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© 2008 International Monetary Fund WP/08/135
IMF Working Paper
Monetary and Capital Markets Department
Central Bank Involvement in Banking Crises in Latin America
Prepared by Luis I. Jácome H.1
Authorized for distribution by Peter Stella
May 2008
Abstract
This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author and are published to elicit comments and to further debate.
This paper reviews the nature of central bank involvement in 26 episodes of financial disturbance and crises in Latin America from the mid-1990s onwards. It finds that, except in a handful of cases, large amounts of central bank money were used to cope with large and small crises alike. Pouring central bank money into the financial system generally derailed monetary policy, fueled further macroeconomic unrest, and contributed to simultaneous currency crises, thereby aggravating financial instability. In contrast, when central bank money issuance was restricted and bank resolution was timely executed, financial disturbances were handled with less economic cost. However, this strategy worked provided appropriate institutional arrangements were in place, which highlights the importance of building a suitable framework for preventing and managing banking crises. JEL Classification: E44, E52, E58, N26 Keywords: Central banks, monetary policy, banking crises, financial instability
Authors’ E-Mail Addresses: [email protected]
1 I would like to thank for valuable comments Zsofia Arvai, Rodolfo Maino, Fabián Valencia, participants at the IMF’s Monetary and Capital Markets Department internal seminar and, in particular, Alain Ize, Peter Stella, and Francisco Vázquez. Remaining errors and omissions are my sole responsibility.
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Contents Page
I. Introduction....................................................................................................................3
II. Taking Stock of Banking Crises in Latin America........................................................5 A. Defining Banking Crises...........................................................................................5 B. The Roots of the Crises .............................................................................................6 C. Some Stylized Macroeconomic Facts Accompanying Banking Crises ..................12
III. The Role of Central Banks in Banking Crises in Latin America.................................15 A. Intensive Use of Central Bank Money....................................................................15 B. The Role of the Institutional Framework ................................................................20
IV. Macroeconomic Repercussions ...................................................................................28 A. On Monetary Policy ................................................................................................28 B. On Macroeconomic Stability ..................................................................................32
V. Lessons and Concluding Remarks ...............................................................................37
References................................................................................................................................47 Tables 1. Banking Crises in Latin America and Relevant Macro-Financial Features ........................13 2. Modalities of Monetization of Banking Crises....................................................................16 3. Institutional Framework behind Banking Crises in Latin America .....................................23 4. Pair-Wise Correlations Between Selected Variables...........................................................33 5. Monetization of Banking Crises, Inflation, and Economic Growth ....................................36 Figures 1. Capital Flows and Banking Crises in Latin America.............................................................7 2. Financial Reform and Banking Crises in Latin America.......................................................8 3. Real Effective Exchange Rate and Banking Crises in Latin America...................................9 4. Banking Crises and Real Credit Growth..............................................................................11 5. Large Banking Crises in Latin America—Selected Episodes .............................................19 6. Minor and Moderate Banking Crises in Latin America—Selected Episodes......................21 7. Performance of the Money Multiplier in the Midst of Banking Crises in Latin America...31 8. Banking Crises and Central Bank Money............................................................................34 9. Central Bank Money in Banking Crises and Currency Depreciation ..................................34 10. Central Bank Money in Banking Crises and Fall in International Reserves .....................35 Boxes 1. Large "Monetization" of Banking Crises in Selected Countries .........................................26 2. Effective Episodes of Bank Restructuring and Resolution in Selected Countries...............27 3. Banking Crises and Monetary Policy ..................................................................................29 Appendix I. Sample of Episodes of Banking Crises in Latin America from 1990 to 2006—Stylized Facts and Policy Response.......................................................................................................39
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I. INTRODUCTION This paper assesses 26 events of central bank involvement in episodes of financial turmoil and crises in Latin America since the mid-1990s, reviews their main macroeconomic repercussions, and distills lessons applicable to future crises.2 It examines both idiosyncratic and systemic events, including episodes that did not turn into full-fledged banking crises due to early government responses, and emphasizes the role played by central banks in managing financial market turmoil. This document sets the stage for future empirical work, which may seek to address policy related questions. Central banks participated in banking crises by providing limited and extended liquidity assistance as lender-of-last-resort (LLR), and also by financing bank resolution. In a number of these events, central banks were required to participate in the official response to banking crises amid fears of a systemic impact that could lead to the collapse of the payments system (Argentina and Uruguay in 2002 are relevant examples). However, they were also required to inject money—beyond limited LLR assistance—to cope with idiosyncratic events. Episodes of financial instability in Dominican Republic (1996), Guatemala (2001), and Honduras (1999) are cases in point. The use of large amounts of central bank money was an empirical regularity, except in a handful of cases. However, pouring central bank money into the financial system derailed monetary policy and fueled further macroeconomic unrest, thereby exacerbating banks’ instability and, on many occasions, triggering simultaneous currency crises. Central bank involvement sometimes also created microeconomic distortions since the assistance provided served to bail out not only small but also large bank depositors, which eventually induced moral hazard and relaxed market discipline. In a small number of cases, governments managed effectively market turmoil without resorting to large amounts of central bank money, which limited the escalation of financial instability. Nonetheless, this was only possible provided adequate institutional arrangements were in place or timely introduced. The intensive use of central bank money was mainly the result of institutional weaknesses that did not allow governments to address banking problems at an early stage.3 It may also have been induced by governments as they tried to avoid using—or at least postponing in the short-term—the use of tax payers’ money to finance the cost of resolving the crisis. When central banks financed the cost of the crises they sometimes incurred large losses, which eventually wiped out their capital without compensation from government. As a result,
2 The systemic banking crises that hit a number of countries in the region during the early to mid-1980s have been extensively analyzed before. See for example Sundararajan and Balino (1991) and Rojas-Suarez and Weisbrod (1995). 3 Most Latin American countries modernized central bank and financial institutions legislation during the 1990s. While the former sought to enhance central banks’ autonomy to abate inflation, the latter liberalized financial markets with the aim of fostering economic growth. The new legislation, however, did not provide a suitable framework to cope with major banking problems.
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central banks operational autonomy became undermined because they were unable to credible commit to successfully tighten liquidity as needed. On the other hand, in those episodes in which central bank money was banned or provided only in limited amounts, major macroeconomic instability was avoided. This alternative approach helped to handle financial disturbance more effectively, thereby minimizing fiscal costs. However, countries could only follow this strategy provided they had in place—or managed to rapidly build—appropriate institutional arrangements (for instance in Argentina (1995), Peru (1999), and Colombia (1999)). A strong macroeconomic position—in particular solid public finances—and a sound financial system also contributed to avert a major banking crisis and limited resolution costs and side effects. Despite its potentially negative effects, the role of central bank money in episodes of financial turmoil is an issue that has been marginally addressed in the literature.4 Although the multiplication of banking crises in recent decades has motivated a large number of studies, they primarily have stressed the identification of early warning indicators, the dynamics of banking crises and their aftermath on a country or regional basis, or the link between banking and currency crises.5 From a microeconomic standpoint, these studies mostly addressed issues such as the government response to banking crises and their fiscal cost, the role of supervision and regulation in explaining banking crises’ eruption and contagion, and the nature of financial restructuring policies.6 This paper helps to fill this gap as it highlights the perils of an excessive use of central bank money to contain a banking crisis—rather than resorting to bank resolution on a timely basis. It also stresses the need to build suitable institutional bases to prevent and manage financial crises—although providing a detailed set of recommendations is beyond the scope of this paper. However, the conclusions of the paper are subject to some caveats. While recognizing their impact in shaping the dynamics of the crises, the countries’ macroeconomic strength and the multilateral international support—most typically from the IMF—at the time of the crises are not factored into the analysis. Similarly, the role played by foreign banks is not addressed.7 Also, the paper does not examine the soundness of the countries’ banking system, which is relevant in those crises that were triggered by an adverse exogenous shock. 4 Only a few studies examine this important issue. See, for example, Dziobeck and Pazarbaşioğlu (1997) who analyze the management of banking crises, including the role of central banks. 5 See for example the comprehensive work on early warning indicators by Goldstein and others (2000). On the dynamics of banking crises, see the work by Collyns and Kincaid (2003).Also Kaminsky and Reinhart (1999), who stress the link between banking and currency crises. 6 See for example the review on how governments managed banking crises by Hoelscher and Quintyn (2003), the analysis by de Juan (1996) on the microeconomic roots of banking crises, and Calomiris and others (2005) for a taxonomy of resolution mechanisms applied to cope with banking crises. 7 This issue is discussed, for example, by Arena and others (2006) based on a sample of more than 1,500 banks from Asia and Latin America.
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The rest of the paper is organized as follows: section II identifies episodes of financial instability and banking crises in Latin America since the mid-1990s and points out macroeconomic features that may have exacerbated the costs of the crises; section III discusses the nature of central bank involvement in those crises; section IV analyzes macroeconomic repercussions; section V draws lessons and concludes.
II. TAKING STOCK OF BANKING CRISES IN LATIN AMERICA After decades of high inflation, governments across the region implemented sound macroeconomic—and in particular fiscal—policies. However, with inflation in decline and, in many cases, following sudden stops and reversals of capital inflows, banking crises hit almost all countries in the region, thereby inflicting significant economic costs. This section identifies main episodes of banking crises in Latin America, highlights their roots, and ascertains whether common macroeconomic factors were present at the time of the crises, which may have exacerbated financial instability.
A. Defining Banking Crises Banking crises have been recurrent events in Latin America and, hence, became the main source of macroeconomic instability during the last 15 years.8 Since 1990, only Chile and Panama have been immune to financial instability, with a number of countries suffering periods of financial turmoil more than once (Argentina, Bolivia, Dominican Republic, Ecuador, Honduras, Guatemala, and Paraguay), and going back to the 1980s, not a single country escaped from this curse. However, instability was more frequent during the early-1980s in the wake of the regional debt crisis, the mid and late-1990s, and the early 2000s. While these events were widespread, not all of them were equally intense. Some countries experienced idiosyncratic problems whereas others suffered full-fledged systemic crises. This paper defines banking crises in a broader sense than is usually found in the literature as it considers full-fledged financial crises and also idiosyncratic events. In particular, banking crises are defined in this paper as those events where at least one institution was intervened and/or closed, or was subject to resolution. Based upon this broad definition, the paper assesses 26 episodes of banking crises in Latin America between the mid-1990s and 2007 (see in Appendix I a brief description of the main stylized facts and the government’s response in each event). Based on the above definition, banking crises are clustered by size into two groups, large and systemic crises and minor and moderate ones.9 The paper discriminates between the two
8 Latin America also seems to have suffered a disproportionate number of banking crises compared with other regions in the world (Carstens and others, 2004). 9 Similar criteria are applied by Caprio and Klingebiel (2002)—they call “systemic” and “borderline and smaller crises”—and Lindgren and others (1996), who make references to “crises” and “significant problems.”
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groups depending on the market share of the failing banks—measured by assets or deposits before the crises erupted. To draw the line between the two groups, a working assumption is adopted, namely setting a threshold of 15 percent market share of the troubled banks. Also as a working assumption, troubled banks are assumed to encompass those institutions that were intervened or subject to bank resolution, plus other institutions that received government support or extended emergency assistance from the central bank—in an amount that exceeded their individual equity. The proposed analysis departs from previous studies because it applies an ex-ante approach when defining and measuring banking crises. By adopting this approach we also incorporate into the analysis events of financial instability that were tackled at an early stage, and hence, did not turn into full-fledged banking crises. These events have not been studied in the banking crises literature. However, they are worth analyzing for the purposes of this paper as they allow to ascertain the role played by central banks in these events and, in particular, because they allow to draw lessons from what can be considered successful cases of banking crises management. Admittedly, other measures of the size of banking crises could also have been used, like the amount of deposit withdrawals or the fiscal cost of the crises.10 However, they pose measurement problems and, therefore, may not provide reliable and comparable information across countries for a number of reasons. Using deposit withdrawals as a measure of the size of banking crises, when a generous financial safety net exists or it is introduced as the crisis unfolds, may underestimate the magnitude of the run on deposits. This may happen if, for instance, off-balance sheet liabilities become part of the official balance sheet of banks as they seek coverage from large deposit insurances or from a blanket guarantee in anticipation of a possible closure of banks. In addition, financial dollarization makes it hard to compare across countries the size of the run on deposits in the event of a currency crisis. This is because comparing deposit withdrawals requires converting into the local currency the value of deposit withdrawals in the dollarized country, which necessarily captures the effect of the exchange rate devaluation. In turn, the inter-temporal nature of the recovery of impaired assets and the difficulties of measuring over time the welfare losses associated with banking crises introduces noise to the calculation of the fiscal costs of banking crises.
B. The Roots of the Crises While there is no single reason beneath all recent Latin American banking crises, the “boom and bust cycle” probably explains most, in particular those classified in this paper as large and systemic. From a microeconomic perspective, “bad banking practices” in an environment 10 There is no standard way of characterizing the size of banking crises in the literature. A number of approaches are found depending on the objective of the study. Crises are typically measured in terms of a given scale of fiscal costs, the share of systemic deposit withdrawals, or the proportion of banks’ capital exhausted. See, for example, Lindgren and others (1996), Demirguc-Kunt and Detragiache (1997), and Bordo and others (2001).
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of weak supervision fueled many episodes of financial instability in the region. In addition, specific macroeconomic features or given initial economic conditions seem to have made countries more prone to banking crises. Financial crises were triggered mostly by external shocks, although contagion from within and outside the region played an important role. In addition, economic policy-induced shocks and even political events were triggers. In general, banking crises were associated with waves of capital outflows (Figure 1).
Figure 1. Capital Flows and Banking Crises in Latin America (Years in which Three or More Crises Occurred, 1980-2006)
0
1
2
3
4
5
6
1980 1984 1988 1992 1996 2000 2004
Mor
e th
an 3
cris
es
0
25
50
75
100
Billo
ns o
f US
dolar
s
Banking crises
Net K flows
Source: Private capital flows, IMF World Economic Outlook. For banking crises: Rojas-Suárez and Weisbrod (1995); Lindgren and others (1996); and author’s updates.
Latin America liberalized financial markets during the late-1980s and early-1990s but this reform was not accompanied with stronger financial surveillance. Financial liberalization was part of a far-reaching program of structural reform and was adopted by literally all countries in the region with more or less intensity (Figure 2). At the same time, however, the enforcement capacity of bank regulators remained weak and, therefore, financial surveillance was not strengthened. In an environment of financial liberalization and loose financial supervision, banks developed a variety of new and at times risky products, many of them denominated in foreign currency, which made financial institutions more vulnerable to changes in market sentiment and, hence, to stops and reversals of capital flows. Financial liberalization attracted capital inflows from abroad, which were also encouraged by the increasing macroeconomic stability in the region. Owing to closer links with international financial markets, capital inflows benefited primarily emerging markets, thereby strengthening their domestic currencies (Figure 3) and fueling a wave of downward pressures on interest rates. The combination of capital inflows, real exchange rate appreciations, and interest rate declines created the conditions for a “credit boom” in various financial systems.
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Figure 2. Financial Reform and Banking Crises in Latin America, 1985–2000 Index of Financial Reform and Year of Banking Crisis (dotted line)
Argentina
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Bolivia
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Venezuela
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Uruguay
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Peru
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Paraguay
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Nicaragua
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Mexico
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Honduras
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Guatemala
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
El Salvador
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Ecuador
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Dominican Republic
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Costa Rica
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Colombia
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Brazil
00.10.20.30.40.50.60.70.80.9
1
1985 1988 1991 1994 1997 2000
Index
numb
er
Source: Index of financial reform elaborated by the Inter-American Development Bank
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Fi
gure
3. R
eal E
xcha
nge
Rat
e an
d B
anki
ng C
rises
in L
atin
Am
eric
a, 1
993–
2006
. (R
eal e
ffec
tive
exch
ange
rate
inde
x an
d ye
ar o
f ban
king
cris
es (d
otte
d lin
es))
Argent
ina
20406080100120 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Bolivia
406080100120 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Colom
bia
405060708090100110120130140 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Costa R
ica
8090100110120 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Dominic
an Rep
ublic
406080100120 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Ecuado
r
6090120150180 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
El Salva
dor
406080100120 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Guatem
ala
6080100120140 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Hondur
as
6080100120 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Mexico
406080100120 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Nicara
gua
8090100110120130140 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Paragu
ay
6080100120 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Peru
8090100110120 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
Urugua
y
406080100120 1993M
1199
6M1
1999M
1200
2M1
2005M
1Index number
Venezu
ela
020406080100120 1993M
1199
6M1
1999M
1200
2M1
2005M
1
Index number
So
urce
: IM
F’s I
nfor
mat
ion
Not
ice
Syst
em (r
ow e
reer
).
