Report No. 17864-AR

Argenti naFinancial Sector ReviewSeptember 28, 1998

Argentina, Chile and Uruguay Country Management UnitPoverty Reduction and Economic Management UnitLatin America and the Caribbean Regional Office

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Currency Equivalents

Currency Unit: Peso (As of May 1998)US$1 = ARG$1

Fiscal YearJanuary I - December 31

Glossary of Acronyms

ADR American Depository ReceiptsAFJP Private Pension FundsBASIC Bonds, Audit Control, Superintendency, Infonnation and Rating AgenciesBCRA Cenitral Bank of the Republic of ArgentinaCAMEL Capital, Assets, Management, Earnings, LiquidityCEDEAR Argentine Certificate of DepositCNV National Securities CommissionCPI Consumer Price IndexGDP Gross Domestic ProductIMF International Monetary FundINDEC National Statistics & Census InstituteLIBOR London Interbank Offer RateMAE Electronic Open MarketMCBA Buenos Aires (city)MERCOSUR Southlern Cone Common MarketMERVAL Capital Market IndexMRP Minimuum Relative ProfitabilityNPL Non Performing LoanisOECD Organizationi for Economic Cooperation & DevelopmentSAFJP Superinitendency of Pension FunidsSEDESA Deposit Insurance AgencySEFC Superintendency of Financial InstitutionsUSA Uniited States of AmericaVAT Value Added TaxYPF Oil Company

Vice President: Shahid Javed Burki, LACDirector: Myrna Alexander, LCC7CLead Economist: Paul Levy, LCC7ATask Maniager: Paul Levy, LCC7A

COUNTRY DATA - ARGENTINA

AREA POPULATION DENSITY

2766.9 thous. sq.km. 34.7 million (mid-1995) Country density 1991 11.7 hab.per sq.km

1.4% annual growth Rural density a/ 16.9 hab. per sq.km of arable land

POPULATION CHARACTERISTICS a/ HEALTH bI

Crude Birth Rate (per 1000-1995) 19.8 Populabon per physiian (thous.) 0.4

Crude Death Rate (per 1000 - 1994) 7.5 Population per hospital bed (thous.) 0.2

Infant Mortality (per 1000 live births .1994) 22.0

INCOME DISTRIBUTION bi DISTRiBUTION OF LAND OWNERSHIP

% of natonal income, highest quintle 51.0% % owned by top 10% of land owners

% of national income, lowest quintle 5.0% % owned by smallest 10% of land owners

ACCESS TO SAFE WATER (1993) ACCESS TO ELECTRICITY (1989)

% of population - urban 73% % of population 95%

% of populabon - rural 17%

NUTRITION a/ EDUCATION

Calore intake as % of requirements 119.2% Adult literacy rate % (1980) 95%

Per capita protein intake (grams per day) 99.7 Pnmary school enrollment % a/ 100%

GNP PER CAPITA IN 1997 dl 8,770

GROSS DOMESTIC PRODUCT IN 1997 elANNUAL GROWTH RATES (% constant prices)

USS Bill. %(current prices) of GOP 196S-73 1973-80 1980-9B 1997

GDP atmarketpnces 325.0 100.0 4.3 2.2 1.5 8.6

Gross Domestic Investment 65.3 20.1 6.8 4.3 1.3 26.5

Gross National Savings 54.0 16.6 2.5 2.3 1.5 7.1

Current Account Balance -9.5 .2.9Exports of Goods & NFS 29.3 9.0 -4.7 14.1 6.3 9.1

Imports of Goods & NFS 34.9 10.7 0.6 13.3 7.8 27.1

OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 1995

Value Added (constant prices) Labor Force f/ V.A. Per Worker

Arg $ Thousand % of Total Thousands % Arg $

Agiculture 1,010 7.4 2,973 12.0 340

Industry 5,056 37.0 7,780 31.4 650

Services 7,588 55.6 14,023 56.6 541

Total GDP at Factor Cost 13,654 100.0 24,776 100.0 551

GOVERNMENT FINANCE g/

Federal Govemment Provinclal Govemment

Million Pesos % of GDP Million Pesos % of GDP

1997 1997 1996 1996

Current Revenues 53,838 16.6 Current Revenues 27,658 9.2

Current Expenditures 55,056 16.9 Current Expenditures 25,462 8.5

Capital Revenues 736 0.2 Capital Revenues 316 0.1

Capital Expenditures 3,795 1.2 Capital Expenditures 4,150 1.4

Surplus 4,277 -1.3 Surplus -1,829 -0.6

at For the period 1982-1935.bl For the period 1970-1976.rJ For the period 1987-1992.dt Current US dollars. Estimated using Bank Adas methodology.el Current US dollar estimates, calculated from data in constant Arg S 1986.f Calculated by applying 1980 census shares to 1994 population.g Cash Basis in current Pesos, includes Centra Administration, Social Security and net balance of Public Enterprises. Capital revenues includes privatzabon incomes.

COUNTRY DATA - ARGENTINA

MONEY,CREDITANDPRICES 199 19" 196" 199 1997

(Mllons of P0s0; end of period)

Money and Quasi Money 29,479 33,248 32,817 38.026 44,709Domestic Bnk Ceditto Publ Sector 9,020 9,426 8,157 9.137 1028"Domesc Bank Cr to PrvaFt Sector 42206 50,581 50,568 58,045 64,022

Money andiuasci Moneya% ofGDP 114 11.8 11.7 12.7 13.8Wholesae Prce lndex(Apr IN99llWO) bS 106.4 108.8 115.9 119.5 119.7

Annual peentage thanga In:General Whiotasale Price Index dV 1.8 2.3 8.5 3.2 01BankCredtloPublicSector -0.9 4.5 -13.5 12.0 12.4Bank Credit to Pdrvb Sector 256 19.8 0.0 10.8 14.2 MERCHANDISE EXPORTS (Averag 1991-1997) a

BALANCE OF PAYMENTS ac 1993 994 1995 1996 1997 US$ Mn. % of Total

Primary products 4304.6 24.1Manuf. of agricuttural origin 6493.8 36.3

EMxor of Goods, NFS 15,572 18,437 23,824 27,037 29,318 Manuf. of indusrial origin 546.3 26.2Imports of Goods, NFS 20,728 25,616 23,808 27,910 34,899 Fuels 2049.5 11.5Resource Balnce .5,158 -7,179 18 -873 -5,581 Total Morchandise Export 17894.2 100.0

Interest Payrmnts (not) -1,081 .1,136 -1.054 -1,326 -1,784Other Factor Pamnts (net) -1,848 -2,122 -2.182 -1,922 -2,435 Total Public Debt Outstanding & DOsbured (End 199S) bi USS Mn.NotCurrentTrandferm 411 320 432 334 346BalanceonCurrentAccount -7,872 -10,117 -2,768 -3,787 -9,454 Total 97105

IBRD 5316Capitol Account 10,938 10,218 783 7,203 12,549 IDB 4756

IMF 6279Pdvate Sector 7,849 5,274 -5,175 -2,011 5,983 Bilaterals 10162Public Sector 3,089 3,944 5,958 9,214 8,588 Bonds 88841

Comnercial Banks 1751Changes in Gross Reserves (+ i nrease) 3,266 101 -1,985 3,418 3,095

DEBT SERVICE RATIO, 1996 55.3%RATE OF EXCHANGE

itRDIlDA LENDING, DECEMBER 31,1996 (Mn. US$) blUSS 1- Arg.$ I

IBRD IDA

Outstnding & Disbursed 5316

at Source: Minitry of EconormybV Source: INDECc/Averae indx for th year.dV Based on th average Index for the year.

Table of Contents

EXECUTIVE SUMMARY ............................................................;

1. THE FINANCIAL SYSTEM IN THE CONTEXT OF THE CONVERTIBILITYPLAN ............................................................ 1ARGENTINA'S REFORM AGENDA ............................................................................ 1THE FINANCIAL SYSTEM AND THE CONVERTIBILITY LAW . .................................................................. 2

The 1994/95 Challenge ........................................................................... 5Aftermath to the Crisis ........................................................................... 9

LESSONS OF EAST AsIA ........................................................................... 10

INTERNATIONAL INTEGRATION AND REGULATORY COORDINATION ..................... ............................... 16ENDNOTE ........................................................................... 17

2. THE BANKING SECTOR ........................................................... 18CURRENT CONDMONS .1....................... 18

Structural Change: Overview and Implications ........................................................ 18Recent Developments ........................................................ 21Assessing Current Problems ........................................................ 23

BANKCING SYSTEM: AN EVOLUTIONARY PROCESS ......................................................... 28STRUCTURAL CHANGE: IMPROVING SYSTEM STABILITY ....................................... ................. 32

Foreign-Owned Banks ........................................................ 32Privatization ......................................................... 35Consolidation ........................................................ 37

IMPROVING THE REGULATORY AND SUPERVISORY FRAMEWORK ...................................................... 39Regulation ........................................................ 41

Liquidity Requirements and Capital Standards ...................... .................................. 42The Role of Subordinated Debt ........................................................ 44Contingent Repo Facility ........................................................ 45Central de Deudores ........................................................ 48Bank Regulation: International Comparisons ........................................................ 53Supervision ........................................................ 54

FURTHERING INSTITUTIONAL/STRUCTURAL CHANGE ............................. ........................... 58Failure Resolution Mechanisms ........................................................ 58Liability of BCRA Personnel in Failure Resolution .................... ............................. 60Bank Governance ................................................. 60

3. CAPITAL MARKETS ................................................. 62EQUITY AND BOND MARKETS .................. 6.2.......................... 62

Introduction .................... 62Recent Performance .................... 63The Equity Market .................... 63Bond Market .................... 67The "Co-movement" of Argentine Equity and Bond Prices .............................................. 69Conclusions and Policy Issues ............................................. 72

INSTITUTIONAL INVESTORS AND SECURITIES MARKETS ......................................... 77Introduction ............................................. 77Pension Funds .............................................. 78Insurance Companies ............................................. 87Mutual Funds ............................................. 91

APPENDIX .............................................. 97

EXECUTIVE SUMMARY

1. The Convertibility Plan has proven to be Argentina's most successful economicprogram in decades, and its achievements, durability and continued public support is atestament to its success. The challenge of sustaining a stable and growing economy andreducing poverty are priorities that are setting an ongoing reform agenda for Argentina.This report reviews one dimension of that reform agenda, that of the financial markets.

THE FINANCIAL SYSTEM iN THE CONTEXT OF THE CONVERTIBILITY PLAN

2. The financial markets have developed significantly since the beginning of theConvertibility Plan. Nevertheless, further financial deepening is necessary for overalleconomic development, and to sustain the symbiotic relationship existing between thefinancial system and the Convertibility Plan. While external shocks, which in extremecases, as prescribed by the Convertibility Plan, can lead to the demonetization of theeconomy and challenge the financial system, the health of the financial system might alsochallenge the viability of the Convertibility Plan. Whichever is the nature of the shock, itis critical for the sake of the Convertibility Plan to have a strong financial system, arequirement that emerging and developed countries alike are currently painfullyexperiencing. The strict rules of the Convertibility Law, however, have, in general,played a constructive role in preventing external crises from damaging the Argentineeconomy by instilling discipline on individual banks, and the banking system as a whole.

3. Despite serious prior efforts to strengthen the financial system, the 1994/95 crisisincreased the urgency for reform, since the financial system came close to the point ofcollapse. As a result, following the crisis, Central Bank authorities took a number ofmeasures to build on the growing strengths of the banking system both from theregulatory and supervisory perspectives and to increase the liquidity in the system, actualand contingent. Given the importance of systemic liquidity for a country that has limitedaccess to a lender-of-last-resort and variable access to international credit, theauthorities have now amassed an arsenal of options which can provide liquidityequivalent to over 40 percent of deposits in the system (through obligatory liquidityrequirements, the contingent repo facility, and the use of rediscounts which could back athird of the monetary base with foreign denominated public bonds). Measures taken

The main focus of this report is the review of the cvolut ion of Argentina's financial system,particularly since the tequila crisis of 1995. It poses the question of whether it is stronger or weakerthan before that crisis, and identifies future challenges. Contributors to this report wereMessrs./Mrnes. P. Levy (task managcr, systemic issucs and institutional framework), G. �aprio, R.Cull, C. Caloiniris (banking system, systemic issues), I. Gutierrez (supervision), M. Miller (smalland medium enterprises); D. Vittas (capital markets, institutional investors), S. Schmukler (capitalmarkets). Discussions with Mr. S. Alber, and analytic support by Mr. D. Lederinan, enhanced thereport. The report benefited from a veiny constnmctive and open dialogue with the Central Bank,including its President, Dr. P. Pon, the report's main official counterpart Dr. A. Powell, theSuperintendent and Vice-superintendent of Banks, Messrs. M. Ortiz and J. Boizico, and otherC.B.R.A. directors and staff. The Bank mission benefited from discussions with Messrs. A.Quiroga at the Ministry of Economy, A. Hall at the CNV, H. Domeniconi at SAFJP, F. Susinel atBanco Hipotecario, the Superintendency of Insurance, and SEDESA.

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since 1995 have been instrumental in deflecting the critical early stages of the recentAsian crisis.

4. Increasing the system's access to a lender of last resort, however, works in twodirections. While it strengthens confidence in the banking system's ability to absorbshocks, and in that they might succeed in preventing them from occurring in the firstplace, they also increase the discretion of economic authorities in affecting monetaryaggregates, which the Convertibility Law had successfully constrained.

5. Lessons of E. Asia miggest that (a) capitalflows could be dangerous when theregulatory structure of the financial system cannot enswure their efficient use--inArgentina, regulation is stronig and the suibordinated debt system utilizes marketinformation toflag inefficient use of capital; (b) property and asset market bubbles canoccur even with low inflation. Argentina has set uip a system to track lending, and ifneed be, since the convertibility law does not pernmit countercyclical monetary policy,preferably use fiscal measures to cool the economy; cad (c) diversified foreign bankentry can make the banking system more efficient catid more robust to shocks--Argentinais moving aggressively ini that direction.

6. Growing international integration could lead the Argentine financial system toevolve and resemble regional US financial markets, which have thriving financial sectorsdespite company listings in New York. A strategic decision couild be taken to supportmeasures that pronmote international integration and consequently enhance financialefficiency and improve financial internmediationi, without undue concern over thechanging structure of the domestic financial market.

7. There is a need to address problems arising from lack of coordination acrossfinancial regulatory agencies. Argenltine authorities could examine the advantages ofcreating an umbrella body that could promote coordination amonlg susch agencies,without losing the benefits of specialization.

THE BANKING SECTOR

8. In recent years the banking sector in Argentina has gone through a number ofchanges. In particular, since the Tequila crisis, substantial consolidation, privatization,increased entry by foreign institutions, and tightening of regulation and supervision havetaken place. The fast expansion of the financial system has been taking place in themidst of a restructuring process, which saw the number of financial entities in thebanking system cut by a third. Based on current policy to treat foreign capital in a similarvein to domestic capital, the continuing diversified entry of solid foreign banks shouldstrengthen the system further, reducing systemic risks.

9. Relative to domestic banks, foreign ones are larger, are growing more rapidly,and have much higher portfolio quality than domestic ones (either public or private).There is, however, variation in the quality of the private domestic banks, and it is thesmallest ones (but certainly not all small banks) that appear to pose the greatest risks of

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failure. From a systemic perspective, private domestic banks may not pose that great athreat.' The public banks pose the biggest problems, though the main issue with suchbanks is the misallocation of resources associated with nonperforming loans. Theirportfolio quality is low regardless of size, and this could probably worsen after morerigorous audits.

10. From a systemic perspective, it is encouraging that the weakest banks, bothpublic and domestic private, tend to be smaller. In addition, the smaller, weaker banksalso tend to have lower ratios of liquid to total assets. The combination of weakportfolios and low liquidity implies that these banks are most vulnerable to exogenousshocks. The portfolio quality results are also reflected in 1997 profitability figures.Concerns over the low profitability of the banking system appear to be structural,reflecting more the problematic state of public banks and small banks, with the ten largerbanks having a return to equity of 15.3 percent in 1997.

11. The findings of this report lead to recommenedations for the continuingrestructuring of the banking system, including: (a) Efforts should continue to reducethe presence of public banks in the system, including national, provincial andmunicipal banks. While posing a lesser systemic risk, they introduce significantmisallocation of resources to the econcomy, distort due to their size the efficientfunctioning of the entire banking system ('including the interest rate structure and theentry of private banks in the provinces), and pose a fiscal burden. If a financial crisisis associated to a fiscal crisis, public banks could create a systemic risk as well; (b)restructure more aggressively smaller, weak private banks, which due to their relativelarge number--but small overall share of the market--are a constant source ofinsecurity to the system; (c) to improve merger qcuality, consider restricting bankacquirers to A -rated banks; and (d) improve access to finance for small and mediumenterprises by strengthening the legal protectiotn cafforded to lenders in securedtransactions, strengthening the judicial system 1s ability to address commercial cases,implementing changes in the tax trealmenit of leasing, which deter that industry'sdevelopment, and continuing to improve infornation on7 borrovers' credit history.

