Can emerging market bank regulators establish credible discipline? the case of Argentina, 1992-1999

Can Emerging Market Bank Regulators Establish Credible Discipline ? The Case of Argentina, 1992-1999 Charles W. Calomiris and Andrew Powell May 2000 Abstract In the early 1990s, after decades of high inflation and financial repression, Argentina embarked on a course of macroeconomic and bank regulatory reform. Bank regulatory policy promoted privatization, financial liberalization, and free entry, limited safety net support, and established a novel mix of regulatory and market discipline to ensure stable growth of the banking system during the liberalization process. Argentina suffered some fallout from the Mexican tequila crisis of 1995, but its response to that crisis (allowing weak banks to close) and the redoubling of regulatory efforts to promote market discipline after the crisis made Argentina's banking system quite resilient during the Asian, Russian, and Brazilian crises. Argentina's bank regulatory system now is widely regarded as one of the two or three most successful among emerging market economies. This paper traces the evolution of the regulatory policy changes of the 1990s and shows that the reliance on market discipline has played an important role in prudential regulation by encouraging proper risk management by banks. There is substantial heterogeneity among banks in the interest rates they pay for debt and the rate of growth of their deposits, and that heterogeneity is traceable to fundamental attributes of banks that affect the riskiness of deposits (i.e. asset risk and leverage). Moreover, market perceptions of default risk are mean-reverting, indicating that market discipline encourages banks to respond to increases in default risk by limiting asset risk or lowering leverage. First author : Paul M. Montrone Professor of Finance and Economics, Columbia Business School, Research Associate, National Bureau of Economic Research. Second author : Chief Economist of the Central Bank of Argentina. The views expressed in this paper are those of the authors and do not necessarily represent the views of the Central Bank of Argentina or any other institution. We wish to thank Tamara Burdiso and Laura D'Amato for excellent assistance with the econometric analyses presented in this research. We thank our discussant Douglas Diamond, other conference participants, and Charles Himmelberg and Alejandra Anastasi for helpful comments and discussions. All mistakes naturally remain our own.  I. Introduction In common with many other emerging market countries, Argentina's banking sector was liberalized in the 1990s. That liberalization followed decades of severe "financial repression." The return to deposits placed in banks previously was substantially negative; if $100 worth of deposits had been placed in an Argentine bank in 1944, it would today be worth roughly 3 cents in real terms today (and 1 cent in 1990).1 As recently as 1990, bank deposits were frozen as part of an emergency fiscal adjustment. As elsewhere, liberalization involved lifting controls on interest rates, deregulation of the banking sector, allowing the entry of foreign capital, privatization and adopting international regulatory standards. Nevertheless, the experience of the Argentine banking sector over the past decade has been unique in several respects. Many observers view Argentina's reforms as among the most radical attempts to overhaul a banking system. Traditionally in Argentina, credit was allocated either to the public sector or through public intervention to specific sectors or projects in the private sector. Moreover, the banking sector suffered from ineffective regulation and supervision and repeated, forced government rescues contributed significantly to Argentina's past fiscal and inflationary problems. In contrast, many have argued that today there is a credible, restrictive safety net and high regulatory and supervisory standards. For example, as shown in Table 1, one World Bank study rated Argentina's regulatory regime on par with Hong Kong, second only to Singapore, and higher than the longer-lived and much-admired regime in Chile2. In particular, the Argentine system is praised for its attempt to introduce elements of private market discipline as a central component of its regulatory regime. Table 1. World Bank Comparison of Bank Regulatory Quality in Developing Economies Total Capital Loan Foreign Liquidity Operating Transparency Country Score Position Classification Ownership Environment (management) Singapore 16 1 6 2 5 1 1 Argentina 21 1 4 3 4 7 2 Hong Kong 21 3 9 1 2 2 4 Chile 25 5 1 4 8 5 2 Brazil 30 7 3 4 3 8 5 Peru 35 5 2 6 1 11 10 Malaysia 41 5 9 8 8 3 8 Colombia 44 3 4 11 6 10 10 Korea 45 7 9 10 11 3 5 Philippines 47 4 6 7 7 11 12 Thailand 52 7 12 12 8 6 7 Indonesia 52 7 8 9 12 8 8 Source: World Bank (1998), p. 54. Numbers indicate rankings, where low numbers mean high ranking. The total score is a simple average of the six categories. 1Central Bank estimates. 2We note, however, that Chile has since revised and strengthened its capital requirements on banks.  Private market discipline is enhanced by the following policies: (a) A strictly limited safety net (comprised of a privately funded, limited deposit insurance scheme and restrictions on the Central Bank's potential lender of last resort powers) exposes bank depositors to the possibility of loss. (b) High and credible minimum risk-based capital requirements further ensure that stockholders (rather than taxpayers) bear the risk of bank default. (c) National government programs encourage the privatization of provincial government-owned banks. (d) A credit rating scheme has been introduced whereby each bank must solicit a credit rating from an internationally active rating agency. (e) A subordinated debt requirement mandates that banks must issue a subordinated liability for some 2% of deposits each year. (f) Banks must satisfy a "liquidity requirement" in addition to the capital requirement. This not only reduces portfolio risk, ensures systemic liquidity, and further reduces the potential for taxpayer loss from failed banks, but (because of the structure of the requirement) rewards banks with lower regulatory cost when the market perceives that their risk of failure is low. (g) The Central Bank publishes basic information about bank loans to individuals and firms that borrow from banks (which enhances transparency of credit risk). (h) The quality of accounting data is enhanced by mandatory private audits