Banking Supervision

• Author: Robert Rennhack
• Position: Advisor in the IMF's Western Hemisphere Department

Countries in Latin America and the Caribbean, like other emerging markets, have experienced banking system difficulties that have hampered growth and generated fiscal costs as high as 10 to 20 percent of GDP and even more. Many countries have improved their banking systems, but further reform is needed.

One reason banking crises have typically had a stronger adverse impact in Latin America and the Caribbean than in the industrial countries is that banks usually play a much more important role as financial intermediaries in the former. In many countries in the region, insurance companies and private pension funds are only in the early stages of development, and domestic bond and equity markets are still relatively small.

It has been argued that banks in Latin America and the Caribbean are more vulnerable than those in industrial countries for several reasons. Most deposits tend to be short term, because depositors have little confidence in the stability of countries' macroeconomic policies and the quality of the banks. Banks tend to place a larger share of their assets in loans, and the value of their holdings of government securities is more volatile. Also, banks' access to external financing is often reduced during a crisis, and raising capital during economic downturns can be complicated, especially because domestic securities markets are thin.

Many of the problems that have plagued banking systems in Latin America and the Caribbean were triggered by macroeconomic disruptions. The most prominent of these was the sharp depreciation of the Mexican peso in December 1994, which eroded the quality of the loan portfolios of Mexican banks while cutting off the banks' access to new funds. Banking systems in Colombia, Mexico, and Peru had difficulties adjusting after being liberalized or privatized, while those in Argentina and Peru in the early 1990s and Brazil in the mid-1990s encountered problems after inflation had been reduced from very high rates to moderate levels. Weak bank supervision was an essential ingredient of the difficulties in these countries, while in others-Paraguay, for example-it was the primary cause.

Strengthening bank supervision

Many countries in Latin America and the Caribbean have therefore adopted reforms aimed not just at dealing with problem banks but also-and more important-at strengthening banking supervision to reduce the likelihood of future crises. They have firmed up prudential guidelines, establishing minimum capital requirements, adopting better systems to monitor asset quality and provisioning for bad loans, and imposing tighter...