Regulatory Framework and Supervision

12. The Central Bank has introduced a very sound framework of prudentialregulations, some of them novel and experimental, aimed primarily at the systemic risksfacing the banking system. These are market-oriented regulations which attempt tocomplement oversight responsibilities of the banking system through investors, auditorsand rating agencies (Argentina's home-grown BASIC program). On supervision, theoverall structure is sound, and incorporates many of the current international best

1 We recognize, however, that contagioii could conceivably iiake individtial bank runs worse. Still, thesize of the weaker private domestic banks relative to the large foreigu, public, and private domestic onessuggests that such contagion would have to affect banks that appear quite healthy at the moment to haveserious systemic consequtenices.

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practices. Central Bank efforts in strengthening banking supervision and its regulatoryframework have been successfuzl and commendable. However, since the 1995 crisis,some areas of the supervisory process have been overwhelmed by the need to devotesubstantial resources to crisis management, and there is a need to renew the process ofsupervisory institutional development, and to improve implementation of the existinglegal and institutional framework.

13. In an experimental international comparison of regulation of various bankingsystems in Latin America and E. Asia by using extended CAMEL standards, Singapore,Argentina, and Hong Kong stand out as having the strongest banking regulations.Across virtually all categories, Argentina dominates the East Asian countries that havebeen beset by financial crises. Thus, whereas no banking system is ever immune tosufficiently large shocks, the Argentine regulatory system appears to be among the mostrobust, as it needs to be given the constraints on official intervention that is part of theConvertibility Plan.

14. Findings in this report suggest the followi7ng recommendations: (a) thesupervisory process wouild be greatly strengthened if the implementation of adoptedstrategies by the Superintendency flirther enhaniced in.spectors' ability to assessindividual banking risks and provide advance warning of emerging problems, beforethey became critical. Efforts underway to strengthen supervisory personnel wouldfacilitate this process; (b) to improve failure resolution1 mechanisms, the Central Bankshould consider the arguments for and against separating the functions of the CentralBank, the Superintendency, and SEDE,S.A. While the current structure facilitatesinformation flows anid co-ordinactioni of decision makinig, separation could reducemoral hazard in. crisis resolution, and.facilitate better coordination with otherregulatory entities, particularly oti non-banking financial institutions. (c) SEDESAshould reconsider the "least cost resolution" principal that provides a mechanism formultiple bailouts; (d) pass legislation protecting public of ficials in the exercise of theirpublic duties, to facilitate the restructuring of the bantking systenm;(e) sub/ect publiclyowned banks to the same supervisory rigor and regulatory enforcemlent as privatebanks; (G) improve the quality of internal anld external audits; antd reliability of bankingdata management systems, by applying better incentives and penalties, to obtain amore accuracy picture of portfolio quaclity; anid (g) strengthen guiidelinies for properbank governance, affecting owners, macagenment, and outside directors.

15. On bank regulation, (h) to strentgthen the effectiveness (of subordinated debtrequirements the Central Bank might want to consider using them for preventivepurposes; as high yields on subordinated debt could act as "triggers" for moreintensive examination of such banks. Additionally, the Central Bank might considermaking explicit how excessive batik risk ('as indicated by high yields on subordinateddebt) will be penaclized by the authorities5 Penalties could, for example, take the formof limits on subordinated debt yields (which would trigger limits on the growth oflending as subordinated debt yields reach excessive levels), or alternatively penalties orpunitive requirements that rise with the level of market yields (e.g., capitalrequirements, deposit insurance premia, or reserve requirements); (i) standbys

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purchased by individual banks may be superior lo the B(,IRA repo facility as a form ofreserves, since the repo facility protects against a smaller cla.ss of risks than dostandbys, and because it spreads the cost of protection throughout the financial system(rather than rewarding low-risk bcaniks with lower costs of protectionJ. Hence, the repofacility is not a perfect substitute for individual bank reserves and standbys. That is notto say, however, that there is no role for the B(7Ri?A repo facility reserves since theCentral Bank may create econonmies of scale, reducinig costs and strengthening thesignaling effect; (j) to mitigcate privacy concerns in the functioning of the Central deDeudores, some limits on the public disclosure of credit in?formation - i.e., perhapslimiting information disclosure of the detailed credit histories of individuals tofinancial institutions anid authorized ratings agencies - may be desirable; and (k)consider the eventual privatization of the Central de Deudores functions.

CAPITAL MARKETS

16. The Argentine capital markets have developed in recent years, but still lag behindthe banking sector. Additionally, market capitalization and trading volumes are belowlevels attained in other developing countries. Despite this lag, prospects for capitalmarkets growth are excellent, particularly in view of the rapid evolution of institutionalinvestors, which could turn out to be the defining factor in the development of thecapital markets.

17. In the Argentine equity market, both market capitalization and trading activityare concentrated in big companies. These companies are also the ones that trade ADRsin New York, where their trading activity is substantially higher than in Buenos Aires.Although the volume of outstanding stocks has increased, the number of listedcompanies has declined. This trend intensified the concentration of the Argentine equitymarket. A further development of the local market is needed to .facilitate the issuanceof equities and bonds by new companies, in order to make second-tier companies lessdependent on the banking sector. Despite the considerable progress of recent years,several challenges persist. The first challenge is to increase the numnber of listedcompanies. The Bolsa has already simplified the listing process and has substantiallyreduced the cost of listing, but much remains to be done to persuade the owners offamily groups about the net benefits of public listing. Another alternative would be tofacilitate the participation of smaller com1panies in international markets, consistentwith the ongoing financial integration of Argentina in international financial markets.

18. The bond market has been developing, with the public sector continuing to playthe dominant role in that market. The private sector increased its absolute participationsignificantly relative to the previous year only in 1997. Moreover, in 1997, new sectorsstarted to issue bonds.

19. The authorities have adopted rigorous and strict rules on insider trading, insiderreporting and self dealing in a clear policy to strengthen market integrity, althoughcompliance mechanisims should be strengthened. There has also been a substantial

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increase in authorized corporate bond issues as well as in securitized instruments, whilenew markets for CEDEARs and financial futures and options are under development.

20. The authorities need to improve corporate disclosure by introducingconsolidated group accounts and to strengthen corporate governance by assigning agreater role to indepenidenrt directors. Similarly, the quality of external audits andratings needs to be uipgraded by raisinrg stanldardv, imposing sanctions on auditingfirms that fail to qualify misleading reports, and, if necessary, removing therequirement for compulsory ratings. The regulation (?f capital market intermediarieswould also require tighleitng, with improved market surveillance to prevent tradeallocations and increased capital requirements to better protect small investors fromfraud and gross negligence.

21. The Argentine capital markets are very sensitive to external shocks. Thesensitivity increases during market downturns, and it may reflect the growing integrationof large companies in world markets. Greater transparency and disclosure ofinformation on the strengths of local individual companries might reduce suchsensitivity. Market sensitivity amlong Argentine stocks cani al.so be reduced byencouraging listing by new firms. 7his will increase the scope for di versifrcation andenable internationial investors to discriminate ietter hetween Argentine companies andthose from other emerging countlries.

Institutional Investors

22. Institutional investors are a major emerging force in the Argentine financialsystem. Pension funds, insurance companies and mutual funds collectively mobilizenearly 7 percent of GDP. This constitutes a fundamental change in the structure of thefinancial system and reflects both reforms in the legal and regulatory environment andstable macroeconomic conditions.

23. Pension Funds The growth of pension funds has stimulated financial innovationand financial deepening. The strong regulatory framework has ensured a smoothlaunching of the new pension system with no casualties during the Tequila and Asiancrises of 1995 and 1997. Despite these positive features, the private pension fundss arefaced with several challenges. These include low effective coverage (about 45 percentof eligible workers contribute regularly), the high marketing costs and accountswitching, the high concentrationt of the sector, the strong links between pension funds5and affiliated insurance companies. and the regulation and riskiness (f investments.The liberalizatiotn of pension investments from u/nduily restrictive rules isrecommended, including allowing pension fitds to invest in rated mutual finds thatspecialize in foreign securities without requiring the rating of uinderlyinig securities.

24. Insurance Conmpanies. Despite the deregulation of the early 1990s, whichreplaced premiums and product controls with solvency monitoring, put into liquidationthe state reinsurance company, privatized the largest insurance company, opened themarket to greater competition, and the more recent boost from the implementation of

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pension reform and the new insurance law covering workers compensation, theinsurance sector continues to suffer from high fragmentation and operationalinefficiencies.

25. The insurance sector appears to be lagging behind the growth and modernizationof other types of institutional investors. The main challenges facing the insuranceindustry are the consolidation of the sector, through mergers and closures, introductionof a rating system, creation of an insurance inforniation bureau, structuralimprovements in autonmobile insurance, and establishment of a consuimer complaintsoffice. Despite these challenges, insurance companies are expected to be majorbeneficiaries of pension and other reforms and of the continuing economic recovery.

26. Mutual Fundv. The development of the mutual funds industry was held back bythe macroeconomic instability of recent decades, the inadequacy of the regulatoryframework, and the high level of intermediation costs. Mutual funds also suffered fromthe requirement to place 80 percent of their assets in equities, which prevented thedevelopment of money market and bond funds that could provide greater competition todeposit banks.

27. The main policy issues facing the mu/tulcal f,ind indlustry include: improvedinvestor edcucation; greater transparency, especially qffees and expenses; relaxation ofsome unduly restrictive rules (suich as the 75 percent investment rule in MERCOSURsecurities); and expanditng their scope (e.g. by allowing 'funds /fjunds').

1. THE FINANCIAL SYSTEM IN THE CONTEXT OFTHE CONVERTIBILITY PLAN

ARGENTINA'S REFORM AGENDA

1.1 Seven years have passed since Argentina adopted the Convertibility Plan.' Thishas been Argentina's most successful economic program in decades, and its achievements,durability, and continued public support is a testament to its success. Inflation, thescourge of Argentina for decades, has been defeated, and economic growth during theseseven years, despite the sharp 1995 setback, averaged an annual 6.25 percent.Productivity has been increasing thanks to the broad liberalization of the economy, and theinitial consumption-led boom matured in recent years into a healthy pattern of investment-and export-led growth. While poverty has declined since the inception of this plan,unemployment remains an issue of concern, highlighting the need for continued reforms.

1.2 The Argentine experience so far pertains mostly to the so-called "first generationreforms" that often follow a sustained period of economic decline. The reform strategy inArgentina centered in changing macroeconomic rules, reducing the size and drasticallynarrowing the scope of the state by dismantling institutions that promoted protectionismand statism. The effort to severely curtail an inefficient state apparatus, particularly in theconduct of monetary policy under the Convertibility Plan, was the result of the priordiscrediting of the state. By narrowing the scope of the state, greater responsibilities weregiven to the market, where fundamental market rules prevailed, and the discretionarypowers of the authorities were minimized. However, the task of enhancing theinstitutional capacity of the state is still not finished; the difficult task of creating orrehabilitating indispensable public sector institutions lags behind.2

1.3 The challenge of sustaining a stable and growing economy and reducing povertyare priorities that are setting a reform agenda for the next several years for Argentina.This agenda, of "second generation reforms", calibrated in the context of globalization offinancial markets, trade, investment, information, and technology know-how, comprisesthe following five broad policy areas':

I For definition and assessmuent see "Argenitina; The Convertibility Plan: Assessment and PotentialProspects" 1996, World Banik report.

2 See "Latin America's Journey to the Market: From Macroeconiomiiic Slhocks to InstitutionalTherapy", Moises Naim, 1995, Initerniationial Center for Ecoiiomliic Growth, Occasional Paper 62.

3 See "Argenitiina; Second Generation Reformis" World Banik draft report, 1997.

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(a) Efficient Factor Markets (Financial and Labor Markets)(b) Enhanced Regulatory Environment(c) Quality Public Administration and Governance(d) Fiscal Strengthening, and(e) Investment in Human Capital

1.4 In this report, we review one dimension of this reform agenda, that of the FinancialMarkets. Clearly, the above five policy areas are very closely interconnected. Both thereduction in poverty, which is a priority for the Argentine Government, and economicgrowth, would benefit from, or more likely critically depend on, reforms in the above fiveareas. Furthermore, it is essential to maintain the gains achieved under what we calledfirst generation reforms, since in their absence the whole edifice could be in jeopardy.

THE FINANCIAL SYSTEM AND THE CONVERTIBILITY LAW

1.5 The nature of the Convertibility Law (see Box 1), which made the Central Bankinto a currency board by mandating a 100 percent international reserve requirement forhigh-powered money, creates special challenges for the financial system. Actually, thechallenge points in two directions, given the symbiotic relationship of the ConvertibilityLaw with the financial system: while external shocks, which in extreme cases, asprescribed by the Convertibility Plan, can lead to the demonetization of the economy andchallenge the financial system, the health of the financial system on its own may alsochallenge the viability of the Convertibility Plan. Whichever is the nature of the shock, itis critical for the sake of the Convertibility Plan to have a strong financial system, as othercountries, developed and developing, are currently painfully realizing.

1.6 The inherent rigidity of a currency board, which denies the use of discretionarymonetary or exchange rate policy, has contributed to building the credibility of Argentina'sstabilization program. At the same time, such rigidity reduces the ability of the CentralBank to provide the functions of lender-of-last-resort and other monetary operations,which, in times of crisis, might facilitate the stabilization of the banking system.4

Furthermore, unlike Hong Kong's currency board, which counts on significant

4 In the case of Argentinia, the Central Bailk can serve the limiled functioni of a "classical" lender oflast resort, throtuglh the use of dollar denomiiinated public bonids wlhiclh can be increased to constituteup to a third of monetary base (from about zero percent now), plus the use of the "repo facility"discussed later. What the Central Bank canniot do, is become a "fiscal" lender of last resort, whichother entities in the Government could theoretically provide, to a limited extent, as was the case ofBNA in the 1995 crisis. For furthler discussioni on currenicy boards, see "Tlhe LOLR function undera Currency Board; The Case of Argentinia" by Caprio, Dooley, Leipziger, and Welslh, 1996, "BankSoundness and Currency Board Arrangenicmcts: Issues and Expericnce" IMF Paper on PolicyAnalysis and Assessmenit, 1997, and "Cturrenicy Board Arrangemients; Issues and Experiences", INTOccasional Paper 151, 1997.

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Box I

The Convertibility Plan

The Convertibility Plan, one of Argentina's most successful economic programs, gets its name from the ConvertibilityLaw, but it represents a much wider set of measures aiied at the complete and permianent adjustmenit of the economy. The mainpillars of the Convertibility Plan are:

(a) Monetary Reform, through thc Conivertibility Law, subsequenitly supplemented by the new Charter of the CentralBank;

(b) Fiscal Reform, initially throughi a sharp improvement in the administration of the tax system and later through aredefinitionl of tax instrumenits and rates:

(c) State Reform, through a successful plan of privatization and deregulation of factor and product markets;(d) Social Security reform, allowing for a new capitalization mechaniisimi operated by the private sector,(e) Trade Reform, throughi the eliminiation of export taxes and most quantitative restrictions on imports, and the

reduction of the level and range of import tariffs.

While these are radical reforms, the recent history of hyperitilation., governmental confiscation of private financial assets,and extreme economic instability meanit that only such a radical program would be credible to the Argentine public.

The Convertibility Law

The Convertibility Law of April 1991, fixes the r atc of the Austral at 10,000:1 to the dollar. On January 1992, the Australwas replaced by the Peso at the fixed rate of 1: 1 to the tJS dollar. The law also established that the monetary base could not exceedthe dollar valtie of international reserves, and prohibited all indexation in the goods and labor markets.

The Convertibility Law, in practice, made the Central Bank into a Currency Board by mandating a 100 percentinternational reserve requirement for highi-powered moniey. I'his has lent strong credibility to economic management, with monetarypolicy becoming broadly endogenious. T'he Central Banlk Charter permits a maximum of 33 percent of reserves backing the monetarybase to be in dollar-denominated govenmment bonds (e.g., BONEX). Issuing base money against such bonds allows the CentralBank to regulate short run fluctuations in market liquidity through swaps. T'he Central Bank can additionally exert discretionthrough the use of variable bank licluidity requireimients, and excess interinationial reserves.

