Rating Banks in Emerging Markets: What Credit Rating Agencies Should Learn from Financial Indicators

The rating agencies' and bank supervisors' records of prompt identification of banking problems in emerging markets has not been satisfactory. This paper suggests that such deficiencies could be explained by the use of financial indicators that, while appropriate for industrial countries, do not work in emerging markets. Among the conclusions, this paper shows that the most commonly used indicator of banking problems in industrial countries, the capital-to-asset ratio, has performed poorly as an indicator of banking problems in Latin America and East Asia. This is because of (a) severe deficiencies in the accounting and regulatory framework and (b) lack of liquid markets for bank shares, subordinated debt and other bank liabilities and assets needed to validate the "real" worth of a bank as opposed to its accounting value. In spite of these problems, an appropriate set of indicators for banking problems in emerging markets can be constructed. But such a system should be based not on the quality of banks loans or on levels of capitalization, but on the general principle that good indicators of banking problems are those that reveal the "true" riskiness of individual banks because they are based on markets that work rather than just relying on accounting figures. Of the alternative indicators proposed in this paper, interest rate paid on deposits and interest rate spreads have proven to be strong performers. In contrast to the interpretation of banks' spreads in industrial countries, low spreads in emerging markets have not always indicated an increased in bank efficiency. Instead, low spreads have often reflected the high-risk taking behavior of weak banks. A difficulty that rating agencies may encounter in considering the suggested approach in this paper is that the methodology implies that the appropriate indicators of banks' performance evolve over time as markets develop and that, given large differences among emerging markets, a single set of indicators will not "fit all". The basic principle that "indicators work where markets work" is the leading guide to the selection of effective indicators. In spite of these considerations, we believe that in facing the trade-off between "uniformity across countries" and "effective indicators", rating agencies would be better off by focusing on the latter.

Towards a Sustainable FTAA: DOes Latin America Meet the Necessary Financial Preconditions?

This paper focuses on identifying preconditions that will ensure the sustainability of a Free Trade Area of the Americas (FTAA). It argues that the macro, micro, and political conditions advanced in the literature to measure a country's ability to compete internationally, while necessary, are not sufficient to ensure the success and permanence of a free trade agreement. Instead, two additional financial conditions are needed. The first is that each partner in the free trade area needs to have sustainable public debts as determined by the achievement of credible and sustainable structural fiscal balances. The second is that exchange rate regimes across trading partners should be compatible in the sense that adverse shocks in one country do not generate a policy dilemma in other partners between abandoning their exchange rate system or the free trade area. A preliminary analysis of the evidence in the Latin American and Caribbean region shows the importance of these two preconditions. An analysis of debt sustainability reveals that there are a number of countries in the region that need to deal with potential solvency problems before reaching the status of credible partners in a regional trade arrangement. Argentina is already deemed insolvent, and countries such as Ecuador and Venezuela rank high on the list of countries where the issue of debt sustainability can become a serious problem. Not resolving this before reaching a regional trade agreement can threaten its long-term stability. The examination of the compatibility of exchange rate systems across trading partners is also very revealing. Part of the success of NAFTA since the late 1990s and the "impasse" of Mercosur during 1999-2001 had to do with the choices of exchange rate regimes. In both trade areas the share of trade among the partners is very high, and in NAFTA, this includes significant financial transactions. While Mexico was able to use the flexibility of the exchange rate to improve competitiveness following the sharp decline of portfolio flows from US investors into Mexico following the Asian and Russian crises, Argentina had no mechanisms to deal with an adverse shock from Brazil (such as a depreciation of the real in 1999). From this perspective, the recent move of Argentina towards a more flexible exchange rate system is good news for a sustainable free trade area.

Financial Regulations in Developing Countries: Can they Effectively Limit the Impact of Capital Account Volatility?

This paper identifies two alternative forms of prudential regulation. The first set is formed by regulations that directly control financial aggregates, such as liquidity expansion and credit growth. An example is capital requirements as currently incorporated in internationally accepted standards; namely capital requirements with risk categories used in industrial countries. The second set, which can be identified as the “pricing-risk-right” approach, works by providing incentives to financial institutions to avoid excessive risk-taking activities. A key feature of this set of regulations is that they encourage financial institutions to internalize the costs associated with the particular risks of the environment where they operate. Regulations in this category include ex-ante risk-based provisioning rules and capital requirements that take into account the risk features particular to developing countries. This category also includes incentives for enhancing market discipline as a way to differentiate risk-taking behavior between financial institutions. The main finding of the paper is that the first set of regulations—the most commonly used in developing economies-- have had very limited usefulness in helping countries to contain the risks involved with more liberalized financial systems. The main reason for this disappointing result is that, by not taking into account the particular characteristics of financial markets in developing countries, these regulations cannot effectively control excessive risk taking by financial institutions. Moreover, the paper shows that, contrary to policy intentions, this set of prudential regulations can exacerbate rather than decrease financial sector fragility, especially in episodes of sudden reversal of capital flows. In contrast, the paper claims, the second set of prudential regulation can go a long way in helping developing countries achieving their goals. The paper advances suggestions for the sequencing of implementation of these regulations for different groups of countries.regulation, liquidity, credit growth, pricing-risk-right, financial institutions, capital flows, developing countries