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The credit boom lasted only until various shocks hit Latin America starting in the mid-1990s, which in many cases led to banking crises. These shocks triggered massive capital outflows, in particular in emerging markets, inducing liquidity and credit crunches (Figure 4). In turn, liquidity shortages brought to the forefront deficiencies in asset quality, which had been acquired as a result of lax credit policies by commercial banks, leading eventually to solvency problems. Domestic political events or economic policy-induced factors led to generalized macroeconomic disarray, including banking crises, in Argentina (2002), Brazil (1994), and Mexico (1995). On the other hand, the crises in Argentina (1995) and in Paraguay and Uruguay in 2002 are clear examples of external contagion, as they were hit by the crises in Mexico—the former—and in Argentina—the other two countries. Similarly, the crises in the Andean countries in the late 1990s (Colombia, Ecuador, and Peru) were triggered by the impact of the Russian and the Brazilian currency crises, which fueled capital outflows. In turn, the crisis in Costa Rica, the Dominican Republic, El Salvador, Guatemala, and Honduras illustrate episodes where solvency problems were the underlying cause and external shocks were mostly absent. The severity of the banking crises was exacerbated by the lack of appropriate institutional arrangements to tackle them at an early stage. The financial reforms adopted in the region during the early 1990s emphasized deregulation with the aim of strengthening financial deepening and promoting free entry and exit of financial institutions. However, the reform did not create a suitable framework for preventing and handling crises and did not lay the ground for the smooth exiting of failing institutions. As a result, banking crises unfolded in a disorderly manner, inflicting high social and economic costs. The central bank reform adopted during the 1990s typically did not assign them a clear role in the institutional framework aimed at preserving financial stability. They fundamentally focused on enhancing central bank political and operational autonomy to fight inflation.11 And, in the event of financial distress, in a number of countries, central banks were empowered with excessive discretion to “monetize” banking crises should a systemic risk emerge. In addition, with few exceptions, the reform did not envisage a need to ensure financial autonomy for central banks, as governments were not obliged to compensate central banks if they lost their capital. Under this institutional setting, most governments in the region resorted to central banks to obtain financing to handle both systemic and idiosyncratic banking crises, without compensating them for their financial losses.
11 See Carstens and Jácome (2005) for a review of the nature of central banks reform in Latin America during the 1990s.
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Figure 4. Banking Crises and Real Credit Growth
(Selected Latin American countries. 0 = initial year of the crisis)
Argentina 1995
-5%
0%
5%
10%
15%
20%
25%
-3 -2 -1 0 1 2
Real
grow
th y/y
Argentina 2001-02
-40%
-30%
-20%
-10%
0%
10%
20%
-3 -2 -1 0 1 2
Real
grow
th y/y
Brazil 1994- 1995
-40%
-20%
0%
20%
40%
60%
80%
-3 -2 -1 0 1 2
Real
grow
th y/y
Colombia 1999
-20%
-10%
0%
10%
20%
-3 -2 -1 0 1 2
Real
grow
th y/y
Dominican Republic 2003
-40%
-30%
-20%
-10%
0%
10%
20%
-3 -2 -1 0 1 2
Real
grow
th y/y
Costa Rica 1994
-20%
-10%
0%
10%
20%
30%
-3 -2 -1 0 1 2
Real
grow
th y/y
Ecuador 1998-99
-30%
-20%
-10%
0%
10%
20%
30%
40%
-3 -2 -1 0 1 2
Real
grow
th y/y
Mexico 1994
-40%
-20%
0%
20%
40%
-3 -2 -1 0 1 2
Real
grow
th y/y
Nicaragua 2001-02
-45%
-30%
-15%
0%
15%
30%
-3 -2 -1 0 1 2
Real
grow
th y/y
Peru 1999
-10%
0%
10%
20%
30%
40%
-3 -2 -1 0 1 2
Real
grow
th y/y
Uruguay 2002
-40%
-30%
-20%
-10%
0%
10%
20%
-3 -2 -1 0 1 2
Real
grow
th y/y
Venezuela 1994-95
-45%
-30%
-15%
0%
15%
30%
-3 -2 -1 0 1 2
Real
grow
th y/y
Source: International Financial Statistics, IMF (22d deflated by 64).
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C. Some Stylized Macroeconomic Facts Accompanying Banking Crises There are a number of macroeconomic features that could have made Latin American countries more vulnerable to banking crises, in particular to systemic events. These features include the prevailing exchange rate regime, financial dollarization, and a weak fiscal position—measured in terms of the country’s debt burden—at the time of the crises. The degree of financial integration with the rest of the world, namely if the country was an emerging market, may be another relevant characteristic (see Table 1). To carry out this preliminary analysis we make specific working assumptions. We discriminate between “hard” peg, “soft” peg, and flexible exchange rate regimes, based on the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions.12 We define financial dollarization whenever banks’ foreign currency deposits account for more than 50 percent of total deposits.13 A weak fiscal stance is characterized by a public debt burden exceeding 50 percent of GDP at the time of the crisis. In turn, emerging markets are those Latin American countries included in the Emerging Market Bond Index (EMBI) elaborated by J.P. Morgan. A general reading of Table 1 suggests that countries that suffered systemic banking crises generally had in place “soft” pegs and were mostly financially dollarized emerging markets. Although one can say that pegged regimes were the prevailing exchange rate arrangement in the region, they seem to be more common in those countries that experienced systemic crises. Moreover, most countries—typically emerging markets—that went through systemic crises abandoned the peg in the middle of the crisis, which largely exacerbated the financial turmoil. The combined effect of banking and currency crises buttressed macro-financial instability and magnified side effects. The crises in Argentina (2002), Ecuador (1999), Mexico, and Uruguay illustrate the devastating macroeconomic effects of exiting a peg in mid-course of the crises.
12 In this classification “hard” pegs comprise currency boards and formally dollarized systems; flexible rates refer to pure floating and managed floating arrangements; and “soft” pegs include all other regimes, including fixed rates, crawling rates, and crawling bands. 13 This percentage does not consolidate the onshore and offshore data because of information problems, which implies that the amount of foreign currency deposits at the time of banking crises, like those in Ecuador during the mid-1990s and Venezuela, are underestimated.
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Table 1. Banking Crises in Latin America and Relevant Macro-Financial Features
Exchange regime 1/ Financial dollarization2/
Emerging market 3/
Fiscal weakness4/
Country and crises years
Hard peg Soft peg Floating rate
Minor and moderate crises
Argentina (1995) Bolivia (1994) Bolivia (1999) Dom. Repub. (1996) Ecuador (1994) Ecuador (1996) El Salvador (1998-99) Guatemala (2001) Guatemala (2006) Honduras (1999) Honduras (2001) Honduras (2002) Paraguay (1995) Paraguay (2002) Systemic crises Argentina (2002) Brazil (1994-95) Colombia (1999) Costa Rica (1994) Dom. Repub. (2003) Ecuador (1998-99) Mexico (1995) Nicaragua (2000-01) Paraguay (1997-98) Peru (1999) Uruguay (2002) Venezuela (1994-95)
1/: Based on the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions. 2/: The banking system holds more than 40 percent of deposits denominated in foreign currency, although off-shore deposits are not considered. Data obtained from several IMF reports. 3/: Countries included in the EMBI at the time of the crisis. 4/: If the public debt to GDP ratio was more than 50 percent. The reason why emerging markets were probably more prone to systemic crises is their higher exposure to changes in capital flows. As opposed to developing countries, like the Central American countries, emerging markets are vulnerable to recurrent external financial shocks—like the “Tequila effect” in 1995, the Asian crisis in 1997 and 1998, and the Russian and Brazilian currency crises during the late 1990s—which triggered capital flights back to mature markets. This is because foreign financial investors monitor closely macroeconomic and financial developments in emerging countries, and hence, initial bank problems lead soon to a deterioration of country risk indicators and later to successive downgrades of the
14
countries’ key debt instruments.14 As a result, runs on deposits escalate and capital outflows take place, thereby putting pressure on and eventually depreciating the domestic currency and heightening initial financial instability. In turn, emerging markets may be in a better position to weather periods of financial distress because they have more developed capital markets, which provide additional sources of financing to endure a liquidity and credit crunch. However, the benefits of deeper capital markets may vanish when financial distress turns into a banking crisis. Although not a rule, financial dollarization may negatively affect the dynamics of banking crises. Until recently, dollarization was considered a factor that contributed to stabilize the deposit base and reduced capital flight in the wake of banking crises. However, in light of recent banking crises worldwide, an alternative notion has emerged claiming that high financial dollarization restricts the ability of government and central bank to confront banking crises. On the one hand, a rapid acceleration of inflation resulting from a sudden and fast depreciation of the domestic currency does not help to reduce the real value of banks’ liabilities when they are denominated in foreign currency. On the other hand, central banks’ inability to print foreign currency undermines the credibility and effectiveness of financial safety nets to protect dollar deposits. Eventually, financial dollarization may fuel a simultaneous currency crisis.15 Yet, from an empirical standpoint, there is no evidence that financial crises are more costly in highly dollarized economies.16 The association between systemic crises and weak public finances captures the restrictions imposed by a high debt burden on the management of banking crises. Highly indebted countries were generally unable to raise money in—domestic or international—capital markets during periods of financial stress, thereby hindering governments’ capacity to cope with banking crises using non-inflationary means. In these circumstances, tightening fiscal policy may be the only alternative countries have to demonstrate the government’s commitment to maintain macroeconomic fundamentals in check and temper market’s expectations in the midst of banking crises. In practice, however, raising taxes to obtain additional fiscal revenue may be politically difficult to implement. This is because economic agents tend to resist an increase in tax rates as their real income is falling, and because adopting revenue measures tends to be associated with “socialization” of private losses—those of banks’ shareholders—and this exacerbates social unrest.
14 Emerging markets are closely scrutinized in light of periodic reports and country risk indicators, which are almost non-existent for other developing countries. 15 See Ingves and Moretti (2004) for a general discussion of the limitations imposed by financial dollarization in managing banking crises, and Jácome (2004), for a description of how dollarization may have affected the unfolding of the late 1990s systemic crisis in Ecuador. 16Arteta (2003) points to the macroeconomic and exchange rate policies in place as more important factors contributing to systemic crises.
15
Fiscal weaknesses also interact with the other macro-financial features in Table 1, and together seem to have contributed to shape the dynamics of banking crises in some countries. For example, a fragile fiscal position during a banking crisis deteriorates market sentiment and accelerates capital outflows; in particular in emerging markets, thereby triggering a simultaneous currency crisis. In turn, the rapid depreciation of the domestic currency not only hampers bank solvency, especially if their degree of financial dollarization is high, but also raises the value of public expenditure, in particular, debt payments denominated in foreign currency, possibly leading to a debt default. The triple crisis (banking, currency, and sovereign debt) in Argentina (2002), Ecuador (1999), and Uruguay (2002) illustrates this interaction.
III. THE ROLE OF CENTRAL BANKS IN BANKING CRISES IN LATIN AMERICA The recent history of financial instability in Latin America is a fertile soil for analyzing central banks’ involvement in banking crises and their aftermath. In most of the 26 crises examined in this paper injecting central bank money was a common policy response. This section identifies the various alternatives central banks employed to manage banking crises, and discusses the institutional underpinnings underlying central bank involvement in these crises. A description of the central bank and government response in each banking crisis is presented in the appendix.
A. Intensive Use of Central Bank Money Central bank involvement in banking crises can vary depending on the degree of financial instability. During periods of financial distress, and provided that commercial banks remain solvent, central bank actions aim to restore the normal functioning of the money market and prevent financial turbulence from turning into a major crisis. To this end, central banks may increase liquidity provision, expand the type of collateral to be pledged by financial institutions in exchange for these resources, and reduce the discount rate vis-à-vis normal times.17 If bank instability worsens, central bank financial support may increase. However, a difficult equilibrium must be found between preventing a systemic collapse—by preserving the integrity of the payment system—and fueling inflation as a result of granting extensive financial assistance to impaired banks. Against this background, Table 2 identifies the types of central bank involvement in our sample of financial crises in Latin America. 17 These transactions are generally intended to cover intra-day and overnight requirements—although they could also be provided at somewhat longer maturities—or even to cover overdraft operations to avoid disturbances in the functioning of the payments system. They are automatic operations by which banks discount or use repo operations using central bank, government, or any other pre-qualified security.
16
Table 2. Modalities of Monetization of Banking Crises
Country and crises years Central banks’ involvement in banking crises
(beyond limited LLR) Extended
LLR 1/ Finance bank resolution 2/
Payment of deposits, insured or guaranteed 3/
Minor and moderate crises Argentina (1995) Bolivia (1994) Bolivia (1999) Ecuador (1994) Ecuador (1996) Dominican Republic (1996) El Salvador (1998-99) Guatemala (2001) Guatemala (2006) Honduras (1999) Honduras (2001) Honduras (2002) Paraguay (1995) Paraguay (2002) Large and systemic crises Argentina (2002) Brazil (1994-1995) Colombia (1999) Costa Rica (1994) Dominican Republic (2003) Ecuador (1998-99) Mexico (1995) Nicaragua (2000-01) Paraguay (1997-98) Peru (1999) Uruguay (2002) Venezuela (1994-95)
1/ Central bank emergency assistance granted to impaired banks was larger than the size of equity. 2/ Central banks discounted government paper to provide open-bank assistance, or they provided resources to facilitate purchase and assumption operations or directly capitalized impaired banks. 3/ Central banks paid an implicit or explicit deposit insurance or deposit guarantee either in cash or by issuing negotiable securities.
17
To cope with banking crises, central banks in the region followed four broad courses of actions. The first line of defense was to assist commercial banks with short-run liquidity to cope with deposit runs.18 Emergency loans were provided upon an explicit request from ailing banks unable to raise funds in the interbank market or elsewhere. Beneficiary institutions were required to submit collateral in the form of government bonds, eligible private sector loans, or real assets, depending on the regulations in each country. In addition, the borrower bank was sometimes required to accept a stabilization program aimed at overcoming its liquidity problems. Second, most central banks stretched LLR provisions to assist financial institutions suffering deeper liquidity and even solvency problems. To limit central bank discretion embedded in these extraordinary provisions, in many cases legislation required a qualified majority of votes in central bank governing bodies or demanded the executive branch to approve the extra financial assistance to troubled banks. These resources were provided in exchange for valuable collateral, and hence, they were bounded by the quality of assets that impaired banks had ready to pledge. Third, in a number of countries, central banks injected money to support bank restructuring and resolution in the midst of financial crises. These transactions varied but they generally aimed at cleaning the troubled bank’s balance sheet and easing its subsequent rehabilitation or purchase by another bank. Central banks typically issued securities and swapped them for non-performing assets of the impaired bank directly or through a bank restructuring institution (Bolivia 1999, El Salvador, Mexico, among others). They also issued securities to be used in purchase and assumption (P&A) operations (Nicaragua), or they simply extended credit to the acquiring institution to pay deposit withdrawals following P&A (Brazil).19 Central banks were also required to pay insured deposits on behalf of deposit insurance institutions or governments. They were required to directly pay deposit insurance and blanket guarantees (Ecuador 1999, Venezuela), advance money to deposit insurance institutions (Honduras), or simply, finance all deposit withdrawals from troubled banks (Bolivia 1994, Costa Rica, Dominican Republic 2003, Guatemala 2001, Paraguay 1995). In most cases, financial assistance aimed to support depositors and not directly bank borrowers—except in the Colombian and Mexican crises—as happened during the 1980s banking crises.20 18 Conventional wisdom says hat central banks should assist only solvent institutions facing temporary liquidity shortages. 19 As an extreme situation, the central bank directly took over an impaired bank, which required printing money to capitalize the absorbed institution and provided open-bank-assistance to assure its continued operation (Ecuador 1996). 20 During the 1980s crises, central banks provided long-term subsidized lines of credit to back the financial system’s rescheduling of loans, sectoral lines of credit under soft financial conditions, and preferential exchange rates for foreign currency liabilities, just to mention a few. See for example Baliño (1991) on Argentina and Velasco (1991) on Chile.