To ensure the full reserve backing, othier conditionis were set on the behavior of the monietary authorities through the newCharter of the Central Bank. This Charler, approved by Congress on September 1992, established the independence of the Board ofDirectors, all of whom are ratitied by Congress and provides fixed termis of tenlure fur the appointees, includinig the president. ThisPlan also encourages prudent fiscal maniagement, since there is no significant scope for monietizinig fiscal deficits. Additionally, theCharter dictates that the Central Bank cannot take any new interest earning liabilities, and it cannot reminerate reserve requirements(liquidity requiremenits are remiLnerated by the Govermilenit). 'I'hese measures eliminiate the possibility of generating a quasifiscaldeficit through the servicing of Central Bank debt. Consisteint with the restrictions for gcnerating Central Bank liabilities other thanthose used to acquire interilationial reserves, the Cliarter does not allow the Central Bank to guarantee commercial bank deposits, i.e.deposit insurance (a privately funded and limited deposit insurance fund was established in 1995). This substantially reduces therole of the Central Bank as a lender of last resort, both for the peso and for the domestic dollar deposits system. Nevertheless, in anemergency the Central Bank can provide, for Iimited time, liquidity up to 100 percent of a bank's capital.

Under the convertibility system, internationial reserves are backinig the monietary base, and cannot be considered asprecautionary reserves. There are no restrictions in capital tlows, and variations in interniational reserves have a direct impact on theeconomy through changes in the money supply and the real interest rate.

An important feature of the coivertibility Plan is its bi-monietary nature, whicih permlits the use of foreign exchange formarket transactions, or the holding of foreign exchanige denominiiated liquid assets in the domestic finaicial system. Dollarization hascontributed to enhanicinig the credibility of exchanige rate policy, siice is redLices vulierability under a fixed exchange rate, becauseportfolio shifts from domestic to foreign currcncy denominiiated deposits, or vice versa, would not necessarily involve a reduction intotal domestic bank deposits.

Under a dollarized system, where fractional reserve requirement are in ctfect, the lender of last resort function becomes morechallenging, since part of the liabilities of the bankinig system are dollar denominiiated, and the Central Bank cannot print dollars tofulfill that function. In a crisis, high bank reserve requiremcints, excess iitcrinational reserves or a foreign lender of last resort areneeded to fulfill that function.

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excess reserves for use in case of crisis, Argentina's access to such reserves hashistorically been quite limited.5 As a result, with a monetary base that is susceptible tomovements in capital flows, interest rates become a major adjustment variable, movingabruptly and substantially.

1.7 Large fluctuations in interest rates have a direct impact on the banking systemthrough the changed valuation of its assets and liabilities, and indirectly through theirimpact on real economic activity. Prolonged rises in interest rates punish more severelyweakest banks first, leading often to insolvency and contagion of other banks which underother arrangements would not be as susceptible to a crisis. However, both the exchangerate and monetary policy rigidities of the Convertibility Law, and the resulting limitationsto the lender-of-last-resort function (see Box 1), have played a constructive role inpreventing crises by instilling discipline on individual banks and the Argentine bankingsystem as a whole.

1.8 The flexibility of factor markets in absorbing an external shock is crucial in acurrency board arrangement, since in the absence of such flexibility, adjustments to theeconomy are more difficult to materialize, resulting in excessive swings in economicactivity, higher unemployment, and other economic dislocations, such as bankruptcies.That applies to both financial markets and labor markets. Argentina's market liberalizingefforts have been significant under the Convertibility Plan, particularly in goods andservices, both domestic and international, but have lagged in the crucial areas of labormarkets, and partially in the financial markets. While financial markets have enjoyed opencompetition and foreign entry, as well as unimpeded capital movements, an important partof the financial system remains in the public sector, injecting an unnecessary degree ofrigidity and inefficiency in the system (reviewed in Chapter 2 of this report). Greaterflexibility in factor markets will be crucial for reducing the costly side-effects of capitalmovements under a currency board arrangement.

1.9 The above suggests a course of action to which the economic authorities inArgentina are keen in implementing. They have taken concrete steps to: reduce thesubstantial presence of the public sector in the financial system; facilitate the restructuringof the private banking system; strengthen banking supervision and regulation; and increaseactual and contingent liquidity of the banking system to mitigate the limitations of thelender-of-last-resort function.

1.10 As will be explored later in this paper, the Asian crisis is an example of randomshocks that can impact the Argentine economy. Judging from the capital markets'reaction to unfolding events, the course of the shocks' transmission has been multifaceted,affecting Argentina, either directly via higher interest rates and altered trade flows, or

It should be noted tlhat, while Hong Kong has ample excess reserves in relation to its monetary base(in Dec. 1997 international reserves were 3.5 times the monletary base), Argentinia has bettercoverage tlhan Hong Kong of M3 (albeit due to lower level of developmenit of Argentina's financialmarkets). In December of 1997, the ratio of interniationial reserves to M3 was 27.4 percent forArgentinia, and 25.6 perccnt for Hong Kong.

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channeled through the perceived vulnerability of a major trading partner like Brazil, or thatof Hong Kong's currency board (as a testing ground of the stability to the currency boardarrangement). Whether the transmission of a shock is direct or indirect, the commonelement is the challenge to the economy in adjusting to that shock, with its limited degreesof policy freedom in Argentina's Convertibility Plan. Such concerns are typically reflectedin the financial markets, which are the most efficient discounters of perceived changes ineconomic prospects. The ability of the financial system to accommodate such changes isan important link to the economy's ability to absorb shocks, and the strength of this link isthe subject of this report. The traditional risks of a pre-electoral period are also currentlypresent in Argentina, although the authorities have control over the magnitude of thatpotential shock.

1.11 While the Convertibility Plan have severely tested the financial system,vulnerabilities of the financial system could also test the Convertibility Plan. Althoughmeasures taken by the economic authorities in Argentina to strengthen the financial systemmake that possibility increasingly remote, banking failures could themselves test thestrength of the Convertibility Plan. In a reverse sequence of the tequila crisis, a bankingrun (that could be externally induced) could result in a currency run which exhausts thepolitical limits of dollarization, putting in peril the continuation of the Convertibility Law.In either of the two scenarios, the strength of the financial system is key, and theArgentine authorities are aggressively taking steps to that effect.

The 1994/95 Challenge

1.12 The challenge of the currency board to the financial system became evident duringthe tequila crisis. Argentina's crisis in 1994/95 began as an exchange rate crisis, not abanking crisis. Initially, Argentine banks experienced outflows from peso-denominatedaccounts and inflows into dollar-denominated accounts, reflecting a concern about themaintenance of convertibility. Such concerns were related to political uncertainty leadingto the May 1995 Presidential elections, recent slippages in fiscal and current accountbalances, rapid growth in credit, and the absence of an IMF program6 . As long asconfidence in the financial system was maintained, the Government could deal with thecurrency run through the dollarization of the financial system. In that sense, the presenceof a bimonetary system played a constructive role during the crisis, by providing analternative to outright capital flight.

1.13 By March of 1995, the shrinkage in domestic money related to outflows of capital(and lack of access to international credit) had produced significant increases in credit riskwithin the banking system, and the character of the crisis changed from a run on the pesoto a run on both the peso and the banking system. The structural conditions of thebanking sector--which were characterized by the absence of a deposit insurance, limitednature of a lender of last resort, and a segmented and inefficient financial system, as well

see "Maintaining Finanicial Stability in Global Economiiy" Remarks by Pcdro Pou in a Conferencesponsored by the Federal Rescrve Bank of Kansas, 1997.

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as memories of previous financial crises that ended in asset confiscation (either outrightconfiscation, or devaluation of assets through inflation or currency depreciation)--fiueled asystemic run on deposits (mostly by domestic residents). Controlling for the systemic runon the banking system, evidence suggests that in the absence of deposit insurance and thelimited nature of lender of last resort, depositors imposed discipline on banks throughflight to quality (depositors reallocated deposits from weaker banks that were offeringhigher interest rates to foreign banks and the ten largest domestic retail banks).7

Simultaneously, interbank market access shrank down to top private sector banks and theinterbank rate increased sharply, pushing several solvent but illiquid institutions to thebrink of failure.

1.14 For the first four months of the crisis prior to the May Presidential elections,Argentina suffered a massive liquidity shock, with bank deposits declining by 18 percent,and liquid international reserves by 30 percent, as access to the international financialmarkets was cut off (with the exception of multilateral lending). Under the ConvertibilityPlan, where the monetary base has to be fully backed by international reserves, capitaloutflows resulted in the demonetization of the economy. However, the credit squeeze inthe economy was moderated by the reduction in reserve requirements, and the increasedused of dollar denominated bonds as part of international reserves.8 This demonetizationaffected both the performance of the financial system, but also, as expected, real economicactivity, leading to a sharp recession. From a policy perspective, given that bank reserverequirements were less than 100 percent, M2 at that time was about 3.5 times the stock ofinternational reserves, under the Convertibility Law the Central Bank had more limitedresources than other countries to confront a run against bank deposits (being a weak"lender of last resort").

1.15 By the end of May, 1995, forceful action both by the Government (cutting thefiscal deficit and obtaining support for its new economic program by multilateralorganizations) and the Central Bank (through skillful management of liquidity to thefinancial system, including lowering remunerated reserve requirements, and the extensionof credit through swaps and rediscounts) reinstated confidence on the peso and thebanking system's solvency. Additional measures included the establishment of a privatelymanaged limited deposit insurance scheme, the establishment of fiduciary trust funds tofacilitate the privatization of provincial banks and the restructuring of private

7 See "IInforiiiationi and Bank Runis; Evidence from a Contemiiporary System witlhout Safety Net:Argentiina after the Tequila Slhock" by Liliana Sclimliaclher, May 1997, mimiieo; and

"Contagioni, Banks funidamiienitals or Macrocconoiniic Slhock? An Empirical Analysis of theArgentinie 1995 Bankinig Problems" by D' Amalo, Gnibisic, and Powell (BCRA, Working paper No.2, 1997). In this paper, controllinig for banik and macro futndamientals, there is still evidence of someconitagioni effect.

8 While the credit cunclh was mitchi less proniouniced (a declinie of 3 percent) thlan ithe contraction indeposits (a decline of 18 pcrcent), thle impact on small and mediuiiii enterprises may lhave been mucllarger than prime borrowers, wlho switclhed from the interniationial to the local financial market. SeeGuillenno Calvo's "Argentinia's Expericnce after thle Mexican Crisis", in "Currenicy Boards andExternal Sliocks", the World Bank, 1997.

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The 1994/95 Finanicial CrisisInitial Shock

* Domestic minii-crisis following failure of bond trading houise shakes confidenice and causes banks tocut lines to these "liayoristas."

* Tequila effect shakes conifdcnce in LA and investors re-evaliate Argentinie exposure.* Stock and bond markets suffcr large losses.* Banks call in loans extended to dealers and provincial banks, now largely insolvenit (due to earlier

mismaniagemiienlt).

Aftershock

* Growing fiscal concerins and lack of IMF agreemenit comipotiuid concerins.Dollarization increases, and selective deposit withidrawals begin, mostly from small banks -- $2b. intwo weeks.Liquidity crisis forces banks to cut credit lines.BCRA persuades top 5 banks to provide $250m. in safety net.

* BCRA establishes second net via rcserve requirciiiemet reductioni for top 25 banks, yielding $790m.

Continuing Crisis

Uncertainty over teie May national elections' outcomiie furilier weakens confidence. From late-February, bank nms become a generalized run on the system (for first two wveeks of March).Cumiulative deposit losses reach 16 percent or $8b.

* Interbanik interest rates skyrocket.* BCRA extends extraordinary liquidity assistance above limits of bank capital and for longer than 30

days, totaling $1.7b. rediscounits and $300m. repos.* Some banks fail.

Freefall Stops

* Interinationial package (IMF, IBRD, IDB), fiscal measures, plis domestic and international bondissues restore confidenice.

* Strong comimiitiimenit to convertibility maintained, althouigih reserve level falls by $5bn.. Deposit insurance (limited, privately financed) annotiliced.. Dual bank restnmcturinig funids to privatize provincial banks and restnimcture private banks established

with aid of multilateral banks.* Fiscal strengtilnicig plans aninouiniced.

Outcome

* Bank consolidation as 28 cooperative and 5 wholesale banks close.* Provincial banks moribiuind, fifteen in process of privatization/closure.* Top 10 private banks increase market shiare as deposits begin to returni.* Crisis ends wilh $8b. deposit outflow hiavinig becn covered by reserve loss ($4b.), BCRA liquidity

($2b.), loani reductions ($1b.) anld foreign loans ($1b.).

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sector banks. These measures facilitated the return of deposits to the banking system,which, by early 1996, reached their pre-crisis levels.

1.16 The Mexican crisis, being the first true test of the Convertibility Plan, brought tolight important lessons for Argentina:

(a) as for any emerging country, it highlighted the importance of a soundbanking system supported by strong prudential regulation and bankingsupervision, and weaknesses related to the absence of a dollar lender of lastresort in an increasingly dollarized system, particularly when governmentaccess to international credit is interrupted (although the absence of a fullsafety net was a strong incentive for responsible behavior by the banks).Increased capital mobility, while welcome in remonetizing the Argentineeconomy has also made the economy more vulnerable to external shocks,and the banking system the agent of transmission of financial crises;

(b) reemphasized the need to sustain sound macroeconomic policies--justbefore the crisis there was a slippage in the fiscal accounts and a growingcurrent account deficit-- and consequently the credibility of theConvertibility Plan;

(c) highlighted the extent of the real economy's vulnerability to volatile capitalflows under a currency board, particularly in view of rigidities in factormarkets (labor markets in particular), and

(d) the Mexican experience highlighted the difficulties in changing theexchange rate regime during periods of crisis, particularly in a highlydollarized economy where the majority of private sector liabilities,government debt, and banking credit is in US dollars. It was a widely heldbelief in Argentina during the crisis, and rightly so, that a devaluation of thecurrency would have had much worse consequences than the ensuingrecession, undermining as it would the edifice of the Convertibility Plan.As a consequence, no serious proposal was raised during the crisis toabandon the currency board.

(e) lessons for the banking system underline the need for substantial liquidassets, to withstand sharp liquidity shocks and the lack of access tointernational credit. Some contagion effects were observed9 and hence alimited deposit insurance scheme was introduced to li-nit that problemamong depositors. Other relevant experiences include: time depositsproved more fickle than sight deposits, and banks with no sight depositssuffered acute liquidity problems; banks with standardized loans and good

9 See D'Ainato, Grubisic, and Powell (1997) Contagioni, Banks Fundamiientlals or MacroeconomicShock? An Empirical Analysis of tile Argentinie 1995 Baikinig Problemis (BCRA, Working paperNo. 2, July).

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documentation marketed loan portfolios easier; market risk capitalrequirements were seen as an important complement to the highcounterparty risk capital requirements that had already been implemented.

1.17 In turn, Argentina's reaction to the crisis sent strong signals to markets about itslong-run credibility--especially its financial sector decisions (a) to remain with the currencyboard (despite rapid decline in the money supply and high unemployment), (b) to allowsome banks to fail and some bank depositors to lose money, and (c) to react to the crisisby tightening market discipline over banks and moving to strengthen the credibility of thecurrency board (for example, by moving bank and Central Bank effective 'reserves'offshore). It might be of interest also to note that throughout the Convertibility Plan, evenat the worst moments of the 1995 crisis, the Convertibility Law (in particular its mandatedcoverage of high powered money by international reserves) was never breached. While atthe height of the crisis usage of dollar denominated bonds reached its legal limitations as ashare of total reserves, following the crisis the usage of bonds was quickly reduced assignal of strength of the Convertibility Plan.

Aftermath to the Crisis

1.18 Despite serious prior efforts to strengthen the financial system, the 1994/95 crisisincreased the urgency for reform, since the financial system came close to the point ofcollapse. As a result, following the crisis, Central Bank authorities took a number ofmeasures to build up on the growing strengths of the banking system both from theregulatory and supervisory perspectives (which also mitigate the need for lender-of-last-resort functions), and increasing the liquidity in the system, actual and contingent.

1.19 Among the specific measures taken are:

(i) the increase in liquidity requirements;

(ii) the establishment of a contingent repo facility with international bankscovering about 10 percent of all domestic deposits;

(iii) the privatization of a significant number of provincial banks;

(iv) the 100 percent coverage of monetary base by international reserves(although backing by foreign denominated bonds is authorized underthe Convertibility Law, none is currently used);

(v) the strengthening of an information clearing house (Central deDeudores) at the Central Bank, to make credit risks more transparent;

(vi) the obligation of banks to issue subordinated debt to other banks for 2percent of their deposits as proof of banks' creditworthiness;

(vii) the continuing r eform of the banking supervisory process;

(viii) the reform of bankruptcy laws; and

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(ix) the continuation of a precautionary IMF program, which can be seenas an implicit lender-of-last-resort instrument in case of crisis.