Can International Capital Standards Strengthen Banks in Emerging Markets?

Who should determine banks' capital standards: authorities or markets? What is the right definition of core capital: equity only or equity plus subordinated debt? Can the assessment of banks' individual credit risks by external rating agencies be of equal or better quality than the assessments derived from banks' own internal rating systems? These are some of the key financial regulatory issues currently being discussed by analysts in industrial countries, especially in the context of the proposed modification to the Basel Capital Adequacy Accord: Basel II is expected to replace the original 1988 Accord. With a few exceptions, these issues are certainly not at the center of the debate in emerging market financial circles. There, the financial issues at hand depend on the country's level of development. For the least developed countries, reform agendas are just advancing in the implementation of accounting standards, disclosure, and other principles of bank supervision; Basel II is certainly not in the medium-term future. If anything, implementation of the original Accord is the issue. The more advanced emerging economies face a different dilemma. Albeit at very different paces, most of these countries embarked on a financial sector reform process in the early 1990s. One of the most important efforts by individual countries, also strongly supported by multilateral organizations, has been the adoption of the recommendations on capital adequacy requirements by the Basel Committee on Banking Supervision. However, in spite of significant advances in implementation, banking crises have abounded in emerging markets during the 1990s and early 2000s. Not surprisingly, some disillusion with a "traditional" reform agenda has emerged. A key debate, therefore, centers on assessing whether regulatory standards that work in industrial countries are appropriate for emerging markets. Among the most relevant issues are: (a) Can an early warning system of banking crisis particular to emerging markets be constructed? (b) How should capital adequacy ratios be designed in emerging markets? Should they diverge from the recommendations of Basel? And, (c) rather than focusing on "strengthening" banks, shouldn't emerging markets limit the role of banks, and instead, focus on the development of corporate bond markets? This paper deals with the appropriateness for emerging markets of implementing capital requirements as recommended by the Basel Committee on Banking Supervision. The paper is part of a research agenda that I initiated in the late-1990s. In my previous research I concluded that such capital standards have had very little usefulness as a supervisory tool in emerging markets. For fundamental reasons that go beyond the improvements in regulatory procedures, and, instead center on the particular features of financial sectors in many emerging economies, the capital-to-asset ratio has not been a useful early warning indicator of banking problems.

Price And Output Fluctuations In An Economy With A Limited Capital Market

This thesis sets out a rational-expectations model of an economy in which firms are constrained to finance their advances to labor and their purchases of commodity inputs by borrowing from a domestic banking system, which constitutes the entire financial system of the economy. The major implication of this financial constraint is that the supply of output comes to depend positively on the real monetary base.;In the closed economy version of the model, a fully anticipated increase in the rate of growth of the monetary base or an anticipated temporary decrease in the level of the monetary base reduces the equilibrium level of output and affects the real wage rate and the real interest rate. Thus, money is not superneutral and the Fisher effect does not hold. In addition, permanent monetary shocks, mistakenly viewed as temporary, also have real effects.;The open economy version of the model distinguishes between tradable and nontradable goods. Here it is shown that the effect of changes in the exogenous variables on the levels of output can be decomposed into a financial constraint effect and a relative price effect .;Under flexible exchange rates, the financial constraint effect always dominates the relative price effect. Hence, any monetary changes that leads to a decrease in output in the closed economy case, also leads to a decrease in the levels of output of both goods in the flexible exchange rate case. In addition, a permanent monetary decrease, mistakenly viewed as temporary, causes the exchange rate to overshoot relative to its full current information level.;Under fixed exchange rates, the output effects of anticipated changes in exogenous variables depend on the importance of the financial constraint effect as compared to the relative price effect. If the financial constraint effect is strong enough, an anticipated rise in the level of the government debt will increase the output of both commodities, while an anticipated rise in the price level of the tradable good or an anticipated devaluation will reduce them. Finally, neither unanticipated changes in the price level of the tradable good, nor an unanticipated devaluation affect the current level of output of either commodity. Both might lead to a contraction of output of both commodities in subsequent periods, however

Financial Integration and Foreign Banks in Latin America: How Do They Impact the Transmission of External Financial Shocks?