18
Assigning this responsibility to central banks was typically specified in a deposit insurance law or under special financial legislation enacted during the crisis when deposit insurance institutions lacked sufficient resources to honor their commitment. Operationally, central bank resources were provided in exchange for government bonds, securities issued by the deposit insurance institution, or high quality assets from the failing bank. Thus, considering these different forms of “monetization” it is evident that central banks injected sizable amounts of money during most large and systemic crises. In Argentina, the central bank provided financial assistance mainly to public banks but also to private domestic banks and a few foreign banks. Among public banks, Banco Nación and Banco Provincia de Buenos Aires (with a 28 percent market share) were the main beneficiaries of this financial assistance as they received about 4.5 and almost 3 times their net worth respectively. Among private banks, Banco Galicia, the largest domestic private institution received more than 3 times its net worth. In the Dominican Republic, the central bank granted extended LLR to three private banks reaching nearly 20 percent of GDP in 2003. In particular, the financial assistance provided to Baninter—the third largest bank in the system—exceeded 10 times its net worth or close to 15 percent of GDP. The crises in Ecuador (1999) and Venezuela followed the same pattern, except that central banks also funneled financial assistance indirectly through the deposit insurance/guarantee institution (AGD and FOGADE, respectively).21 In Ecuador, a blanket guarantee was introduced in the midst of the crisis, which was delivered by discounting government bonds at the central bank, driving total central bank financial assistance to about 12 percent of GDP by late-1999, while in Venezuela resources to FOGADE amounted to close to 10 percent of GDP by end-1995. In all these cases, mopping up liquidity became very difficult, and hence, as central bank assistance soared reserve money also boomed aggravating financial instability (see Figure 5). As opposed to these countries, Colombia and Peru did not pump money extensively into failing banks despite the ex-ante systemic risks they posed, and hence, they were able to sterilize excess liquidity and maintain reserve money under control (Figure 5). Instead, they applied measures of bank resolution and restructuring to cope with the banking crises based primarily on fiscal resources. Although not in the chart, other cases in point are those of the 1995 Argentinean crisis and the recent 2006 banking crisis in Guatemala. In the former country a full-blown crisis was averted by using government funds to execute P&A operations.22 The Bank of Guatemala did not provide any financial assistance as failing banks were liquid. Alternatively, the banking authorities conducted directly P&A operations without requesting central bank cash, rather using money from the deposit insurance institution. Thus, in all these cases, the strategy of managing the crisis at an early stage and preventing the use of large amounts of central bank money heightened the chances of a successful resolution and limited ensuing macroeconomic costs. 21 In addition to delivering the deposit guarantee, these institutions were also empowered to take over and capitalize insolvent banks, provide open-bank assistance, and execute bank resolution. 22 Argentina did not monetize the crisis because the Convertibility Law—in effect at that time—required backing the creation of money base with international reserves.
19
Figure 5. Large Banking Crises in Latin America—Selected Episodes
(Central bank claims on banks and reserve money in each country) Argentina 2002
(Outstanding balances. Millions of pesos)
0
5000
10000
15000
20000
25000
30000
1999M8 2000M7 2001M6 2002M5 2003M410000
20000
30000
40000
50000Crisis period
Claims on banks(left axes)
Reserve money(right axes)
Venezuela (Outstanding balances. Billions of bolivares)
0
200
400
600
800
1000
1991M11 1992M10 1993M9 1994M8 1995M70
200
400
600
800
1000
Claims on banks (left axes)
Reserve money(right axes)
Crisis period
Ecuador 1999 (Outstanding balances. Billions of sucres)
0
4000
8000
12000
16000
20000
24000
1995M4 1996M3 1997M2 1998M1 1998M12 1999M110
4000
8000
12000
16000
Claims on banks(left axes)
Reserve money(right axes)
Crisis period
Dominican Republic(Outstanding balances. Millions of pesos)
0
20000
40000
60000
80000
100000
120000
2000M8 2001M7 2002M6 2003M5 2004M40
25000
50000
75000
100000
Claims on banks(left axes)
Reserve money(right axes)
Crisis period
Peru (Outstanding balances. Millions of nuevos soles)
0
100
200
300
400
500
1997M4 1998M3 1999M2 2000M1 2000M1210000
15000
20000
25000
30000
Reserve money(right axes)
Banking crisis
Claims on banks (left axes)
Colombia (Outstanding balances. Millions of pesos)
0
700
1400
2100
2800
3500
1996M6 1997M5 1998M4 1999M3 2000M20
2000
4000
6000
8000
10000
12000
Claims on banks(left axes)
Reserve money (right axes)
Banking crisis
Source: International Financial Statistics, IMF.
20
The evidence in Latin America also shows that even in minor and moderate crises central bank money was used beyond limited LLR assistance (Figure 6). Thus, countries preferred to honor upfront all or most deposits with central bank money fearing the possibility of contagion. However, given the relatively small size of the crises central banks managed to mop up liquidity expansion, and hence, mitigated the effect on money base. Yet the approach followed by governments/central banks entailed a violation of market discipline while fiscal or quasi-fiscal costs were probably unnecessarily generated. Points in case are the banking crises in Ecuador (1996), Guatemala (2001), and Paraguay (1995). In Ecuador, the central bank took over a failing bank (8.5 percent market share) restored its capital, and paid deposit withdrawals as needed. The Bank of Guatemala followed a different course of action by extending an open line of credit—as part of the intervention of three small banks (7 percent market share)—to withstand all deposit withdrawals. In turn, the Paraguayan government extended an implicit deposit guarantee to prevent a propagation of the crisis and required the central bank to honor deposit withdrawals in four intervened banks (nearly 13 percent market share). Banks were eventually closed in both Guatemala and Paraguay, while in Ecuador the central bank still runs the absorbed bank. In the other three countries in the chart, the policy response followed a slightly different approach as they also involved private commercial banks and government resources in the resolution of the crises. In the 1995 Bolivian crisis, the central bank honored most deposits in two small failing banks but it also managed to incorporate private banks as well as government money in the resolution of the crisis. In the 1999 and 2001 crises in Honduras and in El Salvador, central banks provided financial assistance. However, the Central Bank of Honduras also financed the deposit insurance institution (FOSEDE) to honor the blanket guarantee introduced in 1999 in the wake of a small crisis.23 In turn, the Reserve Central Bank of El Salvador facilitated the restructuring of a small impaired bank by transferring its deposits to four other financial institutions together with central bank long-term tradable securities in order to differ further cash payments.
B. The Role of the Institutional Framework Assessing the institutional framework that countries had in place to contain and manage banking crises helps to understand the large involvement of central banks in financial crises. Institutional aspects are critical because they establish the limits and capabilities that governments and central banks face to respond to episodes of financial distress and crises. This section reviews the financial safety nets and bank resolution instruments that existed at the time of banking crises in Latin America and stresses their role in shaping the unraveling of those crises.
23 This money was later repaid by FOSEDE using commercial banks’ future insurance premia.
21
Figure 6. Minor and Moderate Banking Crises in Latin America—Selected Episodes (Central bank claims on banks and reserve money in each country)
Honduras(Outstanding Balances. Millions of lempiras)
0
100
200
300
400
500
1999M7 2000M6 2001M5 2002M4 2003M30
5000
10000
15000
20000
Claims on banks(left axes)
Reserve money(right axes)
Banking crises
Bolivia 1995 (Outstanding balances. Millions of bolivianos)
0
500
1000
1500
2000
2500
3000
3500
4000
1993M1 1994M1 1995M1 1996M1 1997M10
1000
2000
3000
4000
5000
6000
Banking crisis
Reserve money (right axes)
Claims on banks (left axes)
El Salvador (Outstanding balances. Millions of colones)
200
400
600
800
1996M10 1997M9 1998M8 1999M7 2000M6500
1000
1500
2000
2500
Claims on banks (left axes)
Reserve money(left axes)
Banking crisis
Guatemala 2001(Outstanding balances. Millions of quetzales)
0
1000
2000
3000
1999M2 2000M1 2000M12 2001M11 2002M105000
10000
15000
20000
Claims on banks(left axes)
Reserve money(right axes)
Banking crisis
Paraguay 1995(Outstanding balances. Billions of guaranies)
0
200
400
600
800
1000
1200
1993M6 1994M5 1995M4 1996M3 1997M2600
1200
1800
2400Claims on banks (left axes)
Reserve money(right axes)
Banking crises
Ecuador 1996(Outstanding balances. Billions of sucres)
0
100
200
300
400
500
1993M1 1994M1 1995M1 1996M1 1997M10
200
400
600
800
1000
1200
1400
Claims on banks (left axes)
Reserve money (right axes)
Banking crisis
Source: International Financial Statistics, IMF.
22
There is an increasing consensus that an effective institutional framework to prevent and manage banking crises should be based on four mutually consistent pillars: (i) early corrective actions; (ii) instruments to conduct bank resolution and restructuring; (iii) deposit insurance; and (iv) central bank LLR provisions. Early corrective actions should have an undisputed legal support to empower regulators to impose timely remedial actions on financial institutions that are not observing prudential regulations, especially solvency provisions. Having the legal foundations to implement bank resolution and restructuring in an orderly fashion and minimizing the use of inflationary means—i.e., central bank money—is critical to close unviable banks without inducing further financial instability. The purpose of having in place an appropriately funded deposit insurance mechanism is to protect small depositors and to have them paid immediately if a financial institution needs to be closed.24 In turn, central banks should be empowered to provide limited and short-term financial assistance as LLR to illiquid but solvent banks. The status of pillars (ii) to (iv) at the time of the crises in Latin America are shown in Table 3. Most Latin American countries featured ill-designed institutional arrangements to prevent and confront banking crises. In particular, based on the results obtained from the Financial Sector Assessment Program (FSAP) executed by the IMF and the World Bank, most Latin American countries at the time of the crises were not legally equipped to effectively adopt early remedial actions. The assessment refers to the observance of the Basel Core Principle No. 22, which shows that the vast majority of countries in the region did not comply with the standard requirement. Legal provisions for the implementation of bank resolution operations—using non-inflationary means—were not available in the majority of countries in the region at the time of the crises, in particular P&A operations.25 Argentina was the pioneering country in introducing instruments for bank resolution—based on P&A—which helped to handle the closure of a number of banks during the mid-1990s crisis without generating further turbulence in the financial market and maintaining at the same time the existing currency board.26 The Argentinean legislation served as a model for later reforms in other countries like Nicaragua and Guatemala in 2002. On the other hand, even when having in place bank resolution instruments, some countries were not able to use them. For instance, the Dominican Republic in 2003 failed to implement P&A operations because the required bylaws were lacking at the time of the crisis.
24 When designing a deposit insurance mechanism, conventional wisdom favors an incentive-compatible structure to limit possible moral hazard and adverse selection distortions. 25 While there are a number of modalities of bank resolution, such as bank mergers and the use of bridge banks, which facilitate the market exit of failing banks, we stress here P&A operations as they provide a more effective means for a quick and timely exit strategy. 26 See De la Torre (2000) for an explanation of main features of the Argentinean bank resolution framework.
23
Table 3. Institutional Framework behind Banking Crises in Latin America
at the Time of the Crises
Country and crises years
Bank resolution 1/
Deposit insurance 2/
LLR 3/
1: P&A operations authorized. 0: P&A not authorized
1: Exist 0: Not exist F: Full guarantee
1: Limited 2: Extended
Minor and moderate crises Argentina (1995) 1 1 1 Bolivia (1994) 0 0 2 Bolivia (1999) 0 0 2 Ecuador (1994) 0 0 2 Ecuador (1996) 0 0 2 Dominican Republic (1996) 0 0 2 El Salvador (1998-99) 1 0/1 2 Guatemala (2001) 0 1 2 Guatemala (2006) 1 1 1 Honduras (1999) 0 0/F 2 Honduras (2001) 1 F 2 Honduras (2002) 1 F 2 Paraguay (1995) 0 0 2 Paraguay (2002) 0 0 2 Large and systemic crises Argentina (2002) 1 1 2 Brazil (1994-95) 1 0 2 Colombia (1999) 1 1 1 Costa Rica (1994) 0 0 2 Dominican Rep. (2003) 1 F 1 Ecuador (1998-99) 0 1/F 2 Mexico (1995) 1 F 2 Nicaragua (2000-01) 1 0/1 1 Paraguay (1997-98) 0 0 2 Peru (1999) 1 1 1 Uruguay (2002) 0 0 2 Venezuela (1994-95) 0 1/F 2
1/ Based on countries’ legislation and FSAP evaluations. 2/ Source: Demirguc-Kunt and others (2005) and updates from the author. 3/ Source: countries’ central bank legislation at the time of the crises.
24
Deposit insurance institutions existed in about one half of the crises in the sample, but only a handful of these institutions were appropriately established. Some of them were not adequately funded and others featured moral hazard problems. For instance, the Savings Protection Fund (FOPA) in Guatemala had no money when banks were closed in 2001, and hence, it could not be used. Rather, the central bank paid all deposit withdrawals from the failing banks. Other countries in the sample established a deposit insurance/guarantee mechanism as part of the policy response, imposed an explicit blanket guarantee (Ecuador 1999, Honduras, Mexico), or introduced an implicit full-guarantee in the middle of the crises (Dominican Republic 2003 and Venezuela 1994). In turn, Costa Rica and Uruguay did not have deposit insurance but, in practice, the state-owned banks, which constituted more than 50 percent of the system in both countries, had full coverage of deposits. In turn, LLR provisions were established in all countries, including an open-ended component to be used under special circumstances. Only in six countries (Argentina 1995, Colombia, Dominican Republic 2003, Guatemala 2006, Nicaragua, and Peru) did central bank LLR provisions feature a limited scope both in terms of amount and maturity; although, in practice, the Dominican Republic did not observe the restrictions imposed by law for the provision of liquidity assistance (up to 1.5 times the failing bank’s capital) and, hence, it largely exceeded this cap during the 2003 banking crisis. In a number of countries the special circumstances under which LLR could be extended would generally need to be approved by a qualified majority at the central bank board or would require a validation by the executive branch. Thus, in the vast majority of countries in the sample, the existing institutional framework did not provide the appropriate instruments to address banking crises at an early stage and to manage crises minimizing the use of inflationary means. As a result, a number of countries were left with the alternative of either closing failing banks—paying at most to small depositors—or injecting large amounts of central bank money to avoid a disorderly closure of banks. In practice, both approaches led eventually to the same outcome as traumatic closure of banks triggered contagion, which scaled up central bank financial assistance in an effort to cope with deposit withdrawals in other banks. The banking crises in Venezuela during the mid-1990s and Ecuador in 1999 illustrate the deleterious impact of closing banks followed by large injections of central bank money. In Venezuela, the second largest bank (Banco Latino) was closed in January 1994 and depositors—not even the smallest ones—did not receive their money back for more than a month. From then on the central bank scaled up financial assistance to cope with increasing contagion, but as money poured into the system, pressures on the domestic currency mounted and, hence, central bank international reserves almost halved in six months. Moreover, the bolívar depreciated nearly 70 percent by end 1994, thereby contributing to sink a dozen banks in the same year. In Ecuador, the crisis started with the closure of a small bank, Solbanco (one percent market share), in April 1998. However, as most depositors did not recover their savings, the failure of this bank undermined confidence in banks until a second—medium sized—bank was closed. With a larger group of depositors losing their money, contagion gained momentum, and hence, by end-1998, the second largest bank was
25
taken over by the State to avoid another traumatic closure—while another six banks were requesting assistance from the central bank. Thus, more than 50 percent of the system was eventually closed or taken over by the state. The economy fell more than 6 percent and inflation reached about 100 percent year-on-year in 1999. The government finally adopted the US dollar as the country’s legal tender. Thus, the banking crisis in Ecuador also illustrates how a banking crisis can start as a small event and turn over time into a full-fledged banking crisis because the country did not have the institutional powers to deal with banking crises in an orderly fashion. To a great extent, the 2002 crisis in Uruguay features some similar developments. It started with the closure of an Argentinean bank, which did not receive financial assistance from the central bank and, hence, generated a gradual contagion to other banks. As the crisis escalated, the central bank reacted by providing increasing financial assistance, which lasted until international reserves reached a minimum threshold that motivated the government to declare a bank holiday followed by a restructuring strategy of the banking system (see Box 1).27 Other countries like Dominican Republic in 2003, Paraguay in 1995, and Guatemala in 2001, followed the strategy of injecting large amounts of central bank money instead of closing failing banks. While in the first case—and to some extent in the second—the stability of the whole financial system was at stake because of the risks of a collapse of the payments system (see Box 1), in Guatemala the government may have preferred to use central bank money to avoid the cost of utilizing tax-payers money and assuming that central banks could sterilize liquidity injection. By the same token, having in place—or rapidly approving—an appropriate financial institutional framework also helps to explain relatively successful episodes of banking crises containment and management. Argentina in 1995, Colombia and Peru in 1999, and Guatemala in 2006 handled financial turbulence without allowing it to turn into full-fledged financial crises (see Box 2). Brazil and Nicaragua also relied to a great extent on bank resolution measures to manage the banking crises. In the first four cases, the central bank law imposed limitations for the provision of LLR—both in terms of the amount and the maturity of the loans. Therefore, LLR provisions served only as the first line of defense when banking crises erupted and, hence, functioned as one component of a broader financial safety net, which included legal provisions that empowered the execution of bank resolution. These latter powers were already in place at the moment of the crisis in all cases except in Peru, where the government managed to rapidly pass a law that empowered it to conduct bank resolution and restructuring. The decisions adopted by this group of countries, including Brazil and Nicaragua, typically included P&A operations. In addition, in Brazil, Colombia and Peru, the government designed a comprehensive strategy to tackle not only liquidity and solvency problems, but also provided incentives to restructure debts and carry out bank mergers and acquisitions.
