Financial Sector Reform

Discussion on Bekaert, Harvey and Lundblad Galindo and Micco Sergio Schmukler

Rethinking Structural Reform Conference Federal Reserve Bank of Atlanta Inter-American Development Bank October 2003

Discussion Outline
1.

Reform agenda: logic and scope

Broader than these papers Broader than financial sector reforms

2.

Outcomes for Latin America: mixed or disappointing

Extensive to other regions Not as predicted by these papers

3.

If reforms did disappoint, why?

Policy alternatives to these papers recommendations

4. 5.

Liberalization papers Creditor rights paper

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1. Reform Agenda: Logic Generate more and cheaper financing

FIRMS GOVERNMENT
Supervision and regulation

More financing

BANKS (fragile and inefficient)

Increased competition Higher returns

Cheaper financing

CAPITAL MARKETS

Wider set of instruments

INVESTORS

1. Reform Agenda: Logic Sweeping reforms throughout financial sector

Supervisory agency Investor protection Depository and clearing Trading platforms

More retail investment

Mitigate information and agency problems

Improve exchange infrastructure

Lower transaction costs

DEMAND

CAPITAL MARKETS

SUPPLY

Long-term financing and specialization

Foreign capital available

More discipline and efficiency

Increase liquidity

Promote stocks dissemination

Pension funds Mutual funds Insurance companies

Financial liberalization

Privatization Tax incentives

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1. Reform Agenda: Actions Financial liberalization increasing since late-1980s

Latin America: Indices of Financial Liberalization by Sector
More 3.0 liberalization
2.5

2.0

1.5

1.0

1973

1974

1975 1976

1977

1978

1979

1980

1981

1982

1983 1984

1985

1986

1987

1988

1989

1990 1991

1992

1993

1994

1995

1996

1997

1998 1999

2000

2001

Domestic Financial Sector

Capital Account

Stock Market

Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. The value 1 means repression, 2 partial liberalization, and 3 full liberalization. Figures correspond to end-of-month values. Source: Kaminsky and Schmukler 2002

2002

Less 0.5 liberalization

1. Reform Agenda: Actions Other reforms implemented in the early-1990s

Percentage of Latin American Countries that Implemented Reforms
100 81 69 69 69 69

31

25 6

25

25 13

Creation of current supervisory agency

Establishment of insider trading laws Before 1990

Enforcement of insider trading laws 1990-1995

Improvement in Law and Order index

1996-2001

The figure shows the percentage of countries (from a group of 16 countries) that had implemented reforms before 1990, in 1990-1995, and in 1996-2001. Countries included are Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, Guatemala, Honduras, Jamaica, Mexico, Panama, Paraguay, Peru, Uruguay, Venezuela. 6 Sources: Bhattacharya and Daouk 2000, ICRG, and local data

1. Reform Agenda: Actions Reforms occurred mostly after liberalization

Sequencing: Financial Liberalization and Institutional Reforms

Probabilities of Liberalization Conditional on Law and Order Partial Liberalization Full Liberalization 0.0 28.6 Insider Trading Laws Existence 14.3 71.4 Insider Trading Laws Enforcement 0.0 14.3

The table shows the percentage of coutries that had implemented reforms before partial and full liberalization. Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. 7 Sources: Bhattacharya and Daouk 2000, Kaminsky and Schmukler 2001, and ICRG

2. But Results Not as Expected

(Reforms are good according to these papers) Equity markets
Visible growth (market cap), but not as in OECD Rising concentration and delisting Migration to international equity markets Small relative to bond markets

2. But Results Not as Expected

Bond markets
Dominated by government paper Dollarization Short duration Currency and maturity mismatches

Institutional investors
Fast growth but tapped by governments

2. But Results Not as Expected Latin America Equity Market Growth Is Poor
Stock Market Capitalization
Percentage of GDP
150

125

Latin American countries Asian countries G-7 countries

100

75

50

25

0 1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. Asian countries: Hong Kong, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand. G-7countries: Canada, France, Germany, Italy, Japan, U.K., and U.S. Figures correspond to end-of-year values. Sources: IFC's Emerging Markets Database, World Federation of Exchanges (FIBV), and The World Bank 10

2. But Results Not as Expected Stock Exchanges Affected by Increasing De-listing

Domestic Stock Exchanges: Number of Companies
600

500

400

300

200

100

Argentina

Brazil

Chile

Colombia

Mexico

Peru

Venezuela

1990
Source: IFC's Emerging Markets Database

1995

2000
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2. But Results Not as Expected Large Companies Migrate to International Markets

Latin American Companies: Value Traded
USD Millions
250,000

200,000

Internationalized companies in international market Internationalized companies in domestic market Domestic companies

150,000

100,000

50,000

0 1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. Internationalized companies are defined as companies that cross-list or raise capital in international stock markets at some point in time. Figures correspond to end-of-year values. Sources: The Bank of New York, Euromoney, and IFC's Emerging Markets Database

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2. But Results Not as Expected Equities Traded Belong to a Handful of Large Firms
Stock Market Concentration (end-2000)
Percentage
80 70 60 50 40 30 20 10

Brazil

Chile

Venezuela

Argentina

Colombia

Hong Kong

U.K.