1.20 Given the importance of systemic liquidity for a country that has limited access toa lender-of-last-resort and variable access to international credit, the authorities have nowamassed an arsenal of options which can provide liquidity equivalent to over 40 percent ofdeposits in the system, of which 20 percent are from the obligatory liquidity requirementon banks, 10 percent from the contingent repo facility with foreign banks, and the restfrom rediscounts that can be provided from backing a third of the monetary base withdollar denominated public bonds.

1.21 The adoption of the above measures have been instrumental in deflecting thecritical early stages of the recent Asian crisis. Despite the decline in equity values, and theinitial brief dip in reserves and bond values, the financial markets recovered swiftly.Depositors have maintained their confidence in the domestic banking system andcontinued the strong expansion in deposits, although some increase in dollarization tookplace (at the end of 1997, dollar deposits accounted for 53.3 percent of total deposits),and early in the crisis, larger banks captured more deposits, mostly in dollars. Banks alsodecelerated their rate of credit expansion, and interest rates, after a sharp initial increase,regained pre-crisis levels.

LESSONS OF EAST ASIA

1.22 The turbulence and spread of financial crises in the East Asian 'miracle' economies-- and in Japan -- has raised concerns about the stability of financial systems in manycountries, as well as inquiries as to the lessons of this experience. Although these episodeswill doubtless spawn research for several generations of economists, this section will dwellon some preliminary lessons, and also compare Argentina and East Asian economies on avariety of macro-financial indicators. As will be seen in Chapter 2, Argentina comparesquite favorably in terms of banking regulation. Thus the popular recommendationfollowing the Asian crises, that these countries tighten up their prudential regulatoryframework, already has been effectively pursued in Argentina.

1.23 In summarizing the lessons of East Asia, it is important to recognize that not allthe crises were the same. In Thailand, the finance companies have been the greatestsource of problems; these companies were weakly regulated, were given positiveinducements to grow rapidly, and in some cases were related to commercial banks. InIndonesia, although some banks were weak or insolvent, foreign exchange mismatchesdirectly on the part of the corporate sector were the channel through which the crisisspread. And in Korea, although banks had long been burdened with a high level ofnonperforming loans, the excessive leveraging of corporate sector was the weakest link,one that became apparent as firms lost competitiveness. Non-bank financial intermediariesin Korea were much less problematic, and indeed helped improve the functioning of thefinancial system since the 1 980s while the banks were hampered with problem loans.

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1.24 Notwithstanding these differences, there were a number of similarities.'0 Thailand,Indonesia, and Korea all lost some competitiveness from the Chinese devaluation of 1994and the slide of the yen in 1996-97, and were negatively affected by weak domesticdemand in Japan. As seen in Chart 1, by the end of 1996, the real exchange rate inIndonesia, Malaysia, and Thailand had appreciated by 30-40 percent since the early 1990s,though has risen most significantly in the Philippines, thus far not in crisis, and not inKorea (not shown), which has had a serious crisis. Still, the notion that macrofundamentals were not an issue in East Asia clearly is incorrect. In contrast, in the case ofArgentina, between the beginning of the Convertibility Plan and December 1997, thetrade-weighted real exchange rate has appreciated by only 13.1 percent. Furthermore,structural changes in the economy, associated with the Convertibility Plan, led tosignificant increases in productivity, which in conjunction with the reductions in tariffs,have improved the economy's competitiveness, moderating the impact of the currency'sreal appreciation. Actually, the appreciation occurred mostly in the early years of thePlan, when inflation was higher than international inflation. Since mid-1994, the peso hasbeen experiencing a real depreciation, only to be reversed in 1997 with a 3 percentappreciation (following the dollar's appreciation).

Chart I

Real Exchange Rate Appreciation1990=1 00

180

160

140

120

8c ~~~~~~~~~~Mexico80

60 .. 1990 1991 1992 1993 1994 1995 1996 1997 1997 1997

Q1 Q2 Q3

10 For fuller discussions, sec The World Bank, Global Development Finance, Chapter 2, March 1998;Paul Kngnain, "What lhappened lo Asia, uiiiieo, January 1998, and G. Corsetti, P. Pesenti, and N.Roubini, "What Caused the Asiaii Currency and Finanicial Crisis,' miinieo, Janiuary 1998.

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1.25 In most of the Asian crisis countries, it appears that risk capital was low in thebanking system, even relative to stated minima (Chapter 2) and that the quality of capitalwas low. Depositors enjoyed implicit and then explicit guarantees in Thailand, where evenfinance companies' depositors were fully covered; in Korea, where explicit globalguarantees were given in mid-1 997; and in Indonesia, when the survival of private banksbegan to be doubted, there was a prompt run to the state banking system, where depositsare considered fully insured. Implicitly, foreign loans to private firms were also consideredto be a liability of the government, as suggested by the low spreads on emerging marketdebt until the spring of 1997, and were part of a large inflow of capital that the domesticfinancial system was in a poor position to intermediate effectively, as seen in the lowcomparative scores of their regulatory systems (Table 2. 10).

1.26 Although the Asian crises are now recognized as more financial crises thancurrency crises, it is important to note that systemic financial crises usually involvecorporate finance difficulties. That is, the problem usually traces to imbalances in at leastsome corporate balance sheets. Thailand, Korea, and Indonesia all featured excessivelyhigh levels of short term debt, though comparable data are difficult to obtain for thematurity structure of domestic corporate debt. Short-term exposure to BIS reportingbanks, however, is available and was quite high in Thailand, Indonesia, and Korea (Table1.1), whereas this figure was relatively low in Argentina and Chile. Interestingly, all threecountries also saw sharp expansions of lending by Japanese banks in the late 1980s andearly 1990s, and then very sharp retrenchments -- as much as 50% to 60% reductions -- inthis lending since 1993-4, according to BIS data. It is conceivable that the term structureof corporate debt began shortening as Japanese banks, thought to be suppliers of longer-term loans, pulled out.

Table 1. 1 Foreign Short-term debt to reserves levels, mid- 1997(Percent)

Short-term debl/totil debt Short-term debt/reservesIndonesia 24 160Korea 67 300Thailand 46 107Malaysia 39 55Philippines 19 66

Argentina 23 44Brazil 23 69Chile 25 44Colombia 19 57Mexico 16 126Source: Bank for International Settlements, International Financial Statistics,World Bank.

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1.27 Excessively high leverage, a reliance on short term debt, and property bubbleswere featured in these economies.1 " Consistent with (and encouraged by) the realexchange rate appreciation of their currencies, there was a sharp increase in investment innon-traded goods, especially construction, and it became clear in 1997 that much of thenew office space -- in Bangkok and Jakarta by early 1997, 5-8 times the capacity of theearly 1990s -- was a misallocation of resources. Although credit growth in Argentina hasaccelerated in recent years, with the re-intermediation of the financial system, no signs ofanything like the booms in East Asia has yet been seen.

1.28 One way to summarize the many possible determinants of banking crises is throughthe model of Demirguc-Kunt and Detragiache (1997), who do a multivariate logic analysisof the likelihood of a banking crisis, based on the following indicators:

* macro (growth, change in terms of trade, real interest rate, inflation,depreciation of the exchange rate, and government surplus/GDP);

* financial (M2/ foreign exchange reserves, credit growth/GDP, bank cash/bankassets, and private credit/GDP; and

* institutional indicators (GDP per capita, the presence or absence of explicitdeposit insurance, and an index of law and order, which is a proxy for theability to enforce contracts).

1.29 This model performs quite well in predicting crises, explaining about 70% of thecrises that occurred, and only predicting a crisis when none occurred in 15% of the cases.Chart 2 shows, with the model estimated only with data up to 1996, how the likelihood ofa crisis was rising in Thailand since the early 1990s. Chart 3 shows the correspondingmodel estimates for Argentina, and as is evident, the likelihood of a crisis there in 1997was quite low.12 In addition to favorable macro developments, the high liquidity of thebanking system and still-modest credit risk, in the form of credit to the private sector, helpto keep the probability of a banking crisis low, in sharp contrast to the clear warning signsin the case of Thailand. To be sure, no model can predict crises with 100% accuracy, butthis model, which out-performs any to date, confirms the significant improvements inArgentina and makes a banking crisis less of a concern in the near term.

1.30 Several lessons are evident from the East Asian experience. First, capital inflowsare dangerous when the regulatory structure of the financial system cannot ensure, or atleast make it likely, that the inflows will be well employed. Were rankings of financialregulation routinely available, it would at least raise warning flags if capital were routinelygoing to countries with weak financial sector regulation. When it comes to monitoring

Thlese problems also were secni in Malaysia and, to a lesser extent, in (lie Plhilippines, economiesthat also liave been affccted by currecncy and equity price declines, tlhouglh as yet few significantproblems have been cvident in their banking systeiims. Like Argentinia, botlh counitries saw financialcrises in the 1980s; in the case of (le Plhilippinies, the crisis was quitc severe and re-intermediationhad only beguin O0i a significant scale in tlhe last 4-5 years.

12 The horizontal line indicates wlhen tlie likelilhood of a crisis lias risen to 70%.

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banks, it is important for authorities to utilize market information as much as possible, asmarket participants may know when banks are increasing their real estate exposure even ifofficial data do not reveal it. The subordinated debt system put in place in Argentinashould function well in this regard, as uninsured debt holders will have a good incentive tomonitor the banks.

Chart 2

Thailand

0.16 - ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~~~~~~ ~ ~ ~ ~ ~ - - - - --~~.... .. .. . . - .- .. ..- .... _ __....._

0.14

0.12

0.1

0.08

0.06

0.04

0.0

1991 1992 1993 1994 1995 1996

Chart 3

Ang:hrnAl Crdsis ProbaWiRlhs

0.16

0.14

0.12

0.1-

0.08

0.06

0.04

0.02

1991 1992 1993 1994 1995 199S 1991

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1.31 Second, experience from East Asia (and Japan, the United States, andScandinavia) demonstrates that property and asset market bubbles can occur even duringtimes of relative stability in consumer prices. Even if the data suggest that banks are notlending into a real estate boom, it often turns out that loan classification data aremisleading. Setting up a reporting system to track lending -- as Argentina has done -- andthen assessing penalties for mis-reporting, is important if authorities are to monitor thelinkages between banking and real estate. This also suggests that authorities have to bewilling to slow down their economies when they see signs of real exchange rateappreciation coupled with asset market booms -- even if consumer price inflation ismodest. In the case of Argentina, where the convertibility law makes countercyclicalmonetary policy problematic, fiscal measures to cool the economy are preferable. Also, inthe case of Argentina, deflation of asset prices took place during the 1994/95 regionalfinancial crisis, mitigating the scope for adjustment in the recent crisis.

1.32 A third lesson is that foreign bank entry can play a role in both making the bankingsystem more efficient and more robust to shocks, but it is important to diversify thesources of entry. When a real negative shock hits a country, both local and foreignfinancial institutions will react the same, qualitatively: if they anticipate it, they will reducelending in advance, whereas with an unanticipated negative shock, once the shock is past,both will want to expand their lending to compensate for the lower value of domesticassets in their portfolio. However, if the local institution is more concentrated in domesticassets than the foreign entity, then the hit to its capital may be sufficiently large that itwould have to cut back all lending. So in this case having foreign institutions may bestabilizing. However, if a negative shock hits the foreign financial institution in its owncountry -- lower real estate prices in Japan, say -- then the foreign bank may pull backfrom lending in the developing country, and this could have significant negative effects.'3

Moreover, foreign regulators could pressure their banks to pull back from overseaslending to aid clients in their domiciles. Over a cycle, these effects may well balance out ifdomestic and foreign shocks are distributed evenly. Admitting foreign banks from avariety of countries -- as has occurred in Argentina, although diversification has to beobserved -- will help to increase the benefits of foreign entry while minimizing its potentialcosts.

Peek and Rosengreni (1997) founid evidence that Japancsc banks, whio had large positions (23-44% ofthe real estate lendinig businiess) in Califorinia. Illinois, and Ncw York, substantially reduced theirlending in the wake of lower rcal estate and stock prices at hoiue, and that this had significantnegative effects on thcse local miarkets. Thcsc effeccts occurrcd in very different markets, andnotwithstanding miarkedly differcuit leiding bchavior by US and other foreign banks. Thus it isoverwhelminigly likely that thc effccts were indecd attributable to the decrease in the supply of loansby the Japanese bank, rather than to lower demand, and econometric work corroborates this finding.If the Japanese banks reduced lending in the United States, they may well have done the sameelsewhere, meaning that it is quite possible that, having expanded ilicir lending rapidly in East Asiain the late 1980s and early 1990s, thcy retrenclied therc in 1995-97 in order both to re-balance theirportfolios and to help out key Japanese clients, and thereby miay have played a role in the E. Asiancrises. The point here is not to single out Japanese banks but rather to reveal how foreign shocks aretransmitted when banks are based in different countries.

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INTERNATIONAL INTEGRATION AND REGULATORY COORDINATION

1.33 Two issues of strategic importance are likely to emerge as major policy concerns inthe years to come. Both issues are already evident in the current functioning of thefinancial system but their importance is expected to grow over time. The first concernsthe growing integration of the Argentine financial system with world financial markets andespecially with US markets, while the second concerns the problems encountered in theregulation of financial conglomerates and the need for closer coordination among differentregulatory agencies.

1.34 Local institutions are concerned that greater financial integration would constrainthe growth of the local market. Because of the currency board and free capitalmovements, there is already a high degree of integration, even if this is not properlyregistered and measured. The use of ADRs by 14 large Argentine companies and the highvolume of trading in New York for these shares are manifestations of integration. Themigration of this business to New York heightens the concern of local institutions.Similarly, following the adverse experiences during the period of hyperinflation, manyArgentine households and corporations have become used to obtaining financial servicesfrom offshore financial centers or from US financial institutions. For households, suchservices include maintaining bank deposits, purchasing insurance, and even investing in USmutual funds. Against this trend, one can mention the increased presence of foreign banksand other foreign financial institutions in the local market, the stimulus to financialinnovation and efficiency provided by them, and the training and promotion of Argentineprofessionals to senior positions of their local subsidiaries.

1.35 Such developments could cause the Argentine market to evolve over time andresemble regional US financial markets (e.g. Texas, Florida, or California), which havethriving financial sectors, despite the fact that companies list in New York or Washington.Local markets cater to the needs of medium and small firms as well as to the needs ofhouseholds. Although regional US financial markets also conduct a lot of financialbusiness with non-Americans, most of their financial business is with local firms andresident households. The Argentine authorities would need to assess and publicizeeffectively the benefits of greater integration. A strategic decision would need to be takento support measures that will enhance efficiency and promote further integration, withoutfearing that in the long run this will lead to a major contraction of the local financialmarket. Examples of practical implications of such a strategic approach would be to allowmutual funds to invest freely outside Mercosur, to change the investment regulations ofpension funds to treat securities in Mercosur, Chile and the US as domestic equivalents, toallow pension funds to invest in rated mutual funds that specialize in foreign securitieswithout requiring the underlying securities to be also rated, to encourage smaller firms toseek listing on US markets, and to develop the information and legal infrastructure thatwould enable smaller firms to tap sources of collateralized finance in Argentina or othermarkets.

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1.36 The second point concerns the coordination across regulatory agencies. There is aneed to address the problems that could arise from lack of coordination such as potentialinconsistencies in regulations and supervisory failures. International experience suggeststhat a unified agency may also face serious problems such as the possibility of favoring thedominant segment of the financial sector (e.g. banks) at the expense of new or peripheralsegments and the failure to appreciate the operating characteristics andregulatory/supervisory requirements of different segments. Pending the gaining of greaterexperience from the proposed new systems in the UK and elsewhere, the Argentineauthorities could examine the advantages of creating an umbrella body that could promotecoordination without losing the benefits of specialization. An umbrella body approachwould also avoid the political problems of turf fighting.

