly higher shares of performing loans than do public ones. Their portfolio quality is, however, not nearly as good as that for foreign banks. 2.18 Argentina's weakest banks are found among the public and private domestic ones. The systemic risks posed by each group are different. Portfolio quality data make it clear that the primary problem associated with public banks is the mis-allocation of resources. At the same time, however, these banks impose fiscal burdens on the state as they are frequently in need of re-capitalization. It is through this fiscal channel that public banks pose a systemic risk. Although privatizations, which are discussed in more detail below, have eliminated many of the poorest performing provincial banks, depositors at some public banks still must consider a province's fiscal health when assessing the safety of their deposits.2' Evidence indicates that, with the exception of Buenos Aires and Salta, all provincial banks lost at least 10 percent (and up to 40 percent) of their deposits during the height of the Tequila Crisis. While neither Buenos Aires nor Banco de la Naci6n appear to contribute to this type of systemic risk -- depositors run to them rather than from them in that crisis -- it would be inaccurate to assume that provincial banks, by virtue of their public status, impose no risks.22 2.19 Table 2.4 attempts to quantify the systemic risks posed by these banks. Public and private domestic banks are first grouped into quartiles based on their total assets. The share of normal loans variable indicates that portfolio quality is increasing in size quartile. From a systemic perspective, it is encouraging that the weakest banks tend to be smaller. The smallest two quartiles for private domestic banks represent 2.3 percent of system assets; the bottom three quartiles comprise 5.6 percent. In addition, the smaller, weaker banks also tend to have lower ratios of liquid to total assets. The combination of weak portfolios and low liquidity implies that these banks are most vulnerable to exogenous shocks. 2.20 In scenario 1 we calculate the costs associated with liquidating banks in each quartile assuming that (1) performing illiquid assets are all recovered (or sold at face 21 The deposit insurance sclhcimie makes tIiis concerii somewhiat less pressing, although coverage is limited and much of the deposit fliglt duriing t(le Tcqtila Crisis involved "large" deposits. 22 In thle analysis that follows, we estimate the costs associatcd witll liquidatinig public and weak private banks. For public banks, suclh liqtuidationis could occur abruptly in time of crisis or could occur in non-crisis periods as provinces chose to avoid the future fiscal costs associated re-capitalizing their banks. Even if we assumiie public banks pose no systemic risk and thuis need not be liquidated in time of crisis, the analysis provides useftil estimates of the short-terimi fiscal cost of liquidating (privatizing) these banks if anid wlhen policy makers choose to confronit tlhe problem.  - 26 - value), (2) all other illiquid assets are unrecoverable,23 and (3) liquid assets are used to defray liabilities not met by money from normal loans. It is extremely unlikely that all banks in these two categories would ever be liquidated simultaneously, so the totals for all quartiles should be viewed as an implausibly high upper bound on systemic strain. Total liquidation costs for all private domestic banks under scenario 1 are, however, only 1.6 percent of banking assets. For the two smallest quartiles, those where most problems appear to reside, costs are only 0.3 percent of banking assets. While troubled, their small size makes it unlikely that these banks pose a great threat to the system. 2.21 For the public banks it also appears that those in the largest quartile have better portfolio quality and more liquidity. As noted above, however, their portfolio quality is below that of the largest private domestic banks, and those in the bottom three quartiles all have low shares of performing loans (below 65 percent). As a result, although there are only eighteen public banks that enter the calculation, their total liquidation costs under scenario 1 are 1.8 percent of banking sector assets, 0.2 percent more than for the forty- nine private domestic banks. Most of the losses would come from the relatively large banks in the second-largest quartile; their average share of performing loans is only 52 percent. 