Mexico

Peru

Malaysia

Thailand

Share of trading of top ten companies

Source: IFC's Emerging Markets Database 13

Japan

U.S.

2. But Results Not as Expected Public Bond Trading Outweighs Equity Trading
Value Traded in Domestic Markets (2000)
Percentage of GDP
14 12 10 8 6 4 2 0
68

Argentina

Bolivia

Colombia

Ecuador

El Salvador

Mexico

Government bonds

Equities

The figure shows the value traded through the domestic exchanges. However, in the case of Mexico, repo operations (conducted or not through the exchange) are also considered. Sources: Local data, The Handbook of World Stock, Derivative & Commodity Exchanges 2001, Federacion Iberoamericana de Bolsas de Valores (FIABV), and The World Bank

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3. If Reforms Did Disappoint, Why?

Wrong sequencing
Financial integration went too fast Imperfections in international markets lead to vulnerabilities when domestic sector is not ready Thus, follow right sequencing But, are there sufficient incentives to reform institutions without the discipline from openness and crisis?

Wait for the fruits of reforms and do more

The dividends from reforms have long gestation period Thus, accelerate pace But, we all know what happens in the long run
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3. If Reforms Did Disappoint, Why?

Wrong expectations
Recommendations based on cross-sectional evidence Reforms did not tackle well some basic issues for EMs
Macro policy Systemic risk Domestic and external shocks, e.g. capital flows volatility Institutional factors size, information asymmetries, moral hazard

Globalization Thus, redesign reform to address the basic issues, and revise expectations But, many of these issues are intrinsic to emerging markets and solving them is a daunting task
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4. Liberalization Papers
Great papers!

Important contributions
Welfare implications relative to previous work Growth mean and volatility Solid work Almost painful to read, overwhelming force Incorporated most comments received in the past years, so difficult to discuss
Particularly for the growth mean paper

Volatility paper needs to address the same comments that spur paper already did
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4. Liberalization Papers
Potentially relevant issues to consider
One of the most fundamental national policy decisions of the past 25 years has been the liberalization of equity markets across the world.
Here, allowing foreigners to purchase domestic stocks But witness size of stock markets And witness effects of capital account liberalization

Which samples/estimations make sense?

Mix of developed and developing, including very poor countries Including countries with no change in liberalization Time series for emerging markets Fixed effects estimations
Coefficient diminishes to 0.56 But why including countries with no variation in liberalization here?
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4. Liberalization Papers
Potentially relevant issues to consider (continued)
More on econometrics
Overlapping observations How are common factors treated besides SUR specification? How is endogeneity addressed, specially given that it comes up in the growth paper?

Removing 97-00 seems arbitrary

Crises as outliers? Rationale? Why including 99 and 00? Perhaps, crises consequence of liberalization, as suggested Even with crises, other evidence points towards lower volatility
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4. Liberalization Papers
Caveats related to liberalization measures
Wider set of financial liberalization measures Pace of liberalization Reversals Intensity of liberalization Capital account liberalization
Might seem more important to many readers Treatment of capital account liberalization

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4. Liberalization Papers
Other specific points
More on economic significance would be welcomed Results weakened with other controls For LAC countries, mean results insignificant Other regressors
Other controls, like GDP per capita Level of inflation might matter

Risk sharing
Perhaps, could be another paper
Ability versus actual risk sharing

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5. Creditor Rights Paper

Great paper!

Important points of the paper

Effectiveness of creditor rights, interacted with
With rule of law With efficiency of the judiciary With small and medium firms Perhaps nicest results

Three effects of creditor rights

Credit/GDP Share of bank credit financing of small and medium firms Change in real credit (procyclicality)
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5. Creditor Rights Paper

Potentially relevant issues to consider
More consistency across empirical analysis Creditors rights, rule of law, or broad institutions?
No multivariate analysis, omitted variables
Only done very partially for change in credit, when controlling both for creditor rights and rule of law Perhaps, control for GDP per capita, given that GNP and GDP growth not significant

Interaction might result more from law and order explanatory power than from creditor rights
Perhaps interact with GDP per capita and other variables

Why is creditor rights insignificant by itself second part?

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5. Creditor Rights Paper

Potentially relevant issues to consider (continued)
Why procyclicality?
Risk can be reduced ex-ante, knowing state of institutions More explanation would be welcomed

Policy recommendations
Cross section evidence versus time series recommendation More reforms needed Foreign jurisdictions Systemic shocks and creditors right Repudiation of contracts Shocks to collateral In fact, acknowledged importance in institutional analysis
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5. Creditor Rights Paper

More on data and variables
Macro variables not significant, except budget deficit WEBS survey
Only for 1999 Share of investment financed with bank credit and legal protection What about other type of financing

Other specific point

Econometrics
Procyclicality results weak using IVs Clustering standard errors
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