END NOTE

1.37 The prudential measures taken since 1995, and their impact, will be analyzedfurther in this report. Such measures, however, work in two directions. While theystrengthen confidence in the banking system's ability to absorb shocks, and in that theymight succeed in preventing them from occurring in the first place, they also increase thediscretion of economic authorities in affecting monetary aggregates, which theConvertibility Law had successfully constrained. As the credibility of economicauthorities and institutions rises in Argentina, the adoption of incremental degrees ofpolicy freedom may be reconsidered, in the future. This has been the experience in HongKong, which by amassing significant excess international reserves through consecutivefiscal surpluses, is in the position to conduct discretionary monetary policy (and act aslender of last resort), while at the same time running a credible currency board. In theabsence of such conditions, however, Argentina's measures taken after the tequila crisismay be considered a preferred alternative.

1.38 While this report focuses on financial markets, the strength and flexibility of otherfactor markets, such as labor markets, are imperative in strengthening the ability of theArgentine economy as a whole to absorb external shocks. Given the close interconnectionbetween the Convertibility Plan and the health of the financial system, advancing in the"second generation reform agenda" mentioned in the beginning of this section, is animperative complement to the important efforts underway to strengthen the financialsystem.

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2. THE BANKING SECTOR

2.1 In recent years the banking sector in Argentina has gone through a number ofchanges which we summarize below in Sections 1-3. In particular, since the Tequila crisis,substantial consolidation, privatization, increased entry by foreign institutions, andtightening of regulation and supervision have occurred. In light of those changes, thischapter concludes that the banking system is relatively robust to external shocks, asconfirmed by its recent strong performance in the midst of the 'Asian flu.' Section 4, inparticular, examines the recent changes on banking regulation and supervision and notesthat a 'CAMEL' review of bank regulatory systems rates Argentina quite favorablycompared with other Latin American and Asian systems.

2.2 Notwithstanding this considerable progress, there remain challenges that confrontthe banking system. Section I attempts to summarize the current situation and quantifythe risks and costs imposed by remaining problems. For example, the likely misallocationof resources from state-owned banks, as suggested by their high nonperforming loanratios, is lowering economic growth. We estimate, therefore, the short-term costs ofprivatizing these entities. Despite the costs, continued bank privatization, plus theconsistent application of prudential supervision to the state-owned banks, will be requiredto improve the overall health of the banking system. Although many countries need tomove slowly on privatization while they are improving financial regulation andsupervision, Argentina has made substantial progress in each area, and politicalconsiderations remain the main barrier.

2.3 A sufficiently large shock can result in a financial crisis in any country, but therecent changes in the structure and regulation of the Argentine financial system make thisless likely, both in comparison to Argentina's past and relative to most emerging marketcountries today. As noted in the introduction, moreover, the lack of policy freedomassociated with convertibility may have compelled authorities to make many of theseimprovements. In reviewing those changes this chapter explains how they reduce thelikelihood of crises or lessen their severity when they do occur (Section 4). Futurestructural changes may also reduce systemic risks. We examine, therefore, whether recentlegal and institutional changes such as the creation of bank failure resolution mechanismsare sufficient to support the needed structural changes (Section 5).

CURRENT CONDITIONS

Structural Change: Overview and Implicationls

2.4 The fast expansion of the financial system has been taking place in the midst of arestructuring process. That process has left Argentina with substantial foreign presence inits banking sector. Thirty-seven foreign-owned banks have 43 percent of total assets, 37

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percent of total deposits." By developing country standards, these figures are high.Levine (1996) reports that foreign banks typically do not comprise more than ten percentof the banking sectors of developing countries. 12

2.5 By contrast, the forty-nine remaining private domestic banks hold only 23 percentof total assets, 25 percent of total deposits. Moreover, the smallest twenty-five privatedomestic banks comprise only about 2 percent of system assets. In December, 1994private domestic banks had roughly 45 percent of the system's assets and deposits.Foreign acquisitions and closures are responsible for the steep decline. Public banks havealso declined in number and in market share, though not as steeply. In December, 1994they comprised 40 percent of system assets, 37 percent of system deposits. Eighteenremaining public banks now hold 3 1 percent of system assets, 35 percent of deposits.Recent bank privatizations are largely responsible for the dip. Twelve privatized banksnow comprise about 4 percent of system assets and deposits.

2.6 Structural changes have benefited the sector as foreign banks are, on average,better performers than domestic banks. They tend to be larger than all but the remainingpublic banks, and they have higher ratios of net worth to total liabilities and normal loansto total loans (Table 2.1). They do, however, have ratios of operating income toadministrative costs that are very similar to those for private domestic banks. 3 The loanshare data from Cull (1998) and these results on efficiency and portfolio quality suggestthat foreign-owned banks in Argentina are pursuing lending seriously and that they aredoing it at least as efficiently as domestic ones. 14

2.7 Portfolio quality data in Table 2.1 also indicate that, among the domestic banks,the publicly owned ones are the worst performers. They have much lower percentages ofnormal loans in their portfolios. On the other hand, they do have a higher ratio of net

Results in this sub-sectioni and those that follow rely oni a quarterly panel data set provided byBCRA. Using otlher BCRA data sourccs we identified banks as being either foreign-owned, public,private domestic, or privatized. Non-banik fiiancial institutionis wenit into a catch-all category called"other." This classification should help us in analyzing the structural changes that have taken placein recent years. In some cases we were uniable to classify an entity, or data were not available for anentity over all quarters. We may, tlherefore, sliglhtly understate the numiiber of banks in a certaincategory for some indicators. Comparisonis with BCRA docuLmienits suggest, however, that suchunderstatements are small, anid that minior corrections would not alter the assessments that follow.

12 Ross Levine, "Foreign Banks, Finiancial Developmenit, and Economiiic Growtlh," in Claude E.Barfield, ed., International Financial Mlarkets: Harm0onization Vlersus Competition, WashingtonDC: The AEI Press, 1996.

13 Claessens, Demirgiiq-Kunit, and Huiziniga in "How does foreigni entry affect the domestic bankingmarket?" (1997) find that the ratio of operating overhcad to total assets is higlher for foreign-ownedbanks thani for domestic ones in low incomiie and lower middle incomiie countiries. The reverse is truein upper income counitries. Tlhey argue that a possible explanationi miglht be that foreign banks havehiglh overhead costs if they have to overcome large inforiiiationial disadvantages, but lower overheadcosts (as a percentage of assets) if they engage mostly in wholesale transactions -- as is the case inmany developed countries.

4 Conclusions also hold up wheln the samiple is sub-divided by year, so these disparities are not merelydue to foreign banks arriving late in tlhe period (1997) wheln bankinig coniditions may have beenbetter.

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worth to liabilities than the privatized banks. Clarke and Cull (1 997a) find, however, thatthe net worth of public banks was overstated prior to their privatization and that auditsconducted prior to privatization resulted in a substantial reduction in net worth. In fact,the audits often revealed these banks to be technically insolvent. While relatively low, thenet worth figures for privatized banks are probably more reliable than for other banks andare, in any event, at acceptable levels. In addition, their average portfolio quality isrelatively high.

Table 2.1: Size and Performance By Type of Bank

Type Deposits Net Worth to Total Operating Inicomiie to % Normal16

Liabilities'. Adminiistrative Costs (Loans)

(%/) -(%)Avg. Median** Median** Avg.

1995-97Foreign 381,941 17.0 1.24 90.8Priv Domest 286,502 16.1 1.23 75.5Public 765,173 11.6 0.94 56.4Privatized 148,065 8.8 1.21 86.8Total * 411,121 14.8 1.20 73.81997Foreign 673,479 12.5 1.27 91.2Priv Domnest 344,526 14.0 1.27 76.2Public 1,331,292 13.4 1.09 62.3Privatized 187,270 8.6 1.20 89.5Total 547,431 | 12.8 1.23 79.4* Averages across all four baik types. Non-banks exclUtded fronm calculations. Because each banik- is weightedequally in the calculationis, the average nomial loan percenitage and net worth to liabilities ratio are iiiuch smallerthan if these two figures were calculated from]l a consolidated balance sheet for all banks (as BCRA does when itproduces system-wide figures).** A hanidfil of observations have strong etThcts on the mean1 values ifor these variables. The mediani corrects thesemeasurement errors.

2.8 The portfolio quality results are also reflected in 1997 profitability figures -- profitsthrough December imply a 3.9 percent annual return on capital for public banks, and 7.8percent for private banks. Table 2.2 makes it clear, moreover, that improved profitabilityfor the total system since 1995 is largely attributable to the private banks, especially theten largest ones. Concerns over the low profitability of the banking system appear to bestructural, reflecting more the problematic state of public banks and smaller banks. Taxes

'5 Capital adequacy ratios typically have risk-weiglhted assets in the denomiinlator. Because we use totalliabilities, the figtires in this table mlay be muchi lower than the capital adequacy ratios for banks thathave relatively few risky assets on their balanice sleets. This is likely to be the case for the privatizedbanks as a relatively higlh share of their incomle is generated fromii government services (rather thanlending). The figures for the privatized banks are, however, influenced somewhat by a handful ofobservations witli values below zero. Perhaps we have mis-identified banks as being privatizedbefore the process was comlplete. The negative valies may reflect the problems of the old publicprovincial bank portfolio. If we elimiinlate Ihose observations, t(le figure for privatized banks is inline with those for the other groups.

16 Normal refers to those loans rated in BCRA's top category, EiEn situaci6ni normial/ Cuinplimientononnal." There are six categories. Were we to incltude those in categories two and three ("Conriesgo potencial" and "con problemias"), the estimates of performiing loans would, for exainple,surpass 95 percent for most foreign-owned banks. See "Informaci6n de Entidades Financieras,"SEFyC, B.C.R.A., October, 1997 for details

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on financial intermediation, and regulatory costs such as the cost of the legal liquidityrequirement, and cost of deposit insurance, which are argued as a cause of lowprofitability, are small compared to the high level of operating costs and cost of loanrecovery and provisioning.'7

Table 2.2: Profitability by Banki Type, 1995-97

Bank Type December, 1995 December, 1996 Dccember, 1997

PublicReturn on Equity (%) -0.43 2.80 3.89Retum on Assets (%) -0.09 0.51 0.69PrivateReturn on Equity (%) 0.03 5.49 7.79Return on Assets (O) 0.00 0.61 0.76Top Ten PrivateReturn on Equity(%) 10.81 14.04 15.30Return on Assets (%) 1.29 1.47 1.37Total Banking SystemReturn on Equity (%) -0.21 4.21 5.98Return on Assets (%) -0.03 0.58 0.74Source: "Itiformaci6n de Entidades Financieras," SEFyC, B.C.R.A., April 16, 1998 (www.bcra.ar)

2.9 The portfolio quality data suggest that the most serious threats to the bankingsystem are posed by the remaining public banks and the smaller private domestic ones(although it should be emphasized that not all small private domestic banks are weak), andthat foreign entry has contributed to a healthier financial system overall. Indeed, since theTequila Crisis, the banking sector has apparently become more efficient. For example, there-intermediation of the banking sector, coupled with increased foreign presence (orcompetition) and the removal of weaker banks (see below) has led to greater efficiency interms of deposits per branch or per employee, and improved measures of operatingincome to costs.

Recent Developments

2.10 Despite the Asian crisis, Argentina's banking system continued to expand at a fastpace during 1997, reflecting the remonetization of a growing economy (1997 GDP growthof 8.4 percent). With international reserves at the Central Bank expanding by 28.4percent through 1997 (for the entire financial system--including reserves held abroad--international reserves grew by 37.1 percent), the broader monetary aggregate (M3)reached 25.6 percent of GDP, up from 21.9 percent at the end of 1996.18

17 For 1995-96, IMF staff have estinialcd costs of taxes oni financial interiiiediationi (0.8 percent), legalreserve requiremlenit (0.2 percent), and deposit insurance (0.3 percent), whichi suilii to 1.3 percent,compared to 10. percent in operating costs, and 5.3 percent in costs of loan recovery andprovisioninig. In Argentina--Recent Econoimiic Developlmienlts, IMF, Jani. 1998.

18 Figures in this sub-sectioni are takeni from, B.C.R.A., Gercncia de Ailisis Econ6nmico eInformaci6n, "In.formaci6n Monietaria y Financiera," Decemiber, 1997. Addinig a very roughguestiiiate of dollars in circulationi, M3 could be about 29 percent of GDP.

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2.11 Overall deposits increased by 30.2 percent in 1997. While by year-end dollardeposits had expanded by 30.9 percent, and peso deposits by an approximately equal rateof 29.6 percent, by mid- 1997 (prior to the Asian crisis), peso deposits were growing fasterthan dollar deposits, while during the crisis months the system experienced, as could beexpected in times of uncertainty, a sharp dollarization. At the end of 1997, dollar depositsaccounted for 53.3 percent of total deposits. During the crisis, larger banks capturedmore deposits, mostly in dollars.

2.12 A combination of growing deposits and increasing liquidity requirementscontributed to 45 percent growth in liquid reserves during 1997. While private depositscontinued to expand throughout the year, with the exception of a small dip in December(overall deposits expanded in December), credit expansion felt the impact of the crisis.Credit expansion to the non-financial private sector was expanding on a 12-month basis by18.1 percent in September but, by year-end, it had decelerated to a 15.1 percentannualized growth rate, half the rate for deposits.

2.13 The impact of the crisis was reflected in interest rates as well, starting in October1997. In the interbank market, peso rates rose by approximately 200 basis points, to 8.5percent be end-1997. Dollar rates rose less, widening the spread between peso-dollarrates (an indicator of devaluation risk), from imperceptible rates in September, to 135basis points in December. Prime lending rates rose significantly higher betweenSeptember and November, but started decelerating in December.

2.14 It may still be early to assess the impact of the recent crisis on the quality of bankportfolios (in the 1994/95 crisis it took a full year for the non-performing loans in thesystem to reach their peak). As of September 1997, for the system as a whole, non-performing loans reached 15.2 percent of loans.'9 However, adjusted for provisioning,non-performing loans were only 4.3 percent of all loans. Non-performing loans, adjustedfor provisioning, accounted for 21.5 percent of banking equity. Disparities betweenprivate and public banks are, however, striking. Non-performing loans for private sectorbanks reach 11.1 percent of loans, while for public sector banks that ratio rises to 22.3percent (keeping in mind that the first real audit of BNA and Banco Provincia are not yetcompleted).

2.15 The fast expansion of the financial system has been taking place in the midst of arestructuring process. Compared to December 1994, the number of financial entities inthe banking system by end-1997 rank from 205 to 142. The number of public banksdeclined from 33 to 20, mainly thiough privatizations of provincial banks, while thenumber of private banks declined from 135 to 96 (mainly through mergers andacquisitions). Non-banking entities declined from 37 to 26. The number of branches hasbeen reduced from 4,286 to 4,077 and - - number of persons occupied in the bankingsystem was diminished form 122,760 to 109,058.

19 Totals for the financial systeiii inclutde noni-banik finaiicial instittlionis. Non-perfonning is whatBCRA refers to as "cartera irregular," whiclh inclutdes categories 3,4,5, and 6 of the new ratingsystem and 4,5, and 6 fromii thc old syscim (morc tlhani nintety days late).

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Assessing Current Problems

2.16 Although the rise of foreign and privatized banks has meant improved performanceand stability in the banking sector and improved access to credit in many provinces, about55 percent of total banking assets and liabilities still reside with private and publicdomestic banks.20 It is important to assess the systemic risks that they pose. Percentilebreakdowns by type of bank for five variables -- assets, liabilities, loans, share of normalloans, and the ratio of net worth to liabilities -- appear in Table 2.3. Foreign banks areincluded as a means of comparison. The size profile of foreign banks is more similar topublic banks than to private domestic ones, which tend to be somewhat smaller.

Table 2.3: Percentile Brealkdown, Size and Performance Characteristics,By Type of Bank, June 1997

Bank Type Assets Liabilities Loans % Normal* Net Vorth/LiabilitiesForeign1% 13,554 928 0 78.8 .0425 % 143,904 122,736 95,894 89.5 .1050% 732,038 666,886 233,634 92.8 .1275% 2,077,171 1,987,985 650,769 97.6 .1999% 8,169,123 7,241,889 4,277,751 99.0 21.1

(n=37) (ni=37) (ui=37) (ni= 14) (ni=37)Public1% 14,164 10,360 3,751 27.4 -.0125% 145,626 130,247 79,491 46.9 .0950% 430,143 357,222 331,132 69.7 .1275% 2,083,314 1,515,871 968,750 76.4 .2599% 15,200,000 13,300,000 8,770,519 86.3 1.6

(n= 18) (n= 1 8) (1n= 18) (1n= 1 0) (n= 18)Dom. Priv.1% 4,635 4,910 9,080 30.4 -.0625% 118,961 95,014 43,938 69.5 .1050% 260,427 235,992 143,005 76.4 .1475% 521,331 469,546 307,034 82.2 .2399% 10,000,000 9,007,398 5,754,787 94.7 .66

(n=49) (ni=49) (ni=49) (n=29) (n=49)Total** 1,073,961 935,469 605,226 80.5 .17Nonnal refers to those loans rated in BCRA's top category, "'En situaci6n nornial/ Cumiplimiento nonnal." There

are six categories.*** Averages across all four bank types (including privatized, which are not broken down separately in the table).Non-banks excluded from calculations. Because each bank is weighied equally in the calculations, the averagenormal loan percentage and net worth to liabilities ratio are much small 'han if these two figures were calculatedfrom a consolidated balance sheet for all banks (as BCRA does when it AdLces system-wide figures).