2.22 Privatizations to date indicate that scenario 1 likely under-estimates short-term liquidation costs for public banks. Clarke and Cull (1 997a) describe the post-audit decline in the value of assets for public banks that enter the privatization process.24 On average, these more rigorous audits resulted in a . 15 decline in the ratio of net worth to total liabilities. Even after the post-privatization audits, however, private purchasers refused to assume all of the assets and liabilities of the public bank. On average, only about half of the public banks' assets were acquired. 2.23 Scenarios 2 and 3 attempt to account for this by assuming that a fraction of public banks' loans now considered normal could not be sold. Under scenario 2, which assumes 25 percent of normal assets are unrecoverable, the total costs associated with liquidation are over 7 percent of banking sector assets. Under a more unlikely scenario 3 (50 percent normal assets assumed unrecoverable), costs are over 12 percent of system assets. The privatization experience to date, moreover, suggests that poor performance and over- estimates of asset values have occurred at public banks of all sizes. It would not, therefore, be proper to focus only on the small banks (as we do for our private domestic bank liquidation costs estimate). 23 More precisely, the normal loan percentage is miiltiplied by the total assets (minuis liquid assets) in the quartile. The quartile's othier illiquid asscts are assuiincd unrecoverable. 24 See Bibliograply to Cull (1998) for frill citationis.  - 27 - Table 2.4: Quantifying RiskIs Posed by Public and Domestic Private Baniks, October, 1997 Bank Type Total % Normu Liqui(l. Liquilation Liquidation Liquidation Loans Ratio Scenario I Scenario 2 ,Scenario 3 (All but Normal* (Plus 25% Normal (Plus 50% Normal _Unrecoverable) Unrecoverable) Unrecoverable) (Avg.) (Avg.) (Avg.) 000s %ta 000s %ta ooos -/ota Private Domestic (Grouped by Total Assets) 1-25 Percentile 31,753 63.8 .08 -90 .1 -193 .2 -294 .2 26-50 Percentile 99,470 67.0 .07 -300 .2 -651 .5 -1002 .8 51-75 Percentile 200,655 68.1 .09 -747 .6 -1415 1.1 -2082 1.6 76-100 Percentile 1,056,666 84.3 .09 -962 .7 -5221 4.0 -9480 7.3 TOTAL -2099 1.6 -7479 5.7 -12860 9.9 Public (Grouped by Total Assets) 1-25 Percentile 39,568 64.3 .05 -73 .1 -130 .1 -188 .1 26-50 Percentile 218,501 59.3 .08 -391 .3 -569 .4 -748 .6 51-75 Percentile 657,120 52.4 .09 -1642 1.3 -2304 1.8 -2965 2.3 76-100 Percentile 5,251,736 79.0 .09 -278 .2 -6230 4.8 -12182 9.4 TOTAL -2385 1.8 -9234 7.1 -16082 12.3 *Norrmal refers to those loanis rated in BCRA's top category, "En situaci6ni normiial/ Cumpliiniento normal." There are six categorics. 2.24 The estimates in Table 2.4 assume that assets not recovered (or sold) are forever unrecoverable. In privatizations to date, however, assets not acquired by the purchaser went into a residual entity for liquidation by the province. We have not yet analyzed how that liquidation has progressed, but we recognize that our estimates here represent only short-term liquidation costs because they allow for no residual asset recovery. From a political perspective, scenario 2 and 3 estimates do, however, provide some indication as to the potential magnitude of the short-term problem. By contrast, because steep post- audit declines in asset values and partial purchases of assets and liabilities have not occurred in the case of private domestic bank sales, scenario I may be the more plausible for them.25 2.25 In short, Table 2.3 and Table 2.4 help summarize many key results. Relative to domestic banks, foreign ones are larger, are growing more rapidly, and have much higher portfolio quality than domestic ones (either public or private). There is, however, variation in the quality of the private domestic banks, and it is the smallest ones that appear to pose the greatest risks of failure. From a systemic perspective, therefore, 25 We do, however, lack data on thc recoverability of assces after thc closure (rather than the sale) of private domestic banks. If post-closure asset recovery (is.e, asset sales to other banks) has been especially difficult -- and convcrsationis with BCRA staff suggest that is has becn -- scenarios 2 or 3 are more plausible for some of these banks.  -28 - private domestic banks may not pose that great a threat.26 The public banks pose the biggest problems, though as noted earlier the main issue is the misallocation of resources associated with nonperforming loans. Their portfolio quality is low regardless of size, and this will probably worsen after more rigorous audits. The liquidation estimates here, moreover, make it clear that privatizing these banks may be very costly. If such privatizations, which are clearly our preferred approach, prove politically infeasible, improved supervision of these banks may be the only option for improving their performance. BANKING SYSTEM: AN EVOLUTIONARY PROCESS 2.26 Since the 1991 Convertibility Law, the Argentine financial system has undergone a series of fundamental changes. Hyperinflation in the 1980s had reduced the financial system to levels below that found in the lowest income countries, and in a certain sense these past crises, coupled with effective policies in recent years, have helped make the system more robust today. Once credibility of the Convertibility Law was established, inflation decelerated and the re-intermediation of the financial system began in earnest. As seen in Figure 1, credit, both total and to the private sector, has grown significantly in recent years, though financial depth (M3/GDP), while growing rapidly, is still somewhat modest relative to other countries at comparable levels of per capita income. Using data from 116 countries, King and Levine (1993) find that, among those ranked in the highest quartile in real per capita income, the average ratio of gross claims on the private sector to GDP is .53. Those in the second quartile have a ratio of .31. Throughout the late 80s and 90s Argentina would appear to rank near the dividing line between these quartiles in the King-Levine sample, yet its private credit to GDP ratio is now only . 16. Since 1994, M3/GDP has hovered near .15, in between the average figures for the third and fourth quartiles (.20 and .13). 2.27 The 'Tequila' crisis of 1994-95 marked a turning point for the authorities, with a run on some of the smaller banks and then on the system. Deposits declined sharply (Figure 2), and interest rates rose by as much as 1500 basis points on peso loans and 900 basis points on dollar loans. The crisis was halted by the assembly of a support package by the multilateral institutions, convincing support by the government for convertibility, and a credible program of bank restructuring and closure. 26 We recognize, however, iliat contagioni could coiiceivably miake inidividual bank niis worse. Still, the size of the weaker private domcstic baniks relative to the large foreigii, public, and othier private domestic ones suggests thiat suchi contagion would liave to affect banks Iliat appear quite healthy at the moment to liave serious systciiic coniscqieniccs.  - 29 - Figure 1 Figure 1: Credit Growth and Financial Depth 26.0. ~ ". 2 4 .0 ... ... ... ......... ... ....... . :..:--........... a 22.0 . . ..... ....... . . . 20.0 . -4--.. -*. a 18.0 c 16.0 0 ~14 0- -/-.- : : . recdI 12 0 : - -l 12.0 .----:-: - . Private Cred. 10.0 1991 1992 1993 1994 1995 1996 1997 Note: End of year and figures include pesos and dollars. Credit doesn't include accrual resources 2.28 Figure 2 also describes the evolution of deposits by type of bank by quarter from the fourth quarter of 1994 to third quarter, 1997. In nominal terms, total deposits have been increasing more or less steadily since second quarter, 1995. Total deposits in both private domestic and public banks floated around the 20 billion peso mark, although a recent spate of foreign acquisitions coincided with a dip in private domestic deposits late in the period. The increase in total deposits is accounted for by foreign banks and, to a lesser extent, privatized banks. Figure 2 Total Deposits by Type of Bank by Quarter, 12194-9197 700000000 60000000 . .. :..... . :-;------ 60000000 50000000 --. S ~ 30000 -- ----- -......... 2. 30000000 -t-.~~~~~~~ tot deps 20000000 ..-..... A foreign 10000000 -.