27 Banco Galicia in Uruguay had almost a 100 percent Argentinean deposit base. Other banks, mainly foreign institutions, also had Argentinean depositors.
26
Box 1. Large “Monetization” of Banking Crises in Selected Countries
The traumatic closure of a small bank in April 1998 sparked the banking crisis in Ecuador as medium and large depositors could not recover their savings. It triggered contagion and a run on other banks, and hence, in August a second medium size bank was closed. Subsequently, several other institutions fell apart representing nearly 60 percent market share. Despite a history of recurrent banking crises, Ecuador had a poor institutional framework to contain and handle them. It basically comprised two corner solutions; either to provide extensive financial assistance through the Central Bank of Ecuador (BCE) or to close banks without paying depositors, except to small depositors under a protracted procedure, with BCE money. The legal provisions supporting BCE’s role as LLR allowed it to grant large amounts of money. In addition, a deposit guarantee was in place to protect small depositors, which also relied on BCE resources to be effective. As the crisis unfolded, the government offered a blanket guarantee, which initially was delivered using BCE money. The excessive reliance of financial safety nets on BCE’s resources made the way for a large “monetization” of the banking crisis, which reached 12 percent of GDP by September 1999. As the crisis escalated the government “froze” deposits to avoid a meltdown. However, as the government lifted the controls, the crisis regained momentum until the BCE loosened monetary policy control and the government adopted the dollar as the country’s legal tender. The 2003 banking crisis in the Dominican Republic started with the intervention of the third largest bank—with a market share of 10 percent. Deposit withdrawals had already started by mid-2002 following allegations of fraud resulting from the discovery of hidden liabilities recorded in a “parallel bank.” Immediately after the intervention of this bank, the crisis extended to two other institutions—with an additional 10 percent market share—featuring similar inappropriate accounting practices. The crisis of these three banks was managed using exclusively resources from the Central Bank of the Dominican Republic (BCRD), in particular, using cash at the early stages of the crisis and later utilizing central bank certificates to pay depositors. While the Law of the BCRD established a limit to the provision of emergency loans of 1.5 times the capital of the impaired bank, the largest bank received more than 10 times its capital in financial assistance from the BCRD and the other two banks received 8 and 6 times their capital. The banking crisis in Venezuela started when Banco Latino did not meet its clearing house obligations in early-1994. The closure of this bank triggered contagion to other institutions, but the Central Bank of Venezuela (BCV) decided to provide financial assistance both directly and indirectly via FOGADE to avoid closing another bank, an action that could have exacerbated financial instability. As BCV’s assistance mounted this approach proved to be unsustainable because ailing banks ran out of adequate collateral, and hence, another 12 institutions were either nationalized or closed by end 1994. As financial instability increased, so did pressures on the domestic currency until the government imposed controls on the capital account and fixed the exchange rate, following a nominal depreciation of about 70 percent. In this environment, inflation soared to more than 70 percent by end-1994 and three digit rates during 1996, and the economy contracted more than 2 percent. As the Argentine banking system collapsed and enforced the so-called “corralito financiero,” Uruguay was hit by a systemic crisis in 2002. The crisis started with runs on the Argentine Banco Galicia, which was eventually closed without receiving financial assistance from the Central Bank of Uruguay (BCU). The closure of this bank and the deepening of the Argentine crisis sparked a gradual contagion. Although banks initially withstood deposit withdrawals with their own resources, domestic banks resorted eventually to central bank money. Legislation did not envisage bank resolution and rather allowed the BCU to provide financial assistance mostly against government paper but also against high quality commercial paper up to the impaired bank’s capital. Since these measures did not contain the crisis, the government declared a bank holiday, while Congress approved new legislation empowering the BCU to conduct bank resolution and restructuring. Eventually, three local commercial banks were closed, time deposits were reprogrammed to longer periods, and the government extended a deposit guarantee to checking and saving deposits in public banks.
27
Box 2. Effective Episodes of Bank Restructuring and Resolution in Selected Countries
The end-1994 Mexican devaluation triggered a wave of uncertainty on the sustainability of the currency board in Argentina, leading to widespread deposit runs and large capital outflows. As a result, from end-December to January 1995, peso deposits fell more than 15 percent. From December 1994 to late 1996, about 40 small and medium-size banks failed or were acquired or merged (almost one third of total banks). To cope with the instability created by the “Tequila” shock, the Argentine government passed a law in May 1995 that allowed the central bank to get involved in the resolution of distressed banks. The new legislation created the basis for conducting bank mergers, acquisitions, purchase and assumption operations, as well as other resolution procedures to replace the straight liquidation of an impaired bank. To favor the viability of the new operations, a temporary Capitalization Trust Fund—funded by international and government resources—was created to inject capital into impaired institutions via a subordinated loan or by buying non-liquid assets. A third reform was the creation in April 1995 of a deposit insurance system to be fully funded from the private sector. Based on this new legal framework, from December 1994 to end-1995, out of 137 banks, 9 financial intermediaries failed and over 30 were either acquired or merged into a single institution. In the midst of an adverse international financial environment in 1999, the government intervened, closed, or took-over a large number of financial institutions in Colombia, while others were receiving liquidity support. As a first line of defense, the Bank of the Republic (BoR) provided limited financial assistance by facilitating access to rediscount facilities, up scaling repo transactions, and easing access to longer-term liquidity support. The bulk of the official support was provided by the Government. It approved debt relief programs using government resources and, based on the institutional strength of the deposit insurance institution (FOGAFIN), it provided additional liquidity support, took over large private banks, conducted P&A operations, and introduced recapitalization plans based on credit lines to shareholders of the impaired institutions. In addition, the Superintendency of Banks allowed temporary regulatory forbearance to encourage debt restructuring with financial institutions, while Congress passed a law that suspended traditional bankruptcy procedures for five years in order to promote agreements between creditors and debtors. The late-1990s international financial turmoil also hit Peru. Capital outflows triggered a domestic credit crunch, which unveiled solvency problems in a number of banks, including Banco Wiese, Banco Latino (16.7 and 3 percent market share, respectively), and other smaller financial institutions. The official response was tailored before the crisis turned into a systemic problem. It was conducted by the government with minimum central bank involvement and aimed at restructuring failing banks and consolidating the financial system. The key element of the government response was the approval by Congress—in a fast track—of a reform to allow the supervisory authority to execute P&A operations, and the Deposit Insurance Fund (FSD) to capitalize and take-over impaired banks to prepare them for future privatization. In practice, the government provided support through: (i) capitalization of banks to favor bank mergers; (ii) issuance of bonds to facilitate P&A; (iii) swaps to restructure assets, issuing non-interest bearing treasury bonds in exchange for troubled loans to be repurchased over a four-year period, and for liquidity purposes issuing negotiable US dollar bonds in exchange for performing loans, with a repurchase commitment over a five-year period; and (iv) debt rescheduling programs to the private sector. Public sector financial institutions (COFIDE and Banco Nación) also participated in: (i) taking-over impaired banks through capital injections and the assumption of liabilities; (ii) restructuring debt and converting foreign currency debt into domestic currency debt; and (iii) providing liquidity to troubled banks. The FSD also increased the coverage per depositor to US$18,500 and indexed it to the wholesale price index with the financial support of a government contingency line of credit of up to US$200 million. As opposed to the full monetization executed during the small banking crisis in 2001, Guatemala successfully managed the 2006 crisis of Bancafe (9 percent market share) and the subsequent closure of Banco del Comercio (1 percent market share). Under the provisions of a new legislation approved in 2002, P&A operations were implemented without central bank injection of money, but using alternatively resources from the deposit insurance fund.
28
Admittedly, there are also some episodes in which banking crises were of systemic dimension from the start. Cases in point are the 2002 Argentinean crisis and the Mexico crisis during the mid-1990s. In the former episode, the fiscal crisis had a systemic impact from the outset—as all banks were more or less exposed to sovereign and currency risk. In addition, the uneven “pesofication” hit all banks driving some institutions close to or into insolvency. In Mexico, the currency crash damaged banks’ balance sheets as financial institutions were widely exposed to unhedged borrowers, who were badly hit as a result of the peso devaluation. Despite the good institutional framework in place in Argentina and the broad bank restructuring program implemented in Mexico, it was very difficult to handle crises at low costs.28 The experience of these two countries highlights how adverse macroeconomic developments can have a devastating effect on financial institutions.
IV. MACROECONOMIC REPERCUSSIONS When central bank money was intensively used, like in most banking crises in Latin America, it inevitably generated undesirable adverse macroeconomic effects. As an immediate repercussion, it constrained central banks’ ability to conduct monetary policy and, in the long-run, in a number of cases, central banks’ operational autonomy was inhibited. In general, the more central banks injected money the greater was macroeconomic instability.
A. On Monetary Policy Large central bank assistance to problem banks disturbs the conduct of monetary policy and may potentially compromise central banks operational autonomy in the long-run. Banking crises relegate to a secondary place central banks’ objective of fighting against inflation, and rather, they put at the forefront the objective of preventing an escalation of financial distress. In the short-run, injecting large amounts of money makes opaque the relationship between monetary instruments and operating and intermediate targets, and the link between these and the central banks policy goals. Moreover, if the assets received as collateral—in exchange of the credit provided to troubled banks—are not recovered enough over time, the central bank’s capital may be exhausted, which may restrict its ability to tighten monetary policy when needed because of its adverse impact on the central bank balance sheet (see Box 3). Assessing the impact on monetary policy from central banks involvement in banking crises is an empirical issue. This type of analysis has received little attention in the literature and the existing studies do not provide a conclusive answer.29 While a rigorous analysis based on the experience of banking crises in Latin America is beyond the scope of this paper, we show here its impact on money demand via the money multiplier. 28 These crises have been widely documented before. See for example Perry and Serven (2003) on Argentina, and Mishkin (1999) on Mexico.
29 Garcia-Herrero (1997) and Martinez Peria (2002) investigate this issue but their conclusions point in different directions. While the former finds significant implications for money demand stability in a sample of developing countries, the latter finds no such evidence in a sample of developing and industrial countries.
29
Box 3. Banking Crises and Monetary Policy Depending on the severity of financial crises central banks will be inclined to change their policy objective in the short-run to focus on maintaining the stability of the financial system. When central banks face financial distress they try to preserve the functioning of money markets—such that illiquid banks can access resources they need—without sacrificing their policy objective of maintaining price stability. However, if financial distress worsens central banks may also need to inject large amounts of money to preserve the functioning of the payments system and avoid a systemic collapse until bank resolution measures can be adopted. With a view to handling banks’ severe liquidity problems and crises, central banks may either stick to a tight monetary policy or adopt an accommodative stance depending on the severity of the crisis. In the first scenario central banks mop up all the liquidity assistance provided to banks, raising interest rates high enough to preserve the stability of banking system liabilities. This policy, however, probably hits those banks already facing liquidity shortages, which are borrowing in the interbank market, thereby eventually accelerating their failure and escalating the banking crisis. At the other extreme, a full accommodative approach entails no central bank sterilization, leading initially to a downward trend on interest rates. However, the decline in interest rates creates potential pressures on the domestic currency and the central bank’s international reserves. In this environment, the exchange rate depreciation tends to harm banks’ asset portfolios—and therefore the solvency of banks—at a systemic level as it hits unhedged consumer and corporate bank debtors. In practice, none of these options is sustainable for more than a short period, unless efficient bank resolution is adopted and fiscal adjustment or foreign financing make room for less aggressive central bank sterilization or for an increase in international reserves. An intermediate route, one of partial sterilization, may give the central bank some breath but will not last either if other complementary measures are not adopted. Thus, coping with banking crisis exclusively through monetary policy, especially in the event of prolonged financial assistance, makes monetary policy ineffective and prone to macroeconomic instability. Policy restrictions increase under high financial dollarization as central banks seek not only to preserve the value of bank liabilities but also try to prevent a highly damaging currency crash. Given the widespread availability of financial contracts in foreign currency, market participants are more inclined to reallocate portfolios toward dollar assets in light of uncertain financial developments. Thus, the increase in interest rates needs to be sufficiently high to discourage a dynamic increase in foreign currency demand that inevitably will result in a decline in international reserves and/or a currency depreciation. This, in turn, may eventually turn into a currency crisis that further impairs banks’ financial condition. On the other hand, a sizable increase in interest rates accelerates the failure of illiquid banks, in a situation where financial safety nets are less effective to provide a liquidity buffer as central banks cannot print foreign currency. Banking crises may also inflict lasting effects on monetary policy. As central banks provide credit to impaired institutions, they receive collateral in exchange. However, central bank losses may arise if the value of the central bank’s loans (including interest) are not covered by the present value of the revenues obtained when the central bank realizes the assets pledged as collateral, or if the resources provided by the central bank to deliver deposit insurance are not repaid either by the government or by future contributions by financial institutions. From then on, central bank balance sheets may become impaired as interest bearing assets are smaller than interest bearing liabilities and, eventually, central bank capital may be depleted. This may reduce the room for maneuver in conducting monetary policy as central banks fear that the costs associated with monetary operations can erode even more their already weak financial position—assuming the government is not likely to promptly restore the central bank’s capital.
30
Figure 7 suggests that money demand became unstable in the midst of large episodes of banking crises. The money multiplier initially increased, which can be associated with pressures on banks’ liquidity leading to a gradual drain of bank reserves at the central bank or to a reduction in the rate of reserve requirements. Later, the money multiplier fell as a result of increasing holdings of cash by economic agents in reaction to an enhanced perception of banks’ unsoundness. In some cases, the money multiplier collapsed as the appetite for dollars increased or when freezing of deposits was adopted as part of the government’s response package. In addition, the transmission mechanism of monetary policy became distorted and, in general, monetary policy lost effectiveness. As banking crises unfolded, typically a number of banks became illiquid, leading short-term interest rates to increase and the interbank market to become segmented between groups of banks (the solvent banks in one group and those perceived as insolvent in another group). Under these conditions, the connection between central bank monetary impulses and the real sector weakened. Central bank participation in banking crises also inflicted long lasting adverse effects on monetary policy. Unproductive or low performing assets acquired by central banks in the midst of banking crises became a financial burden leading to losses and eventually exhausting their capital.30 When governments did not restore central bank capital—a fairly common outcome in Latin America following banking crises—financial losses hindered central bank ability to conduct monetary operations.31 In particular, central banks’ capacity to mop up liquidity became restricted as they feared to raise interest rates or issue securities as needed when conducting open-market-operations to avoid exacerbating losses and deteriorating further their negative capital position. The Dominican Republic, Guatemala, Nicaragua, Paraguay, and Venezuela are relevant cases in point to illustrate central bank financial weakness resulting from their involvement in banking crises.32 In general, average central bank losses from a sample of 10 Western Hemisphere countries were 1 percent of GDP in 2005.33 To enable financially weak central banks to fully resume their monetary policy function, governments should effectively restore central bank financial strength.34
30 In some countries, central bank transactions associated with banking crises were improperly accounted—contrary to sound practices of transparency and governance. The collateral received in exchange for the liquidity assistance provided as LLR was not always marked-to-market. As a result, the value of central banks’ assets was inflated, which made room to artificially post a positive equity. 31 Admittedly, central banks do not require a specific amount of capital. However, they should enjoy a financial strength that is sufficient to credibly commit to their policy goals. 32 To restore the central bank’s capital integrity, Congress in the Dominican Republic recently passed a law which allows the government to issue marketable securities in favor of the central bank. 33 See Stella and Lönnberg (2008). 34 The modality of recapitalization should be consistent with the prevailing monetary policy regime and taking into consideration dynamic scenarios of cost and revenue streams (see Stella, 2008).