20 See Cull (1998) (Section 1) for data on total nomiiiial asscts and liabilitics by bank type over time.

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Barriers to Finanice for Small and Medium EnterprisesSmall and medium-size enterprises (SMEs) Lease Finance- The leasing industry is veryArgentina face severe credit constraints. Bank underdeveloped and does not provide afinancing is beyond the reach of most small significant source of non-bank finance for SMEsfirms and when it is available, the high in Argentina as it does in many other countries.interest rates and strict conditions of the loans In 1997, the Argentine industry wrote leasesdiscourage borrowing. As a result, SMEs valued at approximately $250 milliontend to rely on relatively expensive trade the potential market is estimated to be in thefinance, self-finance or on retained earnings billions. The tax treatment of leasing is thefor their credit needs. This has serious major deterrent to the industry's development.economic consequences since SMEs produce Specifically, financial corporations dedicated tomore than two-thirds of value-added in leasing, which are the motor behind developmenmanufacturing and commerce and over 80 of the industry in most countries, are at apercent of employment in these sectors. significant disadvantage with respect to

Weaknesses in the legal and institutional commercial bank-operated leasing ventures dueinfra-structure for financial transactions to the treatment of value-added taxes (IVA). Ascontribute to the high cost and difficulty of a result, investments by leasing firms have notobtaining credit for small businesses. The occurred on any meaningful scale and themost important of these problems are: industry's growth is greatly diminished. In

addition, problems in the legal basis for leasingSecured Transactions A fundamental legal have retarded entry into the industry.problem is the relatively weak protection Information - Information on past borrowerafforded to lenders. The treatment of secured behavior, such as that recorded in a credittransactions provides a clear example of how bureau, is limited in Argentina. Privatethe legal system handicaps credit operations. credit information registries exist, but the dataThe law narrowly defines what constitutes they contain rented and the dataacceptable collateral and who can be a they contain iS fragmented and the quality ofaccetabl colaterl an whocan e adata is uneven. The Central de Deudores createdsecured creditor, so that many common types dt suee h eta eDuoe raeof c crit, such as accounts receivable by the Central Bank is intended to improve thisof crdit, uch s accuntsreceiablesituation by expanding the scope and access offinancing, are not adecluately protected under data available to banks. Still, use of creditthe law. The process of seizing secured assets . '.can take years of court battles so lenders scorig and other data analysis technques, stypically only accept real estate or liquid hampered by data quality and limited historicalinstruments as collateral. As a result, credit information.secured by movable goods represents only a Bank - Business Relationships The bankingsmall fraction of financing in Argentina, community has not invested resources incompared with approximately 40 percent cultivating relationships with SMEs, due in partthe United States, where the legal to the legal, judicial and informationenvironment provides lenders more rights. they face. The specialized services and attention

Judicial Systern- Problems in the legal that small firms require, however, cansystem are compounded by lack of eficiency provide profitable business opportunities forand transparency in the courts. Fewer than 50 banks who are organized to provide them. Apercent of cot n nercial court cases are change in banking culture, and in the attitude ofprentsofv comrial outh ase ar SMEs vis-a-vis their banks, is necessary toresolved within 12 months and the median inres bakcei o hetrtime for closure is approximately three inrease bank credit to the sector.Many commercial court judges lack adequatetraining in business law, having come fromother legal backgrounds. The deficiencies inthe legal framework exacerbate theseproblems - there is a backlog ofcases relating to seizure of assets,bankruptcies and contract violations.

Figures from the 1994 National Economiiic Cciisis.

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2.17 Three-quarters of the foreign banks have shares of performing ("normal") loansabove 90 percent and ratios of net worth to liabilities above 10 percent. Although theprivate domestic banks and the public banks match the foreign ones with respect to networth (at least for the top three quartiles), their shares of performing loans are muchlower. Normal loans do not comprise more than 90 percent of credit for any public bank.For half of them, less than 70 percent of their loans are performing; for a quarter of them,less than half are performing. At all points of the distribution, private domestic banks haveslightly higher shares of performing loans than do public ones. Their portfolio quality is,however, not nearly as good as that for foreign banks.

2.18 Argentina's weakest banks are found among the public and private domestic ones.The systemic risks posed by each group are different. Portfolio quality data make it clearthat the primary problem associated with public banks is the mis-allocation of resources.At the same time, however, these banks impose fiscal burdens on the state as they arefrequently in need of re-capitalization. It is through this fiscal channel that public bankspose a systemic risk. Although privatizations, which are discussed in more detail below,have eliminated many of the poorest performing provincial banks, depositors at somepublic banks still must consider a province's fiscal health when assessing the safety of theirdeposits.2 ' Evidence indicates that, with the exception of Buenos Aires and Salta, allprovincial banks lost at least 10 percent (and up to 40 percent) of their deposits during theheight of the Tequila Crisis. While neither Buenos Aires nor Banco de la Naci6n appearto contribute to this type of systemic risk -- depositors run to them rather than from themin that crisis -- it would be inaccurate to assume that provincial banks, by virtue of theirpublic status, impose no risks.2 2

2.19 Table 2.4 attempts to quantify the systemic risks posed by these banks. Public andprivate domestic banks are first grouped into quartiles based on their total assets. Theshare of normal loans variable indicates that portfolio quality is increasing in size quartile.From a systemic perspective, it is encouraging that the weakest banks tend to be smaller.The smallest two quartiles for private domestic banks represent 2.3 percent of systemassets; the bottom three quartiles comprise 5.6 percent. In addition, the smaller, weakerbanks also tend to have lower ratios of liquid to total assets. The combination of weakportfolios and low liquidity implies that these banks are most vulnerable to exogenousshocks.

2.20 In scenario 1 we calculate the costs associated with liquidating banks in eachquartile assuming that (1) performing illiquid assets are all recovered (or sold at face

21 The deposit insurance sclhcimie makes tIiis concerii somewhiat less pressing, although coverage islimited and much of the deposit fliglt duriing t(le Tcqtila Crisis involved "large" deposits.

22 In thle analysis that follows, we estimate the costs associatcd witll liquidatinig public and weak privatebanks. For public banks, suclh liqtuidationis could occur abruptly in time of crisis or could occur innon-crisis periods as provinces chose to avoid the future fiscal costs associated re-capitalizing theirbanks. Even if we assumiie public banks pose no systemic risk and thuis need not be liquidated intime of crisis, the analysis provides useftil estimates of the short-terimi fiscal cost of liquidating(privatizing) these banks if anid wlhen policy makers choose to confronit tlhe problem.

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value), (2) all other illiquid assets are unrecoverable,23 and (3) liquid assets are used todefray liabilities not met by money from normal loans. It is extremely unlikely that allbanks in these two categories would ever be liquidated simultaneously, so the totals for allquartiles should be viewed as an implausibly high upper bound on systemic strain. Totalliquidation costs for all private domestic banks under scenario 1 are, however, only 1.6percent of banking assets. For the two smallest quartiles, those where most problemsappear to reside, costs are only 0.3 percent of banking assets. While troubled, their smallsize makes it unlikely that these banks pose a great threat to the system.

2.21 For the public banks it also appears that those in the largest quartile have betterportfolio quality and more liquidity. As noted above, however, their portfolio quality isbelow that of the largest private domestic banks, and those in the bottom three quartiles allhave low shares of performing loans (below 65 percent). As a result, although there areonly eighteen public banks that enter the calculation, their total liquidation costs underscenario 1 are 1.8 percent of banking sector assets, 0.2 percent more than for the forty-nine private domestic banks. Most of the losses would come from the relatively largebanks in the second-largest quartile; their average share of performing loans is only 52percent.

2.22 Privatizations to date indicate that scenario 1 likely under-estimates short-termliquidation costs for public banks. Clarke and Cull (1 997a) describe the post-audit declinein the value of assets for public banks that enter the privatization process.24 On average,these more rigorous audits resulted in a .15 decline in the ratio of net worth to totalliabilities. Even after the post-privatization audits, however, private purchasers refused toassume all of the assets and liabilities of the public bank. On average, only about half ofthe public banks' assets were acquired.

2.23 Scenarios 2 and 3 attempt to account for this by assuming that a fraction of publicbanks' loans now considered normal could not be sold. Under scenario 2, which assumes25 percent of normal assets are unrecoverable, the total costs associated with liquidationare over 7 percent of banking sector assets. Under a more unlikely scenario 3 (50 percentnormal assets assumed unrecoverable), costs are over 12 percent of system assets. Theprivatization experience to date, moreover, suggests that poor performance and over-estimates of asset values have occurred at public banks of all sizes. It would not,therefore, be proper to focus only on the small banks (as we do for our private domesticbank liquidation costs estimate).

23 More precisely, the normal loan percentage is miiltiplied by the total assets (minuis liquid assets) inthe quartile. The quartile's othier illiquid asscts are assuiincd unrecoverable.

24 See Bibliograply to Cull (1998) for frill citationis.

- 27 -

Table 2.4: Quantifying RiskIs Posed by Public and Domestic Private Baniks, October, 1997

Bank Type Total % Normu Liqui(l. Liquilation Liquidation LiquidationLoans Ratio Scenario I Scenario 2 ,Scenario 3

(All but Normal* (Plus 25% Normal (Plus 50% Normal_Unrecoverable) Unrecoverable) Unrecoverable)

(Avg.) (Avg.) (Avg.) 000s %ta 000s %ta ooos -/ota

Private Domestic(Grouped by TotalAssets)

1-25 Percentile 31,753 63.8 .08 -90 .1 -193 .2 -294 .226-50 Percentile 99,470 67.0 .07 -300 .2 -651 .5 -1002 .851-75 Percentile 200,655 68.1 .09 -747 .6 -1415 1.1 -2082 1.676-100 Percentile 1,056,666 84.3 .09 -962 .7 -5221 4.0 -9480 7.3TOTAL -2099 1.6 -7479 5.7 -12860 9.9

Public(Grouped by TotalAssets)

1-25 Percentile 39,568 64.3 .05 -73 .1 -130 .1 -188 .126-50 Percentile 218,501 59.3 .08 -391 .3 -569 .4 -748 .651-75 Percentile 657,120 52.4 .09 -1642 1.3 -2304 1.8 -2965 2.376-100 Percentile 5,251,736 79.0 .09 -278 .2 -6230 4.8 -12182 9.4TOTAL -2385 1.8 -9234 7.1 -16082 12.3

*Norrmal refers to those loanis rated in BCRA's top category, "En situaci6ni normiial/ Cumpliinientonormal." There are six categorics.

2.24 The estimates in Table 2.4 assume that assets not recovered (or sold) are foreverunrecoverable. In privatizations to date, however, assets not acquired by the purchaserwent into a residual entity for liquidation by the province. We have not yet analyzed howthat liquidation has progressed, but we recognize that our estimates here represent onlyshort-term liquidation costs because they allow for no residual asset recovery. From apolitical perspective, scenario 2 and 3 estimates do, however, provide some indication asto the potential magnitude of the short-term problem. By contrast, because steep post-audit declines in asset values and partial purchases of assets and liabilities have notoccurred in the case of private domestic bank sales, scenario I may be the more plausiblefor them.25

2.25 In short, Table 2.3 and Table 2.4 help summarize many key results. Relative todomestic banks, foreign ones are larger, are growing more rapidly, and have much higherportfolio quality than domestic ones (either public or private). There is, however,variation in the quality of the private domestic banks, and it is the smallest ones thatappear to pose the greatest risks of failure. From a systemic perspective, therefore,

25 We do, however, lack data on thc recoverability of assces after thc closure (rather than the sale) ofprivate domestic banks. If post-closure asset recovery (is.e, asset sales to other banks) has beenespecially difficult -- and convcrsationis with BCRA staff suggest that is has becn -- scenarios 2 or 3are more plausible for some of these banks.

-28 -

private domestic banks may not pose that great a threat.26 The public banks pose thebiggest problems, though as noted earlier the main issue is the misallocation of resourcesassociated with nonperforming loans. Their portfolio quality is low regardless of size, andthis will probably worsen after more rigorous audits. The liquidation estimates here,moreover, make it clear that privatizing these banks may be very costly. If suchprivatizations, which are clearly our preferred approach, prove politically infeasible,improved supervision of these banks may be the only option for improving theirperformance.

BANKING SYSTEM: AN EVOLUTIONARY PROCESS

2.26 Since the 1991 Convertibility Law, the Argentine financial system has undergone aseries of fundamental changes. Hyperinflation in the 1980s had reduced the financialsystem to levels below that found in the lowest income countries, and in a certain sensethese past crises, coupled with effective policies in recent years, have helped make thesystem more robust today. Once credibility of the Convertibility Law was established,inflation decelerated and the re-intermediation of the financial system began in earnest. Asseen in Figure 1, credit, both total and to the private sector, has grown significantly inrecent years, though financial depth (M3/GDP), while growing rapidly, is still somewhatmodest relative to other countries at comparable levels of per capita income. Using datafrom 116 countries, King and Levine (1993) find that, among those ranked in the highestquartile in real per capita income, the average ratio of gross claims on the private sector toGDP is .53. Those in the second quartile have a ratio of .31. Throughout the late 80s and90s Argentina would appear to rank near the dividing line between these quartiles in theKing-Levine sample, yet its private credit to GDP ratio is now only . 16. Since 1994,M3/GDP has hovered near .15, in between the average figures for the third and fourthquartiles (.20 and .13).

2.27 The 'Tequila' crisis of 1994-95 marked a turning point for the authorities, with arun on some of the smaller banks and then on the system. Deposits declined sharply(Figure 2), and interest rates rose by as much as 1500 basis points on peso loans and 900basis points on dollar loans. The crisis was halted by the assembly of a support packageby the multilateral institutions, convincing support by the government for convertibility,and a credible program of bank restructuring and closure.

26 We recognize, however, iliat contagioni could coiiceivably miake inidividual bank niis worse. Still,the size of the weaker private domcstic baniks relative to the large foreigii, public, and othier privatedomestic ones suggests thiat suchi contagion would liave to affect banks Iliat appear quite healthy atthe moment to liave serious systciiic coniscqieniccs.

- 29 -

Figure 1

Figure 1: Credit Growth and Financial Depth26.0. ~ ".

2 4 .0 ... ... ... ......... .......... . :..:--...........

a 22.0 . . ............ .. .

20.0. -4--.. -*.

a 18.0

c 16.00 ~14 0-

-/-.- : : . recdI12 0 : - -l12.0 .---- :-: -. Private Cred.10.0

1991 1992 1993 1994 1995 1996 1997Note: End of year and figures include pesos and dollars.

Credit doesn't include accrual resources

2.28 Figure 2 also describes the evolution of deposits by type of bank by quarter fromthe fourth quarter of 1994 to third quarter, 1997. In nominal terms, total deposits havebeen increasing more or less steadily since second quarter, 1995. Total deposits in bothprivate domestic and public banks floated around the 20 billion peso mark, although arecent spate of foreign acquisitions coincided with a dip in private domestic deposits latein the period. The increase in total deposits is accounted for by foreign banks and, to alesser extent, privatized banks.

Figure 2

Total Deposits by Type of Bank by Quarter, 12194-9197

700000000

60000000 . .. :..... . :-;------

6000000050000000 --.

S ~ 30000 -- ----- -.........

2. 30000000 -t-.~~~~~~~ tot deps

20000000 ..-..... A foreign

10000000-.- pub

0:c t... . ::priv'tized

o) a) 0 XQuarter 0 0inCQuarter Bnding

- 30 -

2.29 To some extent, the increase for foreign banks reflects not only acquisitions late inthe period, but also depositor flight to quality, especially in the Tequila crisis. In 1994-95, for example, the number of foreign-owned banks did not increase (Figure 4) but theirdeposits, both in nominal terms and as a share of total deposits, climbed steadily if notdramatically. The share figures for foreign-owned banks did, however, stabilize by mid1995 (Figure 3).27 The only type to lose nominal deposits (relative to their December,1994 level) was the private domestic banks, and losses occurred in two waves. Early inthe period, private domestic deposits declinied during the flight to quality. There were alsoa number of domestic bank closures at this time. The end of the period saw a decline indeposits that coincided with aforementioned acquisitions by foreign-owned banks.