-pub 0 :c t... . ::priv'tized o) a) 0 X Quarter 0 0inC Quarter Bnding  - 30 - 2.29 To some extent, the increase for foreign banks reflects not only acquisitions late in the period, but also depositor flight to quality, especially in the Tequila crisis. In 1994- 95, for example, the number of foreign-owned banks did not increase (Figure 4) but their deposits, both in nominal terms and as a share of total deposits, climbed steadily if not dramatically. The share figures for foreign-owned banks did, however, stabilize by mid 1995 (Figure 3).27 The only type to lose nominal deposits (relative to their December, 1994 level) was the private domestic banks, and losses occurred in two waves. Early in the period, private domestic deposits declinied during the flight to quality. There were also a number of domestic bank closures at this time. The end of the period saw a decline in deposits that coincided with aforementioned acquisitions by foreign-owned banks. 2.30 Figure 2 also indicates that, after a decline coinciding with the provincial bank privatizations of 1996, nominal deposits at publicly-owned banks grew from December, 1996 through third quarter, 1997. This casts some doubt on the notion that foreign banks and the remaining private domestic ones will compete away the deposits of the large remaining public banks any time soon. Data on shares of total deposits (Figure 3) also lead to the same conclusion -- the increase in nominal deposits of public banks has enabled them to maintain their share of deposits. Public bank share did fall at the time of the 1996 privatizations, from 40 percent to 35 percent, but their 35 percent share remained constant from mid 1996 through September, 1997. Further confirmation that the loss of public bank deposit share was a one-shot phenomenon attributable to the 1996 privatizations comes from the deposit share for privatized banks. That figure remained at 4 percent throughout 1997, roughly equal to the decline in public bank share in the prior year.28 2.31 The share data (Figure 3) make it especially clear that the largest jump has been for foreign-owned banks (from 15 to over 35 percent), and that the increase has come at the expense of the private domestic banks whose share declined from 45 to 25 percent of total deposits. Similar results obtain for the share of total assets to total loans attributable to foreign-owned banks29. Determining whether the drop in private domestic banks' share was attributable to closures and takeovers by foreign-owned banks or to a shift in depositors' preferences is difficult using only this data. Some tentative conclusions can be reached. Mergers and closures in the wake of the Tequila Crisis account for a steep drop in the number of private domestic banks early in the period (Figure 4). In the first five quarters of the period, the number of private domestic banks declined by over 40 percent (from 108 to 65). At the same time, their share of deposits declined by only 5 percent 27 Inlterestingly, the stabilization coinicided roughlly witli thc adoption of a formal deposit insitrance system in April, 1995. This may have had some effect in stopping thie "nrui" from domiestic to foreign banks. 28 Thne increase in privatized baniks' deposit shiare did not occur unitil 1997, an indication that some time elapsed between the closure of the public provinicial banks anid their re-openinig as privatized banks. 29 "iStructural Change: Interiiationializationi, Consolidation, and Privatization in Argentina's Banking Sector, 12/94-9/97" miiieo by Robert Cull (1997).  - 31 - indicating that those banks that closed were not particularly large, and that the merger process may have helped eliminate a major shift in deposits away from domestic banks. Figure 3 Shares of Total Deposits, By Type of Bank, By Quarter, 12194-9197 50.00% ~...v~vPv__ve.. 45.00% . . ....... : - . .. -.. - 45.00% IL---.... ........... ............ ............ 40.00% ' ..- .-. 35.00%T. 30.00% 25.00%. , :-........ ..: 20AX.00%... . . ,, .. .:. ... ..... ...:., u--- foreign 15.00% ... . ...... ...... 3 10.00% : pri donest , . ~~~- - - - - - - - - - - - - - - - - , - - - - 5.00% - ...... ......... :--pub 0.00% : .&*.* s.