31
Figu
re 7
. Per
form
ance
of t
he M
oney
Mul
tiplie
r in
the
Mid
st o
f Ban
king
Cris
es in
Lat
in A
mer
ica
Ar
genti
na 19
93-19
97
2345678 1993
M119
94M
119
95M
119
96M
119
97M1
Arge
ntina
2000
-2004
2345678 2000
M1
2001
M120
02M
120
03M1
2004
M1
Boliv
ia 19
92-19
96
2345678 1992
M119
93M
119
94M
119
95M
119
96M1
Boliv
ia 19
97-20
03
2345678 1997
M119
98M
119
99M
120
00M
120
01M
120
02M1
Braz
il 199
2-199
6
2345678910 1992
M119
93M1
1994
M119
95M1
1996
M1
Colom
bia 19
97-20
01
2345678 1997
M119
98M
119
99M
120
00M1
2001
M1
Costa
Rica
1992
-1996
01234 1992
M119
93M
119
94M
119
95M
119
96M
1
Domi
nican
Rep
ublic
2001
-2005
2345 2001
M120
02M1
2003
M120
04M1
2005
M1
Guate
mala
1999
-2003
1234 1999
M120
00M
120
01M
120
02M
120
03M
1
Guate
mala
2004
-2006
23456 2004
M120
05M1
2006
M1
Hond
uras
1997
-2001
23456 1997
M119
98M
119
99M
120
00M
120
01M
1
Mex
ico 19
93-19
97
68101214 1993
M1
1994
M1
1995
M1
1996
M1
1997
M1
Hond
uras
2000
-2004
23456 2000
M120
01M1
2002
M1
2003
M120
04M1
Nica
ragu
a 199
8-200
2
23456 1998
M119
99M
120
00M
120
01M
120
02M
1
Para
guay
1993
-1997
012345 1993
M119
94M
119
95M1
1996
M1
1997
M1
Para
guay
1995
-1999
01234 1995
M1
1996
M119
97M
119
98M1
1999
M1
Para
guay
2000
-2004
01234 2000
M120
01M
120
02M
120
03M1
2004
M1
Peru
1997
-2001
01234 1997
M1
1998
M1
1999
M1
2000
M120
01M1
Urug
uay 2
000-2
004
23456 2000
M1
2001
M1
2002
M1
2003
M120
04M1
Vene
zuela
1992
-1996
2345 1992
M1
1993
M1
1994
M1
1995
M1
1996
M1
So
urce
: IM
F’s I
nter
natio
nal F
inan
cial
Sta
tistic
s: ro
w 3
5L /
row
14.
32
B. On Macroeconomic Stability As central banks inject money in the wake of banking crises and loose monetary policy gains momentum, the chances of exacerbating macroeconomic instability increase, which potentially backfires on the financial system. The following analysis checks for preliminary evidence on the link between “monetization” and macroeconomic instability. It focuses on 25 episodes in our sample, excluding the Brazilian banking crisis.35 As a first approximation to the dynamics of banking crises in Latin America we check for pair-wise correlations between relevant variables. Table 4 relates the ex-ante size of the crises (measured by the market share of the impaired banks at the beginning of the crises), with two measures of how much money central banks pumped into the banking system (the percentage increase in central bank claims on commercial banks and the percentage increase in reserve money), and two measures of balance of payments crises, namely the largest accumulated currency devaluation and the largest fall in international reserves in a three-month period following the beginning of the crisis. All coefficients have the expected sign and are statistically significant. A first outcome is that large crises were indeed associated with sizable injections of central bank money and with currency crises. Second, it is clear that growing financial assistance to impaired banks inevitably led to currency crises as increases in central bank money appear significantly correlated with demand for foreign currencies. Third, it seems that central banks used intensively international reserves to limit the impact of growing flows of central bank money on the exchange rate. These conclusions are validated when assessing the combined impact of banking crises on currencies and international reserves by using an index of financial turbulence (not reported).36
35 The sample excludes the Brazilian crisis to avoid introducing a distortion in the analysis since, at the time of the crisis, Brazil was still coming out of hyperinflation, which complicates the comparison of the performance of nominal variables across countries. 36 Calculations were made based on Kaminsky and Reinhart (1999) index of market turbulence that measures the volatilities of nominal exchange rates and central bank international reserves.
33
Table 4. Pair-Wise Correlations between Selected Variables Sample: 25 Countries (excluding Brazil)
Size of the crisis ∆ in central bank
claims on banks a/ ∆ in reserve
money b/ Size of the crises 0.627 * 0.439 * Nominal devaluation c/ 0.816 * 0.535 * 0.408 * ∆ in international reserves d/ 0.567 * - 0.587 * - 0.480*
*/ Coefficients are statistically significant at the 5 percent level. a/ Measured by the ratio of the average change in central bank claims to financial institutions during the first year of the crisis relative to the previous 12 months. b/ Measured by the ratio of the average change in base money during the first year of the crisis relative to the previous 12 months. c/ Largest percentage depreciation of the domestic currency accumulated over a 3-month period during the crisis. d/ Largest percentage fall in international reserves accumulated over a 3-month period during the crisis.
Additional conclusions are obtained when these correlations are broken down by crises events. We check first the relationship between the size of the crises and the increase in central bank assistance to impaired banks—although we should not lose sight that many systemic crises started as idiosyncratic episodes, which however grew over time into a systemic crisis. Making this link is relevant to test the hypothesis that the larger a crisis, the higher are the chances of having central bank money involved—by supplying the resources needed to withstand deposit withdrawals or bank restructuring. Figure 8 confirms the positive correlation between those two events. The chart also shows that there are large crises like those in Peru, Colombia, and Paraguay (1997), where the central bank did not inject large amounts of money. In turn, Argentina (2002) and Ecuador (1996) are outliers. The former because the “corralito” greatly restricted deposit withdrawals, and hence, stifled the need of perpetuating central bank assistance, whereas the latter seemingly made a large “monetization” but this reflects primarily a statistical effect as it is compared with a very small base. Plotting—on a crisis basis—the relationship between the use of central bank money in banking crises and currencies’ depreciation, and with respect to the loss of international reserves, give some additional insights about the dynamics of the crises. Figure 9 shows that the larger was the involvement of central bank money in handling banking crises the higher were the chances of having a currency depreciation. Specifically, as the value of central bank claims on the financial system multiplied by a factor of 2 or more, local currencies depreciated more than 30 percent in most cases thereby triggering a currency crash (Dominican Republic, Ecuador 1996 and 1999, Mexico, Uruguay, Venezuela, and in particular Argentina 2002, where the peso depreciation was almost 140 percent in a three-month period as the currency board collapsed).37 As to small “monetization” episodes, they 37 A nominal depreciation entails an increase in the ratio of peso per dollars.
34
were generally sterilized, thereby avoiding pressures against the domestic currency. As exceptional events, it is worth stressing that the large depreciation of the currency in the 2002 banking crisis in Paraguay took place in the wake of the Argentinean and Uruguayan crises, which had already featured a rapid shift from pesos to dollars.38
Figure 8. Banking Crises and Central Bank Money
0
10
20
30
40
50
60
-200 0 200 400 600 800 1000 1200 1400 1600 1800 2000 2200
Central bank claims on banks. % increase (after/before t +/- 12)
% S
hare
of a
iling
bank
s in
tota
l sys
tem
Small "monetization" Large "monetization"
Large crises
Small crises
Ven
DR03
Mex
Ecu99Arg02
Nic
Uru
Col
Per
Par95 Ecu96
Par97
Figure 9. Injection of Central Bank Money and Currency Depreciation
0
20
40
60
80
100
120
140
-200 0 200 400 600 800 1000 1200 1400 1600 1800 2000 2200
Central bank claims on banks. % increase (after/before t +/- 12)
% C
urre
ncy
depr
eciat
ion. 3
mon
ths
acum
mula
ted
Small "monetization" Large "monetization"
VenDR03
MexEcu99
Arg02
Nic
Uru
Par95
Ecu96Par02
38 Moreover, Banco Aleman in Paraguay—the failing bank—was owned by the main shareholder of Banco Montevideo in Uruguay, which had been suffering a major run of deposits and was later closed.
35
The relationship between the use of central bank money in banking crises and changes in international reserves mirrors the former relationship. An increase in central bank claims on banks spurred the demand for foreign currency, which was satisfied by selling dollars from central bank international reserves. Specifically, increasing central bank claims on banks by a factor of 2 or more induced inevitably a drain in international reserves of 15 percent or more, and in excess of 50 percent in Dominican Republic (2003), Mexico, and Uruguay (Figure 10). In the 1995 Argentinean crisis international reserves dropped sharply as the central bank defended the existing currency board.
Figure 10. Injection of Central Bank Money and Fall in International Reserves */
100-
200
500
800
1100
1400
1700
2000
-100 -80 -60 -40 -20 0Fall in international reserv es
% In
crea
se in
cen
tral b
ank
claim
s on
ban
ks
Mex
DR03
Ecu96
Ven
Ecu99
Uru
Arg02Small "monetization"
Large "monetization"
Arg95
Nic
Par95
*/ Largest percentage fall in international reserves accumulated in a three month period.
The large use of central bank money in handling banking crises also boosted inflation. In small and open economies like those in Latin America, the transmission mechanism from money to prices is generally the exchange rate. Therefore, when exchange rates depreciated rapidly an increase in prices followed. In particular, in those crises where central bank claims on financial institutions increased by a factor of 2 or more, inflation generally accelerated by more than 5 percentage points in a one year period—and in systemic events inflation soared. As expected, there is no country in the sample where a limited involvement of central bank money fueled inflation (see Table 5). In addition, involving central bank money in managing banking crises adversely hit economic growth in a large number of countries, including some where central bank money was injected in small amounts (Table 5). There are at least two channels through which injecting central bank money could have affected growth in the short-run, namely an exchange rate depreciation and an increase in interest rates. The exchange rate channel is particularly relevant in countries featuring financial dollarization given that exchange rate devaluations/depreciations hit immediately unhedged bank borrowers and they suffered a sudden and sharp decrease in net wealth. In turn, the increase in interest rates reflects stress
36
in the money market and an associated credit crunch, as banks accumulate extraordinary liquidity to avoid a possible contagion effect. In the specific case of Argentina (1995), the impact on growth was the result of the sizable increase in interest rates that took place as market participants ran into dollars in the midst of the banking crisis fearing a traumatic exit from the currency board.
Table 5. Monetization of Banking Crises, Inflation, and Economic Growth
Small use of central bank money*/ Large use of central bank money
Moderate surge in inflation
Argentina (1995), Bolivia (1994, 1999), Colombia, Costa Rica, Ecuador (1994) Dominican Rep. (1996), El Salvador, Guatemala (2001, 2006), Honduras (1999, 2001, 2002), Paraguay (1997, 2002), Peru.
Ecuador (1996), Nicaragua, Paraguay (1995).
Significant increase in inflation **/
Argentina (2002), Dominican Rep. (2003), Ecuador (1999), Mexico, Uruguay, Venezuela.
Moderate or no impact on growth
Bolivia (1994), Dominican Rep. (1996), Ecuador (1994), El Salvador, Guatemala (2001, 2006), Honduras (2002), Peru.
Ecuador (1996), Nicaragua.
Major impact on growth ***/
Argentina (1995), Bolivia (1999), Colombia, Costa Rica, Honduras (1999, 2001), Paraguay (1997, 2002).
Argentina (2002), Dominican Rep. (2003), Ecuador (1999), Mexico, Paraguay (1995), Uruguay, Venezuela.
*/ Central bank claims on financial institutions increased by less than 200 percent. **/ Inflation accelerated more than 5 percentage points in t +12. ***/ Economic growth declined 3 percent or more during the first or second year of the crisis.
Summarizing, a large injection of central bank money during banking crises encouraged market participants to demand foreign currency rather than local currency to protect their savings from an imminent acceleration in inflation. This became, however, a self fulfilling expectation because the market’s behavior put pressure on the domestic currency and central bank international reserves, which induced a rapid currency depreciation and, in some countries, forced an exit of the peg. Eventually, inflation increased and economic growth decelerated and even collapsed.
37
V. LESSONS AND CONCLUDING REMARKS The environment in which central banks operate in Latin America has changed. The economies of the region are now more incorporated to the rest of the world and, thus, financial institutions are increasingly integrated to global financial markets, in particular in emerging markets. However, this integration makes these economies vulnerable to external shocks and, hence, prone to recurrent events of financial distress and crises. In this environment, it is relevant to ask what should be the role of central banks in financial stability and, in particular, what should be their degree of involvement in coping with financial disruptions and handling banking crises. This paper reviewed 26 episodes of financial turmoil and banking crises from 1990 onward with the aim of distilling lessons that may be applicable to the design of central banks’ response to future episodes of financial distress and crises. The analysis provides factual information about central bank involvement in banking crises in Latin America. The main lesson extracted is that, when central banks injected significant money in managing banking crises—beyond their role as LLR—it exacerbated macro-financial instability, triggering in some cases a simultaneous currency crash. On the contrary, when central bank assistance was limited, it played a positive role in helping to contain and prevent systemic crises, provided governments implemented appropriate bank resolution measures on a timely basis. In other words, the Latin American experience suggests that confronting banking crises using exclusively monetary policy was not effective to avert a major financial disruption. Rather, a comprehensive action was required, with central banks playing an ancillary role in a comprehensive strategy of bank restructuring and resolution. The excessive use of central bank money was, to a great extent, associated with inappropriate institutional arrangements to cope with banking crises. A review of our sample of crises reveals that many Latin American countries lacked legal provisions to effectively adopt early corrective actions, deposit insurance mechanisms were inexistent or poorly funded in most countries, and the possibility of implementing bank restructuring measures had no legal support, with very few exceptions. Against this background, most countries ended up injecting central bank money in an effort to contain financial instability, which eventually served primarily to finance capital outflows and foster currency depreciations. Looking forward, financial distress and banking crises should be tackled at an early stage—involving limited central bank money. Imposing corrective actions before liquidity and capital shortages become chronic and implementing bank resolution measures before the crises unfold should be the roadmap for governments and central banks facing financial distress. On the contrary, postponing the official response, in particular, the implementation of cost-effective resolution measures generally exacerbates macroeconomic instability, elevates the cost of the crises, and may risk a systemic impact. The resulting macroeconomic effects may include a simultaneous currency crisis and even a sovereign debt crisis—in countries where high dollarization also involves government debt. From a microeconomic perspective, the lack of an early response and a disorderly unraveling of the crisis, may be
38
conducive to the adoption of actions that entail breaching of contracts—like freezing deposits, reprogramming their maturities, imposing capital controls, and granting blanket guarantees—that undermine confidence in the financial system and weaken market discipline for years to come. Nonetheless, if crises inevitably materialize, governments and not central banks should assume directly the costs. And when central banks do initially bear the costs of the crises, they should be compensated by governments in order to restore their financial strength, thereby preserving central bank operational autonomy to exercise future monetary policy and credibly commit to monetary policy goals. In addition, Latin America should make additional strides to strengthen financial regulation and supervision keeping the pace of the permanent innovation of financial instruments. While emerging markets in the region have made significant progress more efforts are needed, especially in light of the recent events of financial instability in mature markets. Progress has taken place through the introduction of risk monitoring techniques, the development of derivative markets to hedge risks, and the approval of legislation to apply prompt corrective actions and bank resolution measures. However, regulations and surveillance should monitor more closely the likely multiplication of structured financial instruments, which tend to be recorded as off-balance sheet transactions—in the same country or in cross border jurisdictions. Finally, improved financial regulation and supervision should be supported by strong macroeconomic underpinnings. This is probably even more important for emerging markets because they are more closely integrated to global financial markets, which makes them more vulnerable to the effects of sudden changes in capital flows associated with the vagaries of international financial markets and episodes of financial distress worldwide. Thus, in order to prevent the deleterious effects of external financial shocks, emerging countries need to build more resilient economies, in particular, maintaining flexible exchange rates and strong public finances, consolidating the development of money and capital markets, and, if necessary, reducing financial dollarization.