2.30 Figure 2 also indicates that, after a decline coinciding with the provincial bankprivatizations of 1996, nominal deposits at publicly-owned banks grew from December,1996 through third quarter, 1997. This casts some doubt on the notion that foreign banksand the remaining private domestic ones will compete away the deposits of the largeremaining public banks any time soon. Data on shares of total deposits (Figure 3) alsolead to the same conclusion -- the increase in nominal deposits of public banks has enabledthem to maintain their share of deposits. Public bank share did fall at the time of the 1996privatizations, from 40 percent to 35 percent, but their 35 percent share remained constantfrom mid 1996 through September, 1997. Further confirmation that the loss of publicbank deposit share was a one-shot phenomenon attributable to the 1996 privatizationscomes from the deposit share for privatized banks. That figure remained at 4 percentthroughout 1997, roughly equal to the decline in public bank share in the prior year.28

2.31 The share data (Figure 3) make it especially clear that the largest jump has been forforeign-owned banks (from 15 to over 35 percent), and that the increase has come at theexpense of the private domestic banks whose share declined from 45 to 25 percent of totaldeposits. Similar results obtain for the share of total assets to total loans attributable toforeign-owned banks29. Determining whether the drop in private domestic banks' sharewas attributable to closures and takeovers by foreign-owned banks or to a shift indepositors' preferences is difficult using only this data. Some tentative conclusions can bereached. Mergers and closures in the wake of the Tequila Crisis account for a steep dropin the number of private domestic banks early in the period (Figure 4). In the first fivequarters of the period, the number of private domestic banks declined by over 40 percent(from 108 to 65). At the same time, their share of deposits declined by only 5 percent

27 Inlterestingly, the stabilization coinicided roughlly witli thc adoption of a formal deposit insitrancesystem in April, 1995. This may have had some effect in stopping thie "nrui" from domiestic toforeign banks.

28 Thne increase in privatized baniks' deposit shiare did not occur unitil 1997, an indication that sometime elapsed between the closure of the public provinicial banks anid their re-openinig as privatizedbanks.

29 "iStructural Change: Interiiationializationi, Consolidation, and Privatization in Argentina's BankingSector, 12/94-9/97" miiieo by Robert Cull (1997).

- 31 -

indicating that those banks that closed were not particularly large, and that the mergerprocess may have helped eliminate a major shift in deposits away from domestic banks.

Figure 3

Shares of Total Deposits, By Type of Bank, By Quarter,12194-9197

50.00% ~...v~vPv__ve.. 45.00% .. ....... : - ... -.. -45.00% IL---.... ........... ............ ............

40.00% ' ..- .-.35.00%T.30.00%25.00%.

, :-........ .. :

20AX.00%... . . ,, .. .:. ... ..... ...:.,u--- foreign

15.00% ... ....... ...... 3

10.00% : pri donest, . ~~~- - - - - - - - - - - - - - - - - , - - - -

5.00% - ...... ......... :--pub0.00% : .&*.* s.- I.. X X priv'tized

Lo rO It-CY) CY) ~~~~0) 0

O ~ ~~~ aU a).

o 0 0~~~~~~~~~~~~~c

Quarter Eiding

2.32 Throughout 1996, when the numbers 'private domestic banks remained near 60,their share of total deposits increased, and at a pace commensurate with that for theforeign-owned banks (whose number also did not change). Depositors' perceptions of theprivate domestic banks that remained, therefore, does no )pear to have been negative.The deposit insurance program of April, 1995 no doubt pldyed a role, but that programdoes not cover large depositors and has accumulated only limited premia for potential bail-outs. It would seem unlikely that deposit insurance can account entirely for the slight mid-period increase in the share of deposits to private domestic banks. The consolidationprocess likely deserves some credit. The point is important because, as will becomeclearer later, the post-merger performance of many of the private domestic banks has notbeen impressive. To attribute those failings to the merger process itself, however, wouldnot be justified, especially when the deposits data suggest that the consolidation may haveimproved depositor perceptions and thus contributed to stability.

2.33 Foreign acquisitions in 1996 and 1997 account for the late-period decline in thenumber of private domestic banks (Figure 4). The private domestic banks that wereacquired were relatively large ones. The number of foreign-owned banks increased byslightly more than 25 percent (from 30 to 38), while the share of foreign-owned depositsdoubled (from 18 to 36 percent). On the flip side, the number of private domestic banksdeclined by one-sixth (from 60 to 50), while deposit share declined deeply from 43 percentto 25 percent. The decline in private domestic banks' deposit share since December, 1996was very different from the one in 1995. The post-Tequila shake-out affected smaller,

- 32 -

weaker banks that were forced to cease operations; the 1996-97 decline resulted fromforeign acquisitions designed, it appears, to obtain large market shares.

Figure 4

Number of Banks, By Type, By Quarter, 12194-9/97

120 .. -. ... Ct -) ''- f 4 ' -4 i: !,f,0.i.: ,,#S i .-, .................... ............ ,E

..., .: ...:? ..::.. .:.#..:ggggg:g:g .|g g g -gg ...-.. .. ...........- -EERhRi :)L d. , : E LE,# ,,

-U .................. ... ...- -...........

, , , ~~~~~~~~~~~. . ,. ........ < ,.. ........,.. ...,,,,.,,,,,.,.,,,,:l,,,;: S :0::::80 .. ? ? ,v ,? , ,,,,,-.......... ................. ...........?'??????ii????..?i..??: .''' ..' ?? ........?? .:'- ..:'.'. :-.i... '..i .SR..EEEEi.::CD.ii.'f.E:.

100 '.?-i,i,,,-,?,? ?? . ?- ? .:-7 .7 i.7 lT n . .' .: ..: .;::00 .t .. . ? .. .. . . .;;;.- ?;???.????.;;? .... ..? ; . .- ....:: - : i........ : ........ f:ER EEEEDEDhD.DD? ? E'