conducted according to Central Bank guidelines, and auditors must post a forfeitable bond. (i) Argentina permits free entry and competition among foreign and domestic banks, which not only encourages the efficient management of banks, but also enhances the ability of bank depositors to punish weak banks by moving their funds to stronger institutions. The Argentine system's high marks from the World Bank also reflect the fact that the regulatory reforms put in place in the early and mid-1990s have been tested by external shocks.The reactions of the banking authorities to those shocks have been encouraging to advocates of market discipline. Rather than retreating from the reform process in the face of the "tequila" crisis of 1994-1995, the Argentine authorities redoubled their efforts to ensure that market discipline prevailed in the banking system. Indeed, many of the features of the current regulatory system listed above were enacted or strengthened after the tequila crisis, as part of a new plan for bank oversight developed at the central bank, which is known as the B.A.S.I.C. system of bank regulation. We define the key elements of that system, and explain its evolution, in Section II below. These included the new liquidity requirement system (replacing a more traditional reserve requirement approach), capital requirements that reflect banks' trading risks and banking book interest rate risks, an expansion of the publicly available database on the condition of bank borrowers, as well as the minimum mandatory subordinated debt and credit rating requirement. The authorities have also negotiated a contingent liquidity facility with international banks in order to be able to inject emergency liquidity on the basis of Argentine collateral in the case of a sharp, systemic, liquidity shock (this facility currently stands at some $6.45bn excluding a $1bn World Bank/IDB enhancement). Also over this period there was significant entry of foreign capital to the banking system such that, at the time of this writing, some 60% of private sector deposits are now in banks under foreign control, accounting for some 40% of the whole system. There remains only one large (top 8) private retail bank that does not have a foreign controlling interest. The only policy reaction to the 1995 crisis that could be construed as a weakening of the commitment to market discipline was the reestablishment of deposit insurance. But the significance of this change for market discipline should not be exaggerated. In November 1992, 2  Argentina abolished its deposit insurance system. When the tequila crisis of 1994-1995 hit, Argentina reestablished limited insurance for small deposits, but it did not retreat on its commitment to market reform by bailing out insolvent banks. Banks suffered large outflows of deposits during 1995 (see BCRA 1995 and D'Amato, Grubisic and Powell 1997 for an analysis). While some critics have pointed to government-assisted acquisitions of banks as a partial bailout of some institutions, it is important to emphasize that, as we describe in detail below, several banks were allowed to fail in the wake of the tequila crisis and that there have been subsequent failures too (see Anastasi, Burdiso, Grubisic and Lencioni 1998). In some of these cases, depositors and other creditors suffered significant losses. During the recent crises in Asia, Russia, and Brazil, Argentina suffered significant macroeconomic fallout, and thus bank deposit growth and credit growth have slowed and interest rates have risen, as shown in Figure 1 (which plots deposit growth, the sovereign yield, and an index of economic activity). In contrast to some other emerging countries, however, the weakness of the banking sector has not itself been a source of macroeconomic problems, foreign exchange attack, or capital flight. Indeed, it is widely perceived that the banking sector as a whole has weathered these storms extremely well, even though some individual banks have been weakened. That record has added to confidence in the credibility of regulation. Figure 1: Deposits, Economic Activity and Country Risk Index 1997=100 Basis Points 140 1100 1000 130 900 120 800 700 110 600 100 500 400 90 300 80 200 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Deposits Industrial Activity Argentine Country Risk In large part, the apparent success of Argentina's banks reflects unique circumstances of history and the current political environment. In particular, Argentina's experience prior to the 1990s with inflation, financial repression, large bank rescues and low quality in terms of banking services created widespread popular support for the continuation of the currency board as an inflation-fighting tool, a restricted safety net for banks and tight fiscal discipline. These factors reduced the temptation to bail out financial institutions during the recent crises and also implied that the authorities could allow a significant increase of foreign capital in the sector without fear of any political or popular backlash. Indeed, one puzzle is that although the sector was opened 3  significantly in 1992, and the rest of the economy received large injections of foreign capital between 1992 and 1996, it was only in the years 1997 and 1998 that the banking system saw a very significant increase in foreign capital. One hypothesis is that these international banks waited until the system was tested by its first major external shock before making such significant investment decisions. Despite this record of apparent success, the reforms and transformation of the banking system have not gone without criticism. Some have suggested that the enactment of limited deposit insurance was unnecessary and counterproductive, that more institutions should have been allowed to fail, and that some assisted mergers, particularly during the tequila period, simply delayed a problem rather than solving it (see World Bank (1998)). Other critics have suggested that Argentina's banking regulations are too tight (in particular capital, liquidity and provisioning) and have diminished banking sector returns and placed the sector at a disadvantage with respect to foreign banks. Other criticisms refer to particular regulations. Some suggest, for example, that a regulatory authority should not establish requirements for the private rating of banks. Others suggest that the effectiveness of the obligation to issue subordinated debt, and therefore, market discipline, has been reduced because the penalties for non-compliance have been lowered