39
A
ppen
dix
I. Sa
mpl
e of
Epi
sode
s of B
anki
ng C
rises
in L
atin
Am
eric
a fr
om 1
990
to 2
006—
Styl
ized
Fac
ts a
nd P
olic
y R
espo
nse
Styl
ized
fact
s Po
licy
resp
onse
M
inor
and
m
oder
ate
cris
es
Arg
entin
a (1
995)
Th
e en
d-19
94 M
exic
an d
eval
uatio
n tri
gger
ed a
w
ave
of u
ncer
tain
ty a
s to
the
sust
aina
bilit
y of
the
curr
ency
boa
rd, l
eadi
ng to
wid
espr
ead
depo
sit
runs
and
larg
e ca
pita
l out
flow
s. A
s a re
sult,
from
en
d-D
ecem
ber t
o Ja
nuar
y 19
95, p
eso
depo
sits
fe
ll m
ore
than
15%
. Fro
m D
ecem
ber 1
994
to la
te
1996
, abo
ut 4
0 sm
all a
nd m
ediu
m si
ze b
anks
fa
iled
or w
ere
acqu
ired
or m
erge
d (a
lmos
t one
th
ird o
f tot
al b
anks
) rep
rese
ntin
g ab
out 1
2% o
f th
e sy
stem
.
The
Arg
entin
e go
vern
men
t pas
sed
a la
w in
May
199
5 th
at e
mpo
wer
ed th
e ce
ntra
l ba
nk to
get
invo
lved
in th
e re
solu
tion
of d
istre
ssed
ban
ks. T
he n
ew le
gisl
atio
n cr
eate
d th
e ba
sis f
or c
ondu
ctin
g ba
nk m
erge
rs, a
cqui
sitio
ns, P
&A
ope
ratio
ns, a
s w
ell a
s oth
er re
solu
tion
proc
edur
es to
repl
ace
the
stra
ight
liqu
idat
ion
of a
n im
paire
d ba
nk. T
o fa
vor t
he v
iabi
lity
of th
e ne
w o
pera
tions
, a te
mpo
rary
C
apita
lizat
ion
Trus
t Fun
d—fu
nded
by
inte
rnat
iona
l and
gov
ernm
ent r
esou
rces
—w
as c
reat
ed to
inje
ct c
apita
l int
o im
paire
d in
stitu
tions
via
subo
rdin
ated
loan
s or t
o bu
y no
n-liq
uid
asse
ts. A
third
refo
rm w
as th
e cr
eatio
n of
a d
epos
it in
sura
nce
syst
em in
Apr
il 19
95 to
be
fully
fund
ed fr
om th
e pr
ivat
e se
ctor
. The
cen
tral b
ank
did
not p
rovi
de m
onet
ary
assi
stan
ce e
xcep
t in
the
limite
d am
ount
s allo
wed
by
the
curr
ency
boa
rd.
B
oliv
ia (1
994)
In
the
wak
e of
the
inte
rnat
iona
l fin
anci
al
turb
ulen
ce tr
igge
red
by th
e M
exic
an c
risis
, tw
o ba
nks (
with
a m
arke
t sha
re o
f 11%
of a
sset
s)
wer
e cl
osed
in la
te-1
994.
Initi
ally
Cen
tral B
ank
of B
oliv
ia (C
BB
) pro
vide
d LL
R su
ppor
t but
late
r it c
ease
d co
mm
ittin
g to
fully
gua
rant
ee d
epos
its. T
he C
BB
pai
d ca
sh to
smal
l dep
osito
rs
and
com
pens
ated
par
tially
larg
e de
posi
tors
by
givi
ng th
em n
on-in
tere
st b
earin
g ce
rtific
ates
with
mat
uriti
es ra
ngin
g fr
om 3
to 1
8 m
onth
s.
B
oliv
ia (1
999)
B
anco
Bol
ivia
no A
mer
ican
o, B
BA
(with
a
mar
ket s
hare
of 4
.5%
of d
epos
its) w
as in
terv
ened
an
d re
solv
ed in
May
199
9.
BB
A h
ad b
een
rece
ivin
g su
ppor
t thr
ough
FO
ND
ESIF
fund
s—a
resc
ue-f
und
crea
ted
to in
crea
se c
apita
l in
wea
k ba
nks—
sinc
e 19
95. I
t was
fina
lly in
terv
ened
as
a re
sult
of li
quid
ity a
nd so
lven
cy p
robl
ems.
The
bank
was
imm
edia
tely
sold
to
Ban
co d
e C
rédi
to, i
nclu
ding
a p
rovi
sion
to sw
ap a
ny u
ndes
ired
asse
ts w
ith C
BB
m
ediu
m te
rm b
onds
pay
ing
slig
htly
bel
ow m
arke
t int
eres
t rat
es.
Ec
uado
r (19
94)
A m
ediu
m si
ze b
ank,
Ban
co d
e lo
s And
es (w
ith a
m
arke
t sha
re o
f 6%
of d
epos
its),
was
inte
rven
ed.
The
bank
was
inte
rven
ed b
ecau
se o
f mon
ey la
unde
ring
char
ges.
The
bank
ad
min
istra
tion
was
rem
oved
and
the
bank
pur
chas
ed b
y an
othe
r priv
ate
bank
.
Ecua
dor (
1996
) A
larg
e ba
nk, B
anco
Con
tinen
tal (
with
a m
arke
t sh
are
of 8
.5%
of d
epos
its),
was
inte
rven
ed a
nd
take
n-ov
er b
y th
e ce
ntra
l ban
k. A
num
ber o
f fin
anci
al c
ompa
nies
wer
e al
so in
terv
ened
.
Follo
win
g a
perio
d of
cap
ital i
nflo
ws a
nd c
redi
t boo
m, a
n ex
ogen
ous s
hock
tri
gger
ed c
apita
l out
flow
s. A
s the
Cen
tral B
ank
of E
cuad
or (B
CE)
def
ende
d th
e ex
chan
ge ra
te b
and
rais
ing
inte
rest
rate
s a n
umbe
r of i
nstit
utio
ns w
ere
hit b
ecau
se
of m
atur
ity m
ism
atch
es. B
anco
Con
tinen
tal r
ecei
ved
liqui
dity
ass
ista
nce
from
the
BC
E up
to th
e po
int i
n w
hich
inso
lven
cy w
as d
etec
ted
afte
r con
solid
atin
g of
f-
40
St
yliz
ed fa
cts
Polic
y re
spon
se
bala
nce
shee
t tra
nsac
tions
. In
abse
nce
of b
ank
reso
lutio
n in
stru
men
ts, t
he B
CE
prov
ided
a su
bord
inat
ed lo
an a
nd a
cqui
red
the
faili
ng b
ank
to a
void
a tr
aum
atic
cl
osur
e of
the
bank
. Fro
m th
en o
n, th
e B
CE
prov
ided
ope
n-ba
nk a
ssis
tanc
e un
til
depo
sits
stab
ilize
d.
D
omin
ican
R
epub
lic (1
996)
Th
e th
ird la
rges
t com
mer
cial
ban
k, B
anco
del
C
omer
cio
(with
a m
arke
t sha
re o
f 7%
of a
sset
s),
was
inte
rven
ed.
The
cent
ral b
ank
prov
ided
a si
zabl
e am
ount
of f
inan
cial
supp
ort,
befo
re a
nd a
fter
the
inte
rven
tion
of th
e ba
nk. A
s a re
sult,
cen
tral b
ank
clai
ms o
n th
e fin
anci
al
syst
em in
crea
sed
by a
bout
52%
in a
per
iod
of si
x m
onth
s.
El S
alva
dor
(199
8)
Afte
r a sh
arp
stop
in e
cono
mic
gro
wth
in 1
996
asso
ciat
ed w
ith a
term
s of t
rade
det
erio
ratio
n (d
eclin
e in
cof
fee
pric
es),
the
finan
cial
syst
em
got i
nto
stre
ss fr
om 1
997
onw
ards
. A sm
all t
o m
ediu
m si
ze in
stitu
tion
(Ban
co C
redi
sa),
with
a
5% m
arke
t sha
re w
as c
lose
d.
The
gove
rnm
ent h
ad n
o m
ajor
par
ticip
atio
n in
the
solu
tion
of C
redi
sa c
risis
, but
a
com
preh
ensi
ve re
form
of t
he fi
nanc
ial s
yste
m la
w w
as se
nt to
Con
gres
s and
ap
prov
ed, i
nclu
ding
the
crea
tion
of a
lim
ited
depo
sit i
nsur
ance
syst
em, t
he IG
D,
with
cov
erag
e of
US$
6,25
0. T
he IG
D w
as o
rigin
ally
fund
ed b
y th
e B
CR
and
then
st
arte
d to
be
fully
fina
nced
by
the
com
mer
cial
ban
ks It
was
als
o en
title
d to
co
nduc
t ban
king
reso
lutio
n ac
tiviti
es, m
ainl
y to
reca
pita
lize
and
rest
ruct
ure
inso
lven
t ban
ks—
in th
e ev
ent t
hat t
his s
olut
ion
is le
ss c
ostly
than
liqu
idat
ing
the
bank
, or s
houl
d its
liqu
idat
ion
pose
a sy
stem
ic ri
sk—
afte
r writ
ing-
dow
n sh
areh
olde
rs c
apita
l.
Gua
tem
ala
(200
1)
Thre
e sm
all b
anks
(Ban
ks E
mpr
esar
ial,
Prom
otor
, and
Met
ropo
litan
o), w
ith a
mar
ket
shar
e of
7%
of d
epos
its w
ere
inte
rven
ed a
nd la
ter
clos
ed fo
r not
obs
ervi
ng so
lven
cy re
quire
men
ts.
Whi
le th
e ba
nkin
g cr
isis
was
smal
l, th
e B
ank
of G
uate
mal
a (B
angu
at) e
nded
up
mon
etiz
ing
the
cris
is a
mid
fear
s of c
onta
gion
to o
ther
inst
itutio
ns. B
angu
at h
ad
prov
ided
am
ple
emer
genc
y as
sist
ance
to th
ese
bank
s to
cope
with
liqu
idity
and
so
lven
cy p
robl
ems s
ince
199
8. L
LR p
rovi
sion
s in
the
Law
of t
he B
ank
of
Gua
tem
ala,
enc
ompa
ssed
var
ious
mec
hani
sms i
nclu
ding
: (i)
liqui
dity
loan
s (fo
r id
iosy
ncra
tic e
vent
s); (
ii) e
mer
genc
y lo
ans (
for s
yste
mic
liqu
idity
shor
tage
s); a
nd
(iii)
loan
s to
faci
litat
e ba
nk re
stru
ctur
ing.
Whe
n fa
iling
ban
ks w
ere
inte
rven
ed,
Ban
guat
als
o pr
ovid
ed c
ontin
genc
y lo
ans t
o w
ithst
and
depo
sit o
utflo
ws.
The
rece
ntly
cre
ated
Sav
ings
Pro
tect
ion
Fund
(FO
PA) w
as to
cov
er th
e fir
st U
S$2,
500
of sa
ving
dep
osits
exc
lusi
vely
, but
was
not
ope
ratio
nal d
ue to
a la
ck o
f fun
ding
. In
add
ition
, the
FO
PA L
aw in
corp
orat
ed so
me
inst
rum
ents
of b
ank
reso
lutio
n,
incl
udin
g th
e re
mov
al o
f adm
inis
trato
rs a
nd w
rite-
off o
f sha
reho
lder
s’ e
quity
, and
th
e ap
plic
atio
n of
rest
ruct
urin
g pr
ogra
ms,
but P
&A
ope
ratio
ns w
ere
not
envi
sage
d. T
he la
w a
lso
auth
oriz
ed B
angu
at to
inje
ct c
apita
l or t
o bu
y as
sets
to
impa
ired
inst
itutio
ns.
41
St
yliz
ed fa
cts
Polic
y re
spon
se
Gua
tem
ala
(200
6)
The
third
larg
est b
ank,
Ban
cafe
(9%
of d
epos
its),
was
clo
sed
follo
wed
by
anot
her s
mal
l ban
k,
Ban
co d
el C
omer
cio
(1%
of d
epos
its),
a fe
w
mon
ths l
ater
.
As o
ppos
ed to
the
full
mon
etiz
atio
n of
the
smal
l ban
king
cris
is in
200
1,
Gua
tem
ala
succ
essf
ully
man
aged
the
2006
cris
is o
f Ban
cafe
and
the
subs
eque
nt
clos
ure
of B
anco
del
Com
erci
o. U
nder
the
prov
isio
ns o
f a n
ew le
gisl
atio
n ap
prov
ed in
200
2, P
&A
ope
ratio
ns w
ere
exec
uted
with
out c
entra
l ban
k in
ject
ion
of m
oney
, and
rath
er w
ith a
con
tribu
tion
from
the
depo
sit i
nsur
ance
fund
and
a
trust
cre
ated
to fi
nanc
e ba
nk re
solu
tion.
Hon
dura
s (19
99)
A sm
all b
ank,
Ban
corp
(3%
of d
epos
its),
was
cl
osed
in S
epte
mbe
r 199
9.
The
Ban
corp
cris
is re
quire
d th
e C
entra
l Ban
k of
Hon
dura
s (B
CH
) to
inje
ct
liqui
dity
to c
ope
with
dep
osit
with
draw
als,
until
the
bank
was
clo
sed.
In th
e w
ake
of th
is c
risis
, the
dem
and
for f
orei
gn e
xcha
nge
incr
ease
d in
the
BC
H a
uctio
ns
from
a d
aily
ave
rage
of U
S$6.
5 m
illio
n in
July
to U
S$8.
3 m
illio
n in
Sep
tem
ber.
At t
he sa
me
time,
inte
rest
rate
s inc
reas
ed in
the
inte
rban
k m
arke
t sin
ce e
arly
Se
ptem
ber f
rom
13
perc
ent t
o 17
per
cent
. The
initi
al fi
scal
cos
t was
est
imat
ed a
t ab
out 0
.8%
of G
DP.
The
Nat
iona
l Com
mis
sion
of B
anki
ng a
nd In
sura
nces
(C
NB
S) a
nd th
e B
CH
issu
ed a
n em
erge
ncy
finan
cial
law
, the
“Le
y Te
mpo
ral d
e Es
tabi
lizac
ión
Fina
ncie
ra,”
whi
ch in
clud
ed a
bla
nket
gua
rant
ee fo
r a p
erio
d of
th
ree
year
s and
, for
“on
ly th
is o
ccas
ion,
” a
parti
al g
uara
ntee
for t
he li
abili
ties o
f B
anco
rp tr
ust f
unds
. In
addi
tion,
the
law
est
ablis
hed
the
benc
hmar
k fo
r a fo
rced
liq
uida
tion
of b
anks
in te
rms o
f its
leve
l of c
apita
l ade
quac
y. T
he B
CH
was
em
pow
ered
to d
eliv
er g
uara
ntee
of d
epos
its.
H
ondu
ras (
2001
) A
smal
l ban
k, B
anhc
rese
r (w
ith a
3%
mar
ket
shar
e) w
as c
lose
d.
Whi
le a
maj
or c
risis
was
ave
rted,
the
bad
qual
ity o
f Ban
hcre
ser’
s ass
ets a
nd th
e la
ck o
f exp
ertis
e of
the
CN
BS
in c
ondu
ctin
g P&
A o
pera
tions
ent
aile
d fis
cal c
osts
, as
a v
ery
limite
d am
ount
of a
sset
s wer
e pu
rcha
sed
whe
reas
dep
osits
wer
e fu
lly
trans
ferr
ed to
oth
er b
anks
.
