Lessons from Argentina's 1995 Financial Crisis May Be Applicable to Other Countries

• Pages: 8-9

Page 8

Argentina's banking system did not escape the effects of the Mexican financial crisis of December 1994, which caused a lack of confidence to ripple through many emerging markets. In 1995, Argentina was in the throes of an economic recession, which, in conjunction with the expected growth in banks' share of nonperforming loans, led to a gradual deterioration of their capital-asset ratio in 1995 and 1996. Depositors pan-icked and subsequently became less tolerant of risk. They pressed banks to reduce default risk. Banks responded by contracting the share of loans in their portfolios, thus creating a credit "crunch."

There is evidence that, in the aftermath of the Mexican crisis, Argentine banks were particularly over-exposed, with many experiencing substantial outflows of deposits and equity losses. The ensuing credit retrench-ment lasted for six quarters-until the end of 1996 (see chart, page 9)-when banks showed the first signs of approaching their precrisis equilibrium levels of risk exposure and began to reconstruct their capital bases.

Lessons from Argentina

A chief finding of Ramos s study is that when banks sus-tain asset losses, their deposits are usually jeopardized. The best course of action, the author suggests, is to replenish, or reconstruct, the capital account immediately through an injection of new capital, which would immediately restore the security of deposits. With a higher capital ratio, banks are better able to withstand a deterioration ofthe value of their assets and to safeguard deposits. However, bank managers may instead elect to compensate depositors for the diminished safetybyincreasingliq-uidity and shedding lending risk. Why would banks opt for increased liquidity (forgoing the rents from lending) rather than for immediate recapitalization?

The study postulates that during and immediately after a banking crisis, the cost of raising equity is very high. Because the new capital required for reconstruction will be relatively expensive, shareholders will prefer to pay the opportunity cost of increased liquidity and postpone replenishment until capital is cheaper. In the meantime, depositors must somehow be reassured, implying that banks will have to shed risky assets and increase liquidity, which they are known to do after periods of financial distress. For instance, after the Great Depression and throughout the 1930s, commercial banks...