- I.. X X priv'tized Lo rO It- CY) CY) ~~~~0) 0 O ~ ~~~ aU a). o 0 0~~~~~~~~~~~~~c Quarter Eiding 2.32 Throughout 1996, when the numbers 'private domestic banks remained near 60, their share of total deposits increased, and at a pace commensurate with that for the foreign-owned banks (whose number also did not change). Depositors' perceptions of the private domestic banks that remained, therefore, does no )pear to have been negative. The deposit insurance program of April, 1995 no doubt pldyed a role, but that program does not cover large depositors and has accumulated only limited premia for potential bail- outs. It would seem unlikely that deposit insurance can account entirely for the slight mid- period increase in the share of deposits to private domestic banks. The consolidation process likely deserves some credit. The point is important because, as will become clearer later, the post-merger performance of many of the private domestic banks has not been impressive. To attribute those failings to the merger process itself, however, would not be justified, especially when the deposits data suggest that the consolidation may have improved depositor perceptions and thus contributed to stability. 2.33 Foreign acquisitions in 1996 and 1997 account for the late-period decline in the number of private domestic banks (Figure 4). The private domestic banks that were acquired were relatively large ones. The number of foreign-owned banks increased by slightly more than 25 percent (from 30 to 38), while the share of foreign-owned deposits doubled (from 18 to 36 percent). On the flip side, the number of private domestic banks declined by one-sixth (from 60 to 50), while deposit share declined deeply from 43 percent to 25 percent. The decline in private domestic banks' deposit share since December, 1996 was very different from the one in 1995. The post-Tequila shake-out affected smaller,  - 32 - weaker banks that were forced to cease operations; the 1996-97 decline resulted from foreign acquisitions designed, it appears, to obtain large market shares. Figure 4 Number of Banks, By Type, By Quarter, 12194-9/97 120 .. -. .. . Ct -) ''- f 4 ' -4 i: !,f,0.i.: ,,#S i .-, .................... ............ ,E ..., .: . ..:? ..::.. .:.#..:ggggg:g:g .|g g g -gg ...-.. .. ...........- -EERhRi :)L d. , : E LE,# ,, - U ........ .......... ... ...- - ........... , , , ~~~~~~~~~~~. . ,. . . . . . . . . < ,.. . . . . . . . . ,.. . ..,,,,.,,,,,.,.,,,,:l,,,;: S :0:::: 80 . . ? ? ,v ,? , ,,,,,-.......... ................. ........... ?'??????ii????..?i..??: .''' ..' ?? ........?? .:'- ..:'.'. :-.i... '..i .SR..EEEEi.::CD.ii.'f.E:. 100 '.?-i,i,,,-,?,? ?? . ?- ? .:-7 .7 i.7 lT n . .' .: ..: .;::00 .t .. . ? .. . . . . . ;;;.- ?;???.????.;;? .... ..? ; . .- ....:: - : i........ : ........ f:ER EEEEDEDhD.DD? ? E' 60 .?< ?????i ? _ ^??,:,-^,?,,,?,^~~~~~.- .............. . .... i:.....t0- ........ . . ... ..........z e ~~~~~~~~~~~~~~~~~~..??;??. .:; :...'? .. ... ... ... . . . .. . .?.E.E:EER R RRE ELL ..:4 4 . s ... R:;~ :T ..: S ?.~ ~ ~ ~ ~ ~~~~~~~~~~~.. .... ............... . ? 00iiE i;ilil4 i442500Eg: E|f .50.. _ 80 .. .? ...... ..? ..?' -?- ::S :00000tA AS ilSHN7 S : 0Ei .:.. . ? Arg~~~~~fentin bningsecto an discussethei imlica4|ition for systemic4 sai7itye-.: This - ? i?"i i .. . iii iiiiii iiii i .iiSiidiiiiiiiiiiii- :- . -.- ............. - .1.....................a.;_> sectionfleshes out that ov ieidin ............. ......pr - m r d a.....id at o t t e.... m-ajr 6 0 .X *..... W .4$............. typesX of stutua chng -itratoa nty rvaiainfpbi prov'incalbaks ones. Thecomprions withd prividdatbizedfn pubvicw bank may berusomewhatnmisledn inth tyatman of sthemura werne se-u itoedrectioa ceditrto, parivticuario povince,i butinia theks comparisons with private domestic banks also indicate that foreign banks allocate more than twice as large a share of their total credit to the federal district of Buenos Aires (Capital Federal). Roughly 95 percent of foreign banks' credit is directed to either the Capital District or the rest of the province of Buenos Aires.  - 33 - Table 2.5: Allocation of Total Credit Across Provinces, By Bankl Type Bank Type Capital Federal Otlier Buenos Cordoba Remaining (%) Aires Provinces (%) (%) (%) Foreign 88.5 6.1 1.8 3.5 Priv Domestic 40.8 17.1 11.5 30.6 Public 18.1 4.3 6.2 71.0 Privatized 6.5 0.0 0.0 93.5 2.36 Data in Cull (1998)3