Hon
dura
s (20
02)
Two
smal
l ban
ks, B
anco
Sog
erin
and
Ban
co
Cap
ital (
acco
untin
g to
geth
er to
a 5
% m
arke
t sh
are)
wer
e in
terv
ened
and
take
n-ov
er b
y th
e de
posi
t ins
uran
ce in
stitu
tion.
The
two
bank
s wer
e ta
ken-
over
by
the
depo
sit i
nsur
ance
inst
itutio
n (F
OSE
DE)
un
der t
he “
extra
ordi
nary
mec
hani
sm”
rath
er th
an im
plem
entin
g P&
A o
pera
tions
. A
fter w
ritin
g-of
f sha
reho
lder
s equ
ity a
nd re
stor
ing
capi
tal,
FOSE
DE
appo
inte
d ne
w a
dmin
istra
tors
in e
ach
bank
with
the
man
date
of p
repa
ring
both
inst
itutio
ns
for t
heir
futu
re re
-priv
atiz
atio
n. S
ince
FO
SED
E la
cked
ow
n re
sour
ces a
t tha
t m
omen
t, th
e tw
o ba
nks w
ere
capi
taliz
ed w
ith g
over
nmen
t bon
ds, w
hich
then
wer
e di
scou
nted
at t
he B
CH
. FO
SED
E pa
id b
ack
the
BC
H o
ver t
ime
with
the
proc
eeds
of
the
priv
atiz
atio
n of
the
two
bank
s and
with
insu
ranc
e pr
emiu
ms p
aid
by th
e m
embe
r ins
titut
ions
of t
he d
epos
it in
sura
nce
syst
em in
late
r yea
rs.
42
St
yliz
ed fa
cts
Polic
y re
spon
se
Para
guay
(199
5)
Four
ban
ks, B
anco
par,
Ban
co G
ener
al, B
anco
sur,
and
Ban
co M
erca
ntil,
with
a m
arke
t sha
re o
f ab
out 1
4% o
f tot
al a
sset
s wer
e in
terv
ened
and
cl
osed
.
In a
bsen
ce o
f ban
k re
solu
tion
inst
rum
ents
the
Para
guay
an g
over
nmen
t dec
ided
to
inte
rven
e in
itial
ly tw
o ba
nks,
whi
ch h
ad re
ceiv
ed c
entra
l ban
k fin
anci
al a
ssis
tanc
e bu
t had
faile
d to
rest
ore
its fi
nanc
ial s
treng
th. L
ater
, oth
er tw
o ba
nks—
as w
ell a
s a
num
ber o
f fin
ance
com
pani
es—
wer
e in
terv
ened
. Dur
ing
the
inte
rven
tion
perio
d,
the
four
ban
ks c
ontin
ued
oper
atin
g w
ith fi
nanc
ial s
uppo
rt fr
om th
e C
entra
l Ban
k of
Par
agua
y (B
CP)
, whi
ch p
rovi
ded
finan
cial
ass
ista
nce
for m
ore
than
4%
of G
DP
in 1
995.
Whe
n th
e ba
nks w
ere
clos
ed o
n D
ecem
ber 1
995,
the
gove
rnm
ent
reco
gniz
ed p
aym
ents
to d
epos
itors
up
to U
S$21
,500
. The
Con
gres
s exp
ande
d th
e co
vera
ge o
f thi
s gua
rant
ee to
ben
efit
off-
bala
nce
shee
t dep
osits
up
to U
S$15
,000
in
the
clos
ed in
stitu
tions
. The
dep
osit
guar
ante
e w
as d
eliv
ered
with
BC
P m
oney
.
Para
guay
(200
2)
The
third
larg
est b
ank,
Ban
co A
lem
an, w
ith
alm
ost 1
0% m
arke
t sha
re, w
as in
terv
ened
and
cl
osed
.
The
fall
of B
anco
Ale
mán
was
trig
gere
d by
the
inte
rven
tion
of B
anco
Mon
tevi
deo
in U
rugu
ay, a
s the
y w
ere
part
of th
e sa
me
finan
cial
gro
up. T
his c
risis
was
solv
ed
with
littl
e m
oney
from
the
BC
P. T
he sy
stem
’s b
ase
of d
epos
its st
abili
zed
shor
tly
afte
r the
clo
sure
of B
anco
Ale
mán
.
Ex-
ante
larg
e an
d sy
stem
ic
cris
es
Arg
entin
a (2
002)
12
priv
ate
and
publ
ic b
anks
(40%
of d
epos
its)
rece
ived
liqu
idity
ass
ista
nce,
and
ban
k re
solu
tion
was
app
lied
to th
ree
fore
ign
bank
s tha
t exi
ted
the
mar
ket.
As a
resu
lt of
falli
ng e
cono
mic
gro
wth
, ris
ing
inte
rest
rate
s, fis
cal c
risis
, and
un
certa
inty
abo
ut th
e st
abili
ty o
f the
cur
renc
y bo
ard,
all
publ
ic a
nd d
omes
tic
fore
ign
and
priv
ate
bank
s alik
e su
ffer
ed d
epos
it ru
ns. I
n ad
ditio
n, b
anks
wer
e hi
t by
the
asym
met
ric p
esoi
zatio
n th
at c
onve
rted
fore
ign
curr
ency
loan
s to
the
priv
ate
sect
or a
t a o
ne to
one
exc
hang
e ra
te a
nd lo
ans t
o th
e pu
blic
sect
or a
nd b
ank
liabi
litie
s at a
rate
of 1
.4 p
esos
per
US
dolla
r. To
con
tain
dep
osit
with
draw
als,
the
gove
rnm
ent e
stab
lishe
d th
e so
-cal
led
“cor
ralit
o” a
nd “
corr
alón
” to
lim
it th
e flo
w
of d
epos
its o
ut o
f the
ban
king
syst
em a
nd li
miti
ng p
aym
ents
with
in th
e ba
nkin
g sy
stem
. In
addi
tion,
tim
e de
posi
ts in
the
bank
ing
syst
em w
ere
repr
ogra
mm
ed. T
he
bank
ing
cris
is to
ok a
hig
h to
ll on
the
Arg
entin
ean
econ
omy
as e
cono
mic
act
ivity
ta
nked
mor
e th
an 1
0% a
nd in
flatio
n su
rged
to m
ore
than
25%
yea
r-on
-yea
r in
2002
.
Bra
zil (
1994
-95)
A
s hyp
erin
flatio
n ca
me
to a
nd e
nd in
199
4, b
anks
lo
st si
gnifi
cant
infla
tiona
ry re
venu
e—as
soci
ated
w
ith in
flatio
n-pr
otec
ted
gove
rnm
ent s
ecur
ities
—w
hich
in 1
993
had
exce
eded
4 p
erce
nt o
f GD
P.
To c
ope
with
fina
ncia
l dis
tress
, the
Cen
tral B
ank
of B
razi
l (C
BB
) pro
vide
d ex
tens
ive
finan
cial
ass
ista
nce.
To
prov
ide
a m
ore
last
ing
solu
tion,
a v
ast p
rogr
am
of b
ank
reso
lutio
n an
d re
stru
ctur
ing
was
des
igne
d an
d im
plem
ente
d. T
his
incl
uded
: (i)
The
Prog
ram
of I
ncen
tives
for R
estru
ctur
ing
and
Stre
ngth
enin
g of
43
St
yliz
ed fa
cts
Polic
y re
spon
se
As a
resu
lt of
the
“rem
onet
izat
ion”
of t
he
econ
omy,
ban
k cr
edit
boom
ed u
ntil
the
econ
omy
in a
slow
dow
n ph
ase
due
to th
e ef
fect
s of t
he
Mex
ican
cris
is. D
urin
g 19
94 a
nd 1
995,
18
finan
cial
inst
itutio
ns w
ith a
mar
ket s
hare
of a
bout
35
% w
ere
inte
rven
ed, l
iqui
date
d, o
r pla
ce u
nder
th
e R
egim
e of
Spe
cial
Tem
pora
ry
Adm
inis
tratio
n. A
com
preh
ensi
ve p
rogr
am o
f ba
nk re
stru
ctur
ing
was
ado
pted
mai
nly
until
19
97.
the
Nat
iona
l Fin
anci
al S
yste
m (P
RO
ER),
inst
itute
d in
199
5 w
ith th
e ai
m o
f pr
otec
ting
depo
sito
rs a
nd re
stru
ctur
ing
the
bank
ing
syst
em. T
he P
RO
ER c
reat
ed a
de
posi
t ins
uran
ce a
genc
y an
d es
tabl
ishe
d a
diff
eren
tiate
d tre
atm
ent f
or la
rge
bank
s (us
ing
a “g
ood
bank
/bad
ban
k” a
ppro
ach)
and
smal
l and
med
ium
ban
ks
wou
ld b
e ac
quire
d by
ano
ther
soun
d ba
nk. P
RO
ER b
enef
ited
from
Gov
ernm
ent
and
BC
B re
sour
ces t
o su
ppor
t ban
k re
stru
ctur
ing
trans
actio
ns; (
ii) T
he P
rogr
am o
f In
cent
ives
for R
estru
ctur
ing
and
Stre
ngth
enin
g of
the
Stat
e Pu
blic
Fin
anci
al
Syst
em (P
RO
ES),
whi
ch w
as a
imed
at r
educ
ing
the
Stat
e pa
rtici
patio
n in
the
finan
cial
syst
em a
nd a
lso
serv
ed a
s an
inst
rum
ent o
f fis
cal r
estru
ctur
ing
at th
e st
ate
leve
l. A
s a re
sult
of P
RO
ES im
plem
enta
tion,
the
num
ber o
f ban
ks o
wne
d by
th
e st
ates
dec
lined
from
35
in 1
996
to 1
2 in
200
2; a
nd (i
ii) T
he P
rogr
am fo
r St
reng
then
ing
the
Fede
ral F
inan
cial
Inst
itutio
ns (P
RO
EF),
whi
ch a
imed
at
stre
ngth
enin
g th
e ca
pita
l pos
ition
of f
our p
ublic
ban
ks. T
oday
, the
se in
stitu
tions
fa
ce st
ricte
r cap
ital r
equi
rem
ents
than
Bas
el st
anda
rds.
Col
ombi
a (1
999)
In
the
mid
st o
f an
adve
rse
inte
rnat
iona
l fin
anci
al
envi
ronm
ent i
n 19
99, t
he g
over
nmen
t int
erve
ned,
cl
osed
, or t
ook-
over
a n
umbe
r of f
inan
cial
in
stitu
tions
, whi
le o
ther
s wer
e re
ceiv
ing
liqui
dity
su
ppor
t. Ev
entu
ally
, 2 sm
all f
inan
cial
inst
itutio
ns
wer
e cl
osed
and
7 m
ediu
m in
stitu
tions
wer
e pu
t un
der F
OG
AFI
N c
ontro
l. M
ortg
age
bank
s wer
e th
e m
ost b
adly
aff
ecte
d.
As a
firs
t lin
e of
def
ense
, the
Ban
k of
the
Rep
ublic
(BoR
) pro
vide
d lim
ited
finan
cial
ass
ista
nce
by fa
cilit
atin
g ac
cess
to re
disc
ount
faci
litie
s, up
scal
ing
repo
tra
nsac
tions
, and
eas
ing
acce
ss to
long
er-te
rm li
quid
ity su
ppor
t. Th
e bu
lk o
f the
of
ficia
l sup
port
was
, how
ever
, pro
vide
d by
the
Gov
ernm
ent.
It ap
prov
ed d
ebt
relie
f pro
gram
s usi
ng g
over
nmen
t res
ourc
es a
nd, b
ased
on
the
inst
itutio
nal
stre
ngth
of t
he d
epos
it in
sura
nce
inst
itutio
n (F
OG
AFI
N),
it pr
ovid
ed a
dditi
onal
liq
uidi
ty su
ppor
t, to
ok o
ver l
arge
priv
ate
bank
s, co
nduc
ted
P&A
ope
ratio
ns, a
nd
intro
duce
d a
reca
pita
lizat
ion
plan
bas
ed o
n cr
edit
lines
to sh
areh
olde
rs o
f the
im
paire
d in
stitu
tions
. In
addi
tion,
the
bank
ing
auth
ority
aut
horiz
ed te
mpo
rary
re
gula
tory
forb
eara
nce
to e
ncou
rage
deb
t res
truct
ures
with
fina
ncia
l ins
titut
ions
, w
hile
Con
gres
s pas
sed
a la
w su
spen
ding
trad
ition
al b
ankr
uptc
y pr
oced
ures
for
five
year
s to
prom
ote
agre
emen
ts b
etw
een
cred
itors
and
deb
tors
.
Cos
ta R
ica
(199
4)
Ban
co A
nglo
Cos
tarr
icen
se (B
AC
), a
stat
e-ow
ned
inst
itutio
n w
ith a
17%
mar
ket s
hare
was
in
terv
ened
and
clo
sed.
The
bank
ing
auth
ority
inte
rven
ed B
AC
in Ju
ne 1
994
afte
r det
ectin
g ab
norm
al
trans
actio
ns a
nd w
ithou
t hav
ing
expe
rienc
ed li
quid
ity p
robl
ems.
Giv
en th
e co
nditi
on o
f sta
te-o
wne
d in
stitu
tion,
the
gove
rnm
ent a
nnou
nced
a fu
ll co
vera
ge o
f de
posi
ts. N
otw
ithst
andi
ng, t
otal
dep
osits
shru
nk o
ne th
ird d
urin
g th
e fir
st th
ree
mon
ths o
f the
inte
rven
tion,
whi
ch w
ere
paid
with
mon
ey fr
om th
e C
entra
l Ban
k of
Cos
ta R
ica
(BC
CR
). In
Sep
tem
ber,
the
gove
rnm
ent a
nnou
nced
the
liqui
datio
n of
BA
C b
ut a
ll re
mai
ning
dep
osits
wer
e tra
nsfe
rred
to th
e ot
her p
ubic
sect
or
bank
s. Th
e B
CC
R c
ontin
ued
supp
ortin
g de
posi
t with
draw
als i
n th
e re
cipi
ent
44
St
yliz
ed fa
cts
Polic
y re
spon
se
bank
s and
, hen
ce, b
y en
d-19
94, i
t had
ext
ende
d fin
anci
al a
ssis
tanc
e eq
uiva
lent
to
3.5%
of G
DP,
whi
ch w
as p
artia
lly c
ompe
nsat
ed (n
early
50%
) by
the
gove
rnm
ent
with
long
-term
secu
ritie
s (TU
DES
) pay
ing
belo
w m
arke
t int
eres
t rat
es. T
he
BC
CR
was
abl
e to
mop
up
liqui
dity
onl
y pa
rtial
ly b
y in
crea
sing
rese
rve
requ
irem
ents
and
scal
ing
up o
pen
mar
ket o
pera
tions
. The
cris
is o
f BA
C m
ay h
ave
fuel
ed a
sign
ifica
nt in
crea
se in
infla
tion
(fro
m 1
3.5%
to 2
3% b
etw
een
1994
and
19
95).
D
omin
ican
R
epub
lic (2
003)
Th
e ba
nkin
g cr
isis
star
ted
with
the
inte
rven
tion
of th
e th
ird la
rges
t ban
k (1
0% m
arke
t sha
re).
Dep
osit
with
draw
als h
ad a
lread
y st
arte
d by
mid
-20
02 fo
llow
ing
alle
gatio
ns o
f fra
ud fr
om th
e di
scov
ery
of h
idde
n lia
bilit
ies r
ecor
ded
in a
“p
aral
lel b
ank.
” Im
med
iate
ly a
fter,
the
cris
is
exte
nded
to tw
o ot
her i
nstit
utio
ns—
with
an
addi
tiona
l 10%
mar
ket s
hare
—fe
atur
ing
sim
ilar
inap
prop
riate
acc
ount
ing
prac
tices
.
The
cris
is o
f the
se th
ree
bank
s was
man
aged
usi
ng e
xclu
sive
ly re
sour
ces f
rom
the
Cen
tral B
ank
of th
e D
omin
ican
Rep
ublic
(BC
RD
), in
par
ticul
ar, u
sing
cas
h at
the
early
stag
es o
f the
cris
is a
nd la
ter u
tiliz
ing
cent
ral b
ank
certi
ficat
es to
pay
de
posi
tors
. Whi
le th
e La
w o
f the
BC
RD
est
ablis
hed
a lim
it to
the
prov
isio
n of
em
erge
ncy
loan
s of 1
.5 ti
mes
the
capi
tal o
f the
impa
ired
bank
, the
larg
est b
ank
rece
ived
mor
e th
an 1
0 tim
es it
s cap
ital i
n fin
anci
al a
ssis
tanc
e fr
om th
e B
CR
D a
nd
the
othe
r tw
o ba
nks r
ecei
ved
8 an
d 6
times
thei
r cap
ital.