This paper explores the impact of international financial integration on credit markets in Latin America, using a cross-country dataset covering 17 countries between 1996 and 2008. It is found that financial integration amplifies the impact of international financial shocks on aggregate credit and interest rate fluctuations. Nonetheless, the net impact of integration on deepening credit markets dominates for the large majority of states of nature. The paper also uses a detailed bank-level dataset that covers more than 500 banks for a similar time period to explore the role of financial integration—captured through the participation of foreign banks—in propagating external shocks. It is found that interest rates charged and loans supplied by foreign-owned banks respond more to external financial shocks than those supplied by domestically owned banks. This does not hold for all foreign banks. Spanish banks in the sample behave more like domestic banks and do not amplify the impact of foreign shocks on credit and interest rates.Foreign Banks, Credit, Interest Rates, Financial Shocks

Credit at Times of Stress: Latin American Lessons from the Global Financial Crisis - Working Paper 289

The financial systems in emerging market economies during the 2008–09 global financial crisis performed much better than in previous crisis episodes, albeit with significant differences across regions. For example, real credit growth in Asia and Latin America was less affected than in Central and Eastern Europe. This paper identifies the factors at both the country and the bank levels that contributed to the behavior of real credit growth in Latin America during the global financial crisis. The resilience of real credit during the crisis was highly related to policies, measures and reforms implemented in the pre-crisis period. In particular, we find that the best explanatory variables were those that gauged the economy’s capacity to withstand an external financial shock. Key were balance sheet measures such as the economy’s overall currency mismatches and external debt ratios (measuring either total debt or short-term debt). The quality of pre-crisis credit growth mattered as much as its rate of expansion. Credit expansions that preserved healthy balance sheet measures (the “quality” dimension) proved to be more sustainable. Variables signalling the capacity to set countercyclical monetary and fiscal policies during the crisis were also important determinants. Moreover, financial soundness characteristics of Latin American banks, such as capitalization, liquidity and bank efficiency, also played a role in explaining the dynamics of real credit during the crisis. We also found that foreign banks and banks which had expanded credit growth more before the crisis were also those that cut credit most. The methodology used in this paper includes the construction of indicators of resilience of real credit growth to adverse external shocks in a large number of emerging markets, not just in Latin America. As additional data become available, these indicators could be part of a set of analytical tools to assess how emerging market economies are preparing themselves to cope with the adverse effects of global financial turbulence on real credit growth.Latin America, credit growth, global financial crisis, emerging markets, financial resilience, vulnerability indicators

Integración financiera en Centro América: Nuevos desafíos en el contexto de la crisis internacional

Este documento analiza la importancia de la integración financiera en Centro América, enfatizando los efectos de la actual crisis internacional sobre los sistemas financieros de la subregión. Después de presentar evidencia sobre la integración financiera en Centro América y la compara con otros países de América Latina y otras regiones del mundo en vías de desarrollo, se describen dos factores importantes que han caracterizado el proceso de integración financiera en la última década y se analizan los efectos de la integración financiera y de la participación de la banca extranjera. Motivado por la actual crisis internacional, se enfatiza la respuesta de las variables financieras locales a shocks financieros internacionales. Finalmente, el documento deriva conclusiones y adelanta recomendaciones de política económica.Integración financiera, Sistemas financieros, Centro América

Capital Mobility and Exchange Market Intervention in Developing Countries

This paper develops a new technique for measuring changes in the degree of capital mobility confronting a developing country that has restrictions on capital flows and official ceilings on domestic interest rates. Because such official controls rule out the use of traditional interest rate parity conditions to measure changes in the degree of capital mobility, the analysis first examines an intertemporal model of an open economy. This model describes the linkages between the cost of undertaking disguised capital flows, the current account, capital controls, domestic and external financial market conditions, and the authorities' foreign exchange market interventions. The model suggests a means of measuring changes in the cost of undertaking disguised capital flows, based on the past history of differentials between external interest rates (adjusted for exchange rate changes) and domestic ceiling interest rates, provided that the authorities' foreign exchange market activities are incorporated into the analysis. Parameter estimates for Korea, Mexico, and the Philippines indicate that the real cost of undertaking disguised capital flows declined on average by nearly 70 percent between the early 1970s and the late 1980s.