The
thre
e ba
nks w
ere
inte
rven
ed a
nd c
lose
d or
sold
, afte
r the
cen
tral b
ank
gran
ted
to th
em a
bund
ant
liqui
dity
ass
ista
nce.
Ecua
dor
(199
8-19
99)
A la
x ba
nkin
g su
perv
isio
n th
at a
llow
ed b
ad
bank
ing
prac
tices
in a
n en
viro
nmen
t of f
inan
cial
lib
eral
izat
ion,
wer
e th
e un
derly
ing
reas
ons
behi
nd th
e ba
nkin
g cr
isis
in E
cuad
or. 6
0% o
f the
ba
nkin
g sy
stem
was
inte
rven
ed, t
aken
-ove
r, or
cl
osed
.
It ba
sica
lly c
ompr
ised
two
corn
er so
lutio
ns; e
ither
to p
rovi
de e
xten
sive
ly fi
nanc
ial
assi
stan
ce th
roug
h th
e C
entra
l Ban
k of
Ecu
ador
(BC
E) o
r to
clos
e ba
nks w
ithou
t pa
ying
dep
osito
rs, e
xcep
t to
smal
l dep
osito
rs u
nder
a p
rotra
cted
pro
cedu
re, w
ith
BC
E m
oney
. The
lega
l pro
visi
ons s
uppo
rting
BC
E’s r
ole
as L
LR a
llow
ed it
to
gran
t lar
ge a
mou
nts o
f mon
ey. I
n ad
ditio
n, a
dep
osit
guar
ante
e w
as in
pla
ce to
pr
otec
t sm
all d
epos
itors
, whi
ch a
lso
relie
d on
BC
E re
sour
ces t
o be
eff
ectiv
e. A
s th
e cr
isis
unf
olde
d, th
e go
vern
men
t off
ered
a b
lank
et g
uara
ntee
, whi
ch in
itial
ly
was
del
iver
ed u
sing
BC
E m
oney
. The
exc
essi
ve re
lianc
e of
fina
ncia
l saf
ety
nets
on
BC
E’s r
esou
rces
mad
e th
e w
ay fo
r a la
rge
“mon
etiz
atio
n” o
f the
ban
king
cr
isis
, whi
ch re
ache
d 12
% o
f GD
P by
Sep
tem
ber 1
999.
As t
he c
risis
esc
alat
ed th
e go
vern
men
t rep
rogr
amm
ed d
epos
its to
avo
id a
mel
tdow
n. H
owev
er, t
he
gove
rnm
ent e
ased
con
trols
the
cris
is re
gain
ed m
omen
tum
. Eve
ntua
lly, t
he
gove
rnm
ent a
dopt
ed th
e do
llar a
s the
cou
ntry
’s le
gal t
ende
r.
Mex
ico
(199
5)
12 sm
all a
nd m
ediu
m si
ze b
anks
wer
e in
terv
ened
du
ring
1995
-199
7 an
d a
grou
p of
ban
ks h
over
ing
80%
of t
he sy
stem
rece
ived
gov
ernm
ent s
uppo
rt.
In a
dditi
on to
exi
stin
g ba
nk su
ppor
t mec
hani
sms (
FOB
APR
OA
) and
CN
BV
in
terv
entio
n, th
e go
vern
men
t est
ablis
hed
a te
mpo
rary
reca
pita
lizat
ion
prog
ram
(P
RO
CA
PTE)
, by
whi
ch F
OB
APR
OA
bou
ght s
ubor
dina
ted
debt
issu
ed b
y un
derc
apita
lized
ban
ks. T
he g
over
nmen
t als
o cr
eate
d a
prog
ram
to re
capi
taliz
e
45
St
yliz
ed fa
cts
Polic
y re
spon
se
bank
s thr
ough
the
purc
hase
of n
onpe
rfor
min
g lo
ans,
whe
re b
y th
e go
vern
men
t bo
ught
2 p
esos
wor
th o
f non
-per
form
ing
loan
s for
eve
ry 1
pes
o of
new
cap
ital.
To
faci
litat
e ca
pita
lizat
ion,
the
auth
oriti
es li
bera
lized
the
rule
s of f
orei
gn o
wne
rshi
p of
ban
ks. T
o co
ntai
n th
e ev
olut
ion
of N
PLs,
the
gove
rnm
ent f
acili
tate
d th
e re
stru
ctur
ing
of lo
ans i
nto
real
uni
ts (U
DIs
), ta
king
on
the
inte
rest
rate
risk
, and
in
itiat
ed a
deb
tor-
supp
ort p
rogr
am (A
DE)
.
Nic
arag
ua
(200
0-20
01)
4 ou
t 11
bank
s (re
pres
entin
g ab
out 2
1% m
arke
t sh
are
by e
nd-1
999)
, Int
erba
nk a
nd B
anca
fe in
20
00 a
nd B
amer
and
Bai
nc in
200
1, w
ere
inte
rven
ed a
nd so
ld to
oth
er fi
nanc
ial i
nstit
utio
ns.
In 2
000
ther
e w
as n
o de
posi
t ins
uran
ce, a
nd h
ence
, the
gov
ernm
ent a
nnou
nced
th
at it
wou
ld g
uara
ntee
ban
k de
posi
ts to
be
paid
with
cen
tral b
ank
mon
ey.
App
lyin
g P&
A, b
oth
bank
s wer
e pu
rcha
sed
by o
ther
inst
itutio
ns. T
o se
cure
the
succ
ess o
f the
se tr
ansa
ctio
ns, t
he C
entra
l Ban
k of
Nic
arag
ua (B
CN
) iss
ued
own
secu
ritie
s (C
ENI)
to m
atch
the
valu
e of
the
asse
ts a
cqui
red
by th
e pu
rcha
sing
ba
nks.
Alth
ough
a d
epos
it in
sura
nce
inst
itutio
n w
as c
reat
ed (F
OG
AD
E), p
revi
ous
finan
cial
inst
abili
ty u
nder
min
ed c
onfid
ence
in b
anks
, and
hen
ce, d
epos
it w
ithdr
awal
s hit
anot
her t
wo
inst
itutio
ns in
200
1. T
hese
two
bank
s wer
e in
terv
ened
and
imm
edia
tely
pur
chas
ed u
sing
sim
ilar P
&A
pro
cedu
res a
s bef
ore.
Para
guay
(1
997-
1998
) In
199
7, th
e ba
nkin
g cr
isis
reig
nite
d. S
ix b
anks
(D
esar
rollo
, Cor
fan,
Bus
aif,
Bip
sa, U
nion
, Tr
abaj
ador
es) w
ith a
mar
ket s
hare
of a
bout
22%
m
arke
t sha
re w
ere
inte
rven
ed a
nd c
lose
d be
twee
n th
is a
nd th
e fo
llow
ing
year
.
The
bank
ing
syst
em h
ad re
mai
ned
frag
ile fo
llow
ing
the
1995
cris
is. A
s wea
k ba
nks s
tarte
d to
suff
er p
robl
ems,
the
gove
rnm
ent t
ook
the
deci
sion
of t
ackl
ing
finan
cial
dis
tress
by
subm
ittin
g pr
oble
m b
anks
to re
habi
litat
ion
prog
ram
s with
fin
anci
al su
ppor
t fro
m th
e C
entra
l Ban
k of
Par
agua
y (B
CP)
. The
Gov
ernm
ent
also
requ
ired
the
soci
al se
curit
y in
stitu
tion
(IPS
) to
depo
sit m
oney
in th
ese
bank
s. R
ehab
ilita
tion
prog
ram
s eve
ntua
lly fa
iled
and
all s
ix b
anks
wer
e cl
osed
bet
wee
n 19
97 a
nd 1
998.
The
IPS
lost
abo
ut 3
% o
f GD
P in
dep
osits
at t
he c
lose
d ba
nks,
whi
ch w
ere
parti
ally
mad
e up
with
a lo
ng-te
rm g
over
nmen
t bon
d yi
eldi
ng 1
%
inte
rest
rate
. Con
gres
s pas
sed
a la
w th
at in
crea
sed
the
depo
sit g
uara
ntee
from
10
to 1
00 m
inim
um w
ages
. Dep
osits
wer
e co
vere
d w
ith B
CP
mon
ey sp
aced
ove
r tim
e to
min
imiz
e th
e im
pact
on
mon
etar
y po
licy.
As o
ppos
ed to
the
1995
cris
is,
ther
e w
as si
gnifi
cant
“fli
ght t
o qu
ality
,” w
hich
ben
efite
d pr
imar
ily fo
reig
n ba
nks.
Pe
ru (1
999)
C
apita
l out
flow
s trig
gere
d a
dom
estic
cre
dit
crun
ch, w
hich
unv
eile
d so
lven
cy p
robl
ems i
n a
num
ber o
f ban
ks, i
nclu
ding
Ban
co W
iese
, Ban
co
Latin
o (1
5.1%
and
3.2
% m
arke
t sha
re,
resp
ectiv
ely)
, and
oth
er sm
alle
r fin
anci
al
inst
itutio
ns. .
Ban
k re
solu
tion
was
app
lied
thes
e
The
offic
ial r
espo
nse
was
tailo
red
befo
re th
e cr
isis
turn
ed in
to a
syst
emic
pr
oble
m. I
t was
con
duct
ed b
y th
e go
vern
men
t with
min
imum
cen
tral b
ank
invo
lvem
ent a
nd a
imed
at r
estru
ctur
ing
faili
ng b
anks
and
con
solid
atin
g th
e fin
anci
al sy
stem
. The
key
ele
men
t of t
he g
over
nmen
t res
pons
e w
as th
e ap
prov
al
by C
ongr
ess—
in a
fast
trac
k—of
a re
form
to a
llow
the
supe
rvis
ory
auth
ority
to
exec
ute
P&A
, and
the
Dep
osit
Insu
ranc
e Fu
nd (F
SD) t
o ca
pita
lize
and
take
-ove
r
46
St
yliz
ed fa
cts
Polic
y re
spon
se
two
bank
s. In
stab
ility
als
o af
fect
ed a
noth
er 6
sm
all b
anks
(6.5
% o
f dep
osits
). im
paire
d ba
nks t
o pr
epar
e th
em fo
r fut
ure
priv
atiz
atio
n. In
pra
ctic
e, th
e go
vern
men
t pro
vide
d su
ppor
t thr
ough
: (i)
capi
taliz
atio
n of
ban
ks to
favo
r ban
k m
erge
rs; (
ii) is
suan
ce o
f bon
ds to
faci
litat
e P&
A; (
iii) s
wap
s to
rest
ruct
ure
asse
ts,
issu
ing
non-
inte
rest
bea
ring
treas
ury
bond
s in
exch
ange
for t
roub
led
loan
s to
be
repu
rcha
sed
over
a fo
ur-y
ear p
erio
d, a
nd is
suin
g ne
gotia
ble
US
dolla
r bon
ds in
ex
chan
ge fo
r per
form
ing
loan
s, w
ith a
repu
rcha
se c
omm
itmen
t ove
r a fi
ve-y
ear
perio
d fo
r liq
uidi
ty p
urpo
ses;
and
(iv)
deb
t res
ched
ulin
g pr
ogra
ms t
o th
e pr
ivat
e se
ctor
. Pub
lic se
ctor
fina
ncia
l ins
titut
ions
(CO
FID
E an
d B
anco
Nac
ión)
als
o pa
rtici
pate
d in
: (i)
taki
ng-o
ver i
mpa
ired
bank
s thr
ough
cap
ital i
njec
tions
and
the
assu
mpt
ion
of li
abili
ties;
(ii)
rest
ruct
urin
g de
bt a
nd c
onve
rting
fore
ign
curr
ency
de
bt in
to d
omes
tic c
urre
ncy
debt
; and
(iii)
pro
vidi
ng li
quid
ity to
trou
bled
ban
ks.
The
FSD
als
o in
crea
sed
the
cove
rage
per
dep
osito
r to
US$
18,5
00 a
nd in
dexe
d it
to th
e w
hole
sale
pric
e in
dex
with
the
finan
cial
supp
ort o
f a g
over
nmen
t co
ntin
genc
y lin
e of
cre
dit o
f up
to U
S$20
0 m
illio
n.
U
rugu
ay (2
002)
D
ue to
the
colla
pse
of th
e A
rgen
tinea
n ba
nkin
g sy
stem
and
the
enfo
rcem
ent o
f the
so-c
alle
d “c
orra
lito
finan
cier
o,”
Uru
guay
suff
ered
dep
osit
runs
in 2
002.
The
cris
is in
volv
ed a
ll ba
nks,
dom
estic
and
fore
ign
alik
e. F
our p
rivat
e ba
nks
wer
e te
mpo
raril
y in
terv
ened
, clo
sed,
and
mer
ged
in a
sing
le b
ank,
two
larg
e pu
blic
ban
ks re
ceiv
ed
finan
cial
ass
ista
nce
from
the
cent
ral b
ank,
and
on
e la
rge
fore
ign
bran
ch w
as c
lose
d, a
ll of
whi
ch
acco
unte
d fo
r abo
ut 6
0% m
arke
t sha
re.
Alth
ough
ban
ks in
itial
ly w
ithst
ood
depo
sit w
ithdr
awal
s with
thei
r ow
n re
sour
ces,
dom
estic
ban
ks re
sorte
d ev
entu
ally
to c
entra
l ban
k m
oney
. Leg
isla
tion
did
not
envi
sage
d ba
nk re
stru
ctur
ing
prov
isio
ns a
nd ra
ther
allo
wed
the
Cen
tral B
ank
of
Uru
guay
(BC
U) t
o pr
ovid
e fin
anci
al a
ssis
tanc
e w
ith th
e fo
llow
ing
char
acte
ristic
s:
(i) d
isco
unt e
xces
s sec
uriti
es is
sued
by
the
BC
U to
con
stitu
te re
serv
e re
quire
men
ts; (
ii) S
olve
nt b
anks
had
acc
ess t
o ad
vanc
es fr
om B
CU
in p
esos
for u
p to
90
days
on
the
basi
s of a
dequ
ate
colla
tera
l and
not
exc
eedi
ng in
tota
l the
equ
ity
of th
e ba
nk; (
iii) b
anks
whi
ch a
re so
lven
t may
sell
to o
r red
isco
unt a
t BC
U in
pe
sos.
BC
U m
ay a
lso
purc
hase
or r
edis
coun
t hig
h qu
ality
(i.e
. Cat
egor
y on
e)
com
mer
cial
pap
er a
nd se
curit
ies u
p to
a to
tal o
f the
ban
k’s c
apita
l.
Ven
ezue
la
(199
4-19
95)
The
seco
nd la
rges
t ban
k (B
anco
Lat
ino)
co
llaps
ed in
ear
ly 1
994.
12
bank
s wer
e cl
osed
or
take
n ov
er b
y th
e St
ate
in 1
994
and
anot
her 4
in
1995
, tot
alin
g 56
% m
arke
t sha
re (m
easu
red
by
depo
sits
).
Dire
ct d
isbu
rsem
ents
for f
inan
cial
cris
es w
ere
appr
oxim
atel
y 17
% o
f GD
P du
ring
1994
-95.
Afte
r tw
o m
onth
s of t
he L
atin
o cr
isis
, FO
GA
DE
quad
rupl
ed th
e co
vera
ge o
f the
dep
osits
insu
red.
It a
lso
offe
red
subs
tant
ial f
inan
cial
ass
ista
nce
to
troub
led
inst
itutio
ns. T
he g
over
nmen
t nat
iona
lized
seve
ral b
anks
and
issu
ed
bond
s to
pay
depo
sits
tran
sfer
red
to n
atio
naliz
ed b
anks
. The
new
ban
king
le
gisl
atio
n up
grad
ed p
roce
dure
s for
han
dlin
g ba
nk p
robl
ems,
but i
t was
app
rove
d w
hen
the
cris
es h
ad a
lread
y ga
ined
mom
entu
m.
Sour
ce: V
ario
us IM
F St
aff R
epor
ts.
47
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