60 .?< ?????i ? _ ^??,:,-^,?,,,?,^~~~~~.- .............. . .... i:.....t0-

........ . . ... .......... z e

~~~~~~~~~~~~~~~~~~..??;??. .:; :...'? .. ... ... ... . . . .. . .?.E.E:EER R RRE ELL ..:4 4 . s ... R:;~ :T ..: S?.~ ~ ~ ~ ~ ~~~~~~~~~~~.. .... ............... . ? 00iiE i;ilil4 i442500Eg: E|f .50.. _

80 .. .? ...... ..? ..?' -?- ::S :00000tA AS ilSHN7 S : 0Ei .:.. . ?

Arg~~~~~fentin bningsecto an discussethei imlica4|ition for systemic4 sai7itye-.: This - ?

i?"i i .. .iii iiiiii iiii i .iiSiidiiiiiiiiiiii- :- . -.- ............. - .1.....................a.;_>

sectionfleshes out that ov ieidin ............. ......pr - m r d a.....id at o t t e.... m-ajr

6 0 .X *..... W .4$.............

typesX of stutua chng -itratoa nty rvaiainfpbi prov'incalbaks

ones. Thecomprions withd prividdatbizedfn pubvicw bank may berusomewhatnmisledn inth

tyatman of sthemura werne se-u itoedrectioa ceditrto, parivticuario povince,i butinia theks

comparisons with private domestic banks also indicate that foreign banks allocate morethan twice as large a share of their total credit to the federal district of Buenos Aires(Capital Federal). Roughly 95 percent of foreign banks' credit is directed to either theCapital District or the rest of the province of Buenos Aires.

- 33 -

Table 2.5: Allocation of Total Credit Across Provinces, By Bankl Type

Bank Type Capital Federal Otlier Buenos Cordoba Remaining(%) Aires Provinces

(%) (%) (%)Foreign 88.5 6.1 1.8 3.5Priv Domestic 40.8 17.1 11.5 30.6Public 18.1 4.3 6.2 71.0Privatized 6.5 0.0 0.0 93.5

2.36 Data in Cull (1998)3° demonstrate, however, that foreign bank credit to manyprovinces is now increasing. Additionally, in those provinces that have privatized theirbanks, total nominal credit has grown by, on average, 78.9 percent over its January, 1994level due to increased credit from both privatized and foreign banks. In only one of twelvecases (Entre Rios) did nominal credit decline. By contrast, in those that have notprivatized, the average increase in nominal credit has been only 26.9 percent -- in seven ofthe twelve such cases there was a contraction in nominal credit. If we exclude CapitalFederal and two provinces whose nominal credit more than doubled (Chubut and SantaCruz), provinces that did not privatize banks had a 9.4 percent average decline in nominalcredit.3 ' In short, although foreign credit growth has not been the dominant force in allprovinces, the combination of foreign and privatized credit growth has left those provincesthat privatized banks with substantially more access to credit than other provinces.

2.37 Disparities in credit allocation across productive sectors between bank types arenearly as striking as those across provinces (Table 2.6). Foreign banks appear much morelikely to involve themselves in large-scale projects (manufacturing and utilities) thandomestic ones. For their part domestic banks are more likely to involve themselves inprimary production (cereals, grains, other food products, wood, metal, etc.) and retailtrade (comercio minorista); and the public and privatized banks concentrate much of theiractivity on government services.3 2 Both geographic and sectoral break-downs of creditindicate that the credit market in Argentina is relatively segmented. Regardless of thesector, however, foreign banks have the highest share of normal loans. Low portfolioquality is evident across all sectors for public banks. Especially disconcerting is that only38 percent of public credit extended for primary production is rated normal. This suggestsstrongly that public baniks do not awaverd credit accordinig to commercial criteria. Given

30 i.b.i.d.

31 These calcuilationis include only thosc financial instituitionis (a) for whicih credit break-downs byprovince are available and (b) whichi were identified in BCRA docuienicits as being either public,private domestic, foreign, or privatized banks. Altlhouiglh this captures only a subset of total credit toa province, there is no obvious reason to think that this would affcct comiparisonis between privatizersanld noin-privatizers rcgardinlg pcrccnitage changcs in total credit.

32 The nine listed categories accounit for only 90 pcrcent of thc total financial assets of foreign banks;for the three types of domestic banks thcy cover 96-97 percent. However, provided that the 10percent unaccounted for foreign banks isn't concentrated too heavily in any one of tlhese sectors, it issafe to conclude thlat they allocate credit quite differeolly tlhan do domestic ones.

- 34 -

the large size of the public banks, this is troubling. Again, more rigorous audits presentlybeing conducted by BCRA are likely to reveal that the situation could be even worse thanthese numbers suggest.

Table 2.6: Total Financial Assets By Real Sector, By Type of Bank

Iidustry Foreigni Privatc Doiiicstic Public Privatized%of % of %of %of

Finaiiciaci6ni Finaanciaci6ii Fiinanciaci6n Financiaci6nProduccion PrimNaria 4.9 8.2 13.9 6.5(% Normal)* (87.5) (72.2) (38.0) (67.7)

Ind Manufactureras 29.8 13.1 9.7 4.5(% Normal) (90.2) (70.4) (36.9) (65.2)

Construccion 3.2 4.3 6.4 3.1(% Nonnal) (93.6) (77.3) (41.4) (84.4)

Elect, Gas, Agua 3.6 0.7 0.4 0.3(% Noniial) (94.5) (87.3) (70.2) (95.0)

Comercio Mayorista 6.7 6.6 3.3 2.7(% Normal) (89.0) (70.8) (41.7) (59.7)

Comercio Minorista 3.8 16.8 14.7 8.3(%Norinal) (89.1) (69.0) (39.5) (69.4)

,Servicios y Finanzas 16.2 19.2 26.7 54.0(% Normal) (94.0) (80.3) (75.3) (96.1)

Familias 16.5 23.4 16.3 11.2(% Nonnal) (86.6) (75.7) (65.7) (84.2)

Otros 5.8 3.7 4.6 6.5(% Normal) (88.7) (77.6) (54.8) (76.0)*Normal refers to tlhose loanis rated in BCRA's top category, "'En situaci6i inorniial/ Cuiipliinieiitononnal." There are six categories.

2.38 The differences between foreign and domestic banks are striking. Foreign banksare somewhat better capitalized and have much higher portfolio quality than domesticbanks, which should have beneficial effects on banking sector stability. They also appearto direct credit to sectors that domestic banks tend not to emphasize. In addition, foreignbanks have exerted both direct effects on the banks they have acquired and indirect oneson the remaining domestic banks. Results from simple discrete choice models indicate thatforeign banks looked to acquire large domestic banks, presumably to acquire marketshare33. The quality of the bank as reflected in performing loans, capitalization, andoperating efficiency were far less important factors.

33 See Cull (1998), i.b.i.d.

- 35 -

2.39 To the extent that large, mediocre banks are being transformed into stronger onesthrough these acquisitions, the system is no doubt healthier. The data available to date dosuggest that there has been a bit of dislocation as operating efficiency has declined slightlywhile non-performing loans have increased slightly in the wake of the most recentacquisitions.3 4 At the same time, however, foreign banks have been increasing theirlending activity at a rate faster than domestic ones. Provided that they remain well-capitalized, and indications on that front are positive, foreign bank growth and theresulting better developed lending markets should be a benefit to the country.

2.40 Regarding indirect effects, interest margins and operating profits are lowest forthose domestic banks with high exposures to the Capital District and to the manufacturingsector, areas where foreign banks have long focused a remarkably high share of theirlending (See Annex for details). Foreign banks' increased emphasis on mortgage,property, and personal lending does not appear to have had an adverse effect on domesticbanks. In fact, those domestic banks that have also shifted into those areas have, onaverage, experienced the largest increases in net interest income and profits. Effects maybe felt later but, up to this point, there has been sufficient room to grow in these areas forboth foreign and domestic banks so inclined. This no doubt reflects the embryonic state ofthese lending markets after years of severe financial disintermediation. By contrast, thosedomestic banks that have shifted into a more traditional line of business, public sectorcredit, have seen little change in their performance".

Privatization

2.41 A recent Bank report36 summarize Argentina's experience with recent bankprivatizations. Those results lend credence to the claim that recent structural change haseliminated some of Argentina's most troubled banks. Cull (1998)37 provides results froma proportional hazard model that describes the likelihood that a province privatized itsbank. Controlling for a province's fiscal and political situation, weaker provincial banks --those that had lower net worth relative to liabilities, a lower share of performing("normal") loans, and a higher share of credit to the public sector -- were more likely to beprivatized. Regarding politics, provinces where President Menem's Ilcariido Justicialistaheld the governorship were more likely to privatize. In addition, a dire fiscal situation andthe strain of the Tequila Crisis both increased the probability that a province privatized itsbank(s).

2.42 Taken together, these results indicate that the Tequila Crisis imposed the greatestpressure on provinces whose banks perforned poorly and whose fiscal situation made it

34 It should be noted that cross-couLltry results indicatc that in developing countiries this often occurs forforeign banks due to thlcir informatioiial disadvantages.

35 See Cull (1998) Section 3.

36 "'Argentina; The Fiscal Dimenisioni of the Convertibility Plan" 1998, and Clark and Cull (1998)

37 i.b.i.d.

- 36 -

difficult for them to finance bail-outs. No doubt, the liquidity crunch precipitated bydepositors' flight to stronger banks hit public banks in such provinces especially hard. It isno surprise that these banks were the first to be privatized.38 Although privatization haseliminated some of the poorest performing public banks, data in Table 2.3 and Table 2.4make it clear that the remaining ones are still among the weakest in the system. Cull(1998) (Table 2.1) also indicates that the average size of the public banks increased asprivatization progressed. Privatization has, therefore, eliminated a number of severe, butrelatively small problem banks.

2.43 Regarding their current performance, privatized banks do rely on income fromservices to a great extent, but their lending has also grown substantially, and a decliningshare of that lending is going to the public sector. Table 2.7 presents quarterlyperformance data for twelve privatized banks since first quarter, 1997. We have post-privatization data for many of these banks for only three or four quarters, but somegeneral impressions emerge. Average assets, liabilities, and loans have increased for thisgroup in each quarter, and at a rate faster than for other banks, even those banks recentlyacquired by foreign interests39 . At the same time, the average ratio of net worth toliabilities has increased while credit to the public sector has declined. For the nineprivatized banks for which we have data for the first half of 1997, the percentage ofnormal loans remained near 90 percent.

2.44 Similar qualitative results emerge if we focus on only the four privatized banks(labeled "older" in Table 2.7) for which we have six quarters of post-privatizationperformance data. With only very minor exceptions, average assets, liabilities, total loans,and share of normal loans increased in each successive quarter. At the same time, theshare of credit to the public sector declined steadily. The ratio of net worth to liabilitieshovered between .09 and .13. In short, privatized banks are entering private sectorlending more forcefully while at the same time improving portfolio quality and maintainingtheir capitalization ratios.

38 Provinces that agrccd to privatize lhcir banks were eligible for support fromii the Fondo Fiduciario, anagency created by thle federal governmiienlt (willi loans from thle World Banik). Provinces receivedmoney from the Fonido in the formii of lonig-termii loans. Loan proceeds were used to retire provincialbanks obligations that were not absorbed by the bank's purclhaser. As noted, in all privatizations todate the purchaser did not assume all assets and liabilities of the public provincial bank. Some wentinto a residtual entity for wvhicli tie provinice retained responsibility. In thiis way, provinces were ableto convert the slhort-termii obligations (eg. demlaiid deposits) into long-termii obligations. See Clarke

and Cull (1997a) for additional details.

39 See Cull (1998) i.b.i.d.

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Table 2.7: Performance of Privatized Bankes, By Quartcr

Type Assets Liabilities Loans % Nornmal % Public Net Worth/Sector Liabilities

Avg. Avg. Avg. Avg. Avg. Avg.All1/97 252,014 238,281 117,391 89.2 20.8 .052/97 272,494 250,983 134,589 89.8 17.1 .093/97 300,375 275,017 150,776 16.4 .10

(n=12) (n=12) (n=12) (ii=9) (n=12) (n=12)

Older2/96 131,791 119,601 61,073 76.2 15.7 .113/96 124,381 111,097 80,843 80.8 11.2 .134/96 165,814 152.188 93,958 85.3 8.9 .101/97 184,912 170,393 107,611 94.0 9.4 .092/97 234,940 210,374 151,856 95.7 5.9 .123/97 229,040 203,315 146,222 5.6 .13

(ii=4) (ii=4) (0=4) (ni=2) (ni=4) (n=4)

2.45 Although these banks are relatively small with activities disproportionately focusedon government services, their portfolio quality and operating efficiency comparesfavorably with the largest private banks in Argentina, of which many are foreign-owned.The privatized banks are, moreover, increasing their lending activity, and an increasingshare of that credit is going to the private sector. The data strongly indicate that, to thispoint, privatization has been a positive structural change for the banking sector.

Consolidatioii

2.46 For the most part, however, much of the recent merger activity among domesticbanks involved relatively small, struggling banks for whom merger may have been anecessary, if insufficient, action to insure survival.4 0 Further confirmation that thisconsolidation process has been a scramnble among relatively weak banks comes from logicmodels that describe those banks that avoided the process (Table 2.8). These banks werenot merged into another entity, acquired by a foreign bank, nor did they exit the industry.They tended to have a high ratio of net worth to total liabilities, a low percentage of loansto total assets, and tended to be foreign-owned. In some specifications, there is also weaksupport for the notion that they had a higher share of normal loans.4'

40 This sub-sectioni is not concernied witli tlhe acquisitioin of domestic banks by foreign interests, onlyacquisitions of domestic banks by otlher domestic banks.

41 In the first and fourtlh models of Tablc 2., we lose thlc nct wortli result bccause we incltuded somebanks for whichi loans comprised lcss tliai a quarter of total assets. Balance sheet data for these"banks" is quite strange. Thicir ratio of nct wortlh to total liabilities exceeds ten in some cases. Indrawing iniferences about tliosc banks that avoided the mergcr process, it is probably safe to excludethese so-called noni-baniks from ithe specificationi. Suchi models indicate that it was relatively healthybaniks tliat avoided thle consolidationi process (botli mergers anid closures) altogetlher.

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Table 2.8: Logit Models, Dep Var = I if No change in Banklo's Ownershtip (Bankll Not Merged IntoAnother or Acquired by a Forcign Entry, anid Did Not Close)

Explan. All Years All Years All Years Recent Recent RecentVariable (Fuill Samiple) ("Non-Banks" (Public Also (Full Saiiiple) ("Non-Banks" (Public Also

Excluded) Excluded) Excluded) Excluded)(1995-97) (1995-97) (1995-97) (1996-97) (1996-97) (1996-97)

1 2 3 4 5 6Net Worth to -0.003 3.44 2.95 -0.005 3.46 3.06Liabil. (0.17) (2.28) (1.78) (0.25) (2.18) (1.71)

Netlnc to Costs 0.49 0.20 1.02 0.55 0.23 1.08(1.28) (0.64) (1.39) (1.41) (0.53) (1.39)

% Loans Nornmal1.31 1.31 2.97 1.61 1.63 3.50

Foreign (1.37) (1.28) (1.26) (1.64) (1.55) (1.41)Owned

3.62 3.07 3.6() 3.48 2.95 3.49Loans as % Assets (3.30) (2.89) (3.25) (3.15) (2.77) (3.14)

Total Liabilities -2.66 -3.67 -5.62 -3.15 -3.98 -6.33(f00,OOOs) (2.19) (2.26) (2.77) (2.33) (2.28) (2.81)

0.39 0.53 0.15 0.35 0.48 0.08Obs. (1.42) (1.64) (0.40) (1.29) (1.51) (0.23)Chi-sqreP>Chi-SqPseudo R2

166 158 127 157 150 11943.09 47.61 49.97 40.77 44.36 46.900.0(( 0.(00 0.()00 0.000 0.000 0.0000.19 0.22 0.28 0.19 0.22 0.29

z-scores in parentheses; Explanatory Vlariables measured just prior to Tequila (risis (12/94).

2.47 Further confirmation that target banks haven't necessarily been acquired bystronger domestic entities, and that the acquisition itself has not necessarily improved theperformance of the acquirer, is found in pre- and post-merger performance comparisons.Many of these mergers are quite recent, so we have only a year of post-merger data (fourquarters) from which to draw inferences. That said, a pattern again emerges -- the banksimmediately get bigger, the percentage of non-performing loans increases, operatingefficiency declines slightly, and the net worth ratio declines (Table 2.9).

2.48 If this were a one-shot effect, it might not be very worrisome. Indeed, the first-year performance decline for foreign acquisitions is similar, though generally lesspronounced42 . Unfortunately, for those mergers that occurred two or three years ago, thepattern of growth in assets and liabilities, declining efficiency and net worth, and a highershare of non-performing loans continued. Perhaps this is a reflection of an increasingly

42 See Cull (1998) Sectioni 3.

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competitive environment. However, to blame the merger process for poorer performanceis again probably inappropriate. Regression results in Table 2.843 suggest that it wasbanks that were not especially strong that were acquiring smaller, poorly capitalized ones.It may not be so surprising, therefore, that their post-merger performance has beenunimpressive.

Table 2.9: Pcrform ance Comparisons, Pre- and Post-Mcrger

Merger Assets Liabil Loanis % Lnis % Lns % Lns Net Inc NetVintage Non BA Capit. Feder. Irregildar to Cost Worth!

Liab

>= Jyr (12)Pre-Merger 577.7 504.9 412.7 41.3 40.1 17.7 1.05 0.15Yearl 942.9 846.6 604.1 36.7 44.8 21.7 0.97 0.12

> = 2yrs (9)Pre-Merger 451.3 385.1 345.2 39.2 44.9 15.8 0.96 0.16Year 1 796.0 708.8 523.7 39.9 43.9 24.7 0.91 0.11Year 2 934.6 841.9 607.1 27.6 0.75 0.10

>= 3yrs (3)Pre-Merger 291.5 249.8 206.5 30.8 62.5 15.8 1.40 0.17Year 1 372.0 331.7 238.2 37.0 57.7 24.3 1.11 0.12Year 2 403.8 365.4 256.7 35.3 59.4 30.1 1.01 0.09Year 3 429.7 393.8 277.4 * 31.0 * 0.07* Missing data for at least one bank in the groulp.

2.49 Thinking about the counter-factual is probably useful: what would have happenedto these banks had the mergers not occurred? From a systemic perspective, these mergersmay have helped avert closures at a time when stability was much needed. We note,however, that if additional closures are not politically feasible, merging with a "notespecially strong" bank and then subjecting the entity to close oversight and closing itshould it not recover is a viable strategy if the original "bad bank" problem is not toolarge. The larger the insolvent banks, the greater the likelihood that merger withsomewhat healthier institutions will neither be sustainable nor gain authorities much time.44

IMPROVING THE REGULATORY AND SUPERVISORY FRAMEWORK

2.50 Although the Tequila Crisis had its short-term costs, it also had the salutary effectof accelerating reforms in the financial sector, contributing to the emergence of a systemthat is more resilient to external shocks. As a result, despite unease in the early stages ofthe more recent Asian crisis, the resolve of the monetary authorities during the TequilaCrisis (e.g. in staying with the Convertibility Plan, and allowing banks to fail), were

3 And Cull (1998)

44 In short, the strategy is more defensible wlheni a sysiemic event is making it hiard to close too manybanks at onice. Duirinig '"norinal" tiics, the strategy just delays or exacerbates problems.

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enhanced by significant regulatory and supervision changes implemented since then,contributed to an early recovery of confidence in the banking system, and its vigoroussubsequent expansion.

2.51 The central goal of prudential regulation and supervision is to limit the riskiness offinancial institutions, and thereby limit both the potentially destabilizing macroeconomiceffects of banking system fragility, and the potential costs to taxpayers from the explicit orimplicit protection provided by the government to financial institutions. The merits of anysystem of prudential regulation and supervision must be measured with regard to thedesign of its safeguards and the political credibility of the enforcement of thosesafeguards. The truest test of a system of bank regulation and supervision is how itresponds to the riskiest banks. If risky banks are able to survive with impunity, the systemwill not be effective in limiting risk. Capital requirements, reserve requirements,disclosure policy, and supervisory procedures, therefore, must be geared towardestablishing credible limits on risk taking, and making those limits apparent in advance tobanks and to market participants.

2.52 The Central Bank has introduced a sound framework of prudential regulations,some of them novel and experimental, ained primarily at the systemic risks facing thebanking system. These are market-oriented regulations which attempt to complementoverseeing responsibilities of the banking system through investors, auditors and ratingagencies. On supervision, the overall structure is sound, and incorporates many of thecurrent international best practices. Central Bank's efforts in strengthening bankingsupervision and its regulatory framework have been successful and commendable.However, due to the 1995 crisis, some areas of the supervisory process have beenoverwhelmed by the need to devote substantial resources to crisis management, and thereis a need to renew the process of supervisory institutional development. Nevertheless,despite significant progress to date, there is scope for improved implementation of theexisting legal and institutional framework.

2.53 Since December 1996, BCRA has superimposed to the CAMEL 45 approach aprogram of Argentine origin named BASIC 46 with the intention of bringing market forcesto bear in the supervisory approach. In parallel to the ratings provided by CAMEL, theBASIC elements include:

* B (for Bonos/Bonds). A prudential regulatory program that requires banks toissue subordinated debt equal to 2 percent of their deposits, with a minimum

45 A supervisory approaclh originatcd anid operated by U.S. Agencies whereby five crucial bankingaspects are rated fromi I (bcst) to 5 (worse) based on eacih bank's relative strengilh regarding: Capitaladequacy, Asset quality, Maniagelucict capacity, Earnings stability and quality, and Liquiditysufficiency.

46 See "Main features of tlie Regulalory Framcwork of tihe Argentinie Finanicial System", BCRA, April,1997. The BASIC programs is still experimiciial, willh more time requiired to assess its advantagesin practice.

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maturity of two years. Medium and smaller institutions are offered alternativeways to comply (see above the section dealing with regulatory developments);

* A ( for Audit Control). A program oriented to improve the weak quality of banks'external and internal audit programs, including: a) evaluation by the SEFC specialteam of auditors of the quality of banks' internal and external audit programs;rating following the CAMEL approach; and requirement to both banks and auditfirms to improve programs and practices.

* S (for Superintendency). A program intended to evaluate and enhance certain ofthe superintendency's key supervisory tools including: supervision on aconsolidated basis encompassing subsidiaries and 50 percent or more ownedaffiliates; the report of inspection, and the CAMEL program which is based uponthe expectation that institutions will establish and maintain their own selfsupervisory programs in the form of sound, continuing risk management processes.

* I (for Information) - A program aiming at generating further transparency in thefinancial system through the collection of monthly and quarterly financialinformation; publication of uniform balance sheet and income data as well asselected ratios for comparison of institutions on the basis of strength andperformance. Financial institutions also must submit information on companiesaffiliated through direct ownership, or ownership by major shareholders. Changesin ownership of 2 percent or more of an institution's capital stock must be reportedto the BCRA.

* and, C (for Calificadoras de Riesgo / Rating Agencies). A program requiring eachinstitution to acquire an annual rating by an international rating agency representedin Argentina. Institutions with more than $50 million in assets are required to haveratings. This program also includes an internal BCRA unit to perform after thefact reviews of the work performed by rating agencies. When all banks are rated,these ratings will be made public.

Regulation

2.54 As a key part of the process of improving the framework for sound banking, theauthorities made a number of regulatory changes aimed at making the banking systemmore resilient to shocks. The principles changes include:

* the increase in the minimum capital ratio to 11.5 percent of risk weighted assets, todiscourage excessive risk-taking (below).

* a boost in liquidity requirements, to 20 percent of (most) bank liabilities as ofFebruary, 1998, from 15 percent two years earlier. These requirements now can beheld in a variety of forms (below). Thus, although high liquidity requirementsnormally constitute a burden, these are remunerated and flexible.

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* enhanced disclosure on borrowers. The information is collected and distributedthrough two BCRA facilities - the Central de Riesgo (which tracks large corporateentities) and the Central de Informaci6n Crediticia (which provides information onall loans of greater than $50, e.g., loans to individuals and small firms).

* the subordinated debt requirement (below), which creates a class of bank debtholders with the incentive to monitor bank performance (Banks were to haveaccomplished the first issuance by 12/31/97; about half the banks accounting for72 percent of assets have met that target.47 ).

* a contingent repo facility (see below), which gives the BCRA the option to selldollar-denominated government bonds and provincial loans (collateralized byprovincial government claims on the taxes received by the federal government) tointernational banks subject a buy-back clause.

2.55 As a result of these changes, Argentina's bank regulatory requirements are amongthe strictest in the world. Togetlher they hielp limit the possibility of extensive loss on bankdeposits.48 Importantly, the authorities have made their capital requirements and reserverequirements risk-sensilive.

Liqui(lity Requirenents and Calaital Standardls

2.56 Argentina's liquidity requirements are high by international standards. As ofFebruary 1998, most deposits (those with maturity less than 89 days) require a 20 percentreserve. Other deposits of under one year bear liquidity requirements of either 10 percent(for 6-months or more) or 15 percent (for 3-6 month deposits). For deposits with greaterthan one year maturity, there is no liquidity requirement.

2.57 Banks can hold liquidity in the form of low-risk securities of various kinds whichoffer market returns to the banks, thereby avoiding the taxation of banks through highliquidity requirements. Banks can satisfy liquidity requirements in a number of ways,including: (1) reverse repos with the BCRA, (2) deposits in an international custodian(currently Deutsche Bank), (3) OECD government bonds rated 'A' or above, maintainedin the same custodian, (4) Argentine public or private bonds so long as the local Argentinebank retains a put option against an A-rated foreign bank on those bonds, (5) 1 percent of

47 Some of the small baniks put off fulfllinig this requireiiicmt on time, wlieni Ihey would have lhad to paymuch higlher interest rates due to the Asian crisis. They have becii given an additional six monthis tocomply.

48 To some extent, capital anid rcscrves are substitutc mICans of reduciiig deposit default risk; a higherratio of riskless assets (reserves) reduces default risk for any given capital ratio (measured hiere inmarket value terms), and a lhiglher capital ratio reduces deflault risk for any given ratio of risklessassets. However, the riskiness of noni-reserve assets is not conitrolled by the ratio of reserves or theratio of capital. Highi noni-reserve-asset risk can boost deposit derault risk for any given ratio ofreserves and capital, and thle latter is measuired in mnarket value terms. Supervisors (either because ofinability, or poor inicentives to discipline baniks) somctimiies do not eniforce capital regulations.

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mortgages in normal standing, (6) Argentine mortgage-backed securities, so long as thelocal bank retains a 60-day put option against them with an A-rated foreign institution, (7)bonds or equities with OECD companies rated 'A' or above with daily quotations onOECD stock markets (so long as holdings do not exceed 5 percent of the daily amounttraded in these markets and the securities must be maintained in the internationalcustodian, (8) mutual funds of OECD securities so long as they are deposited with thecustodian, (9) certificates of deposit held in 'AA'-rated banks, so long as the local bankretains a put option deposited with the international custodian, and (10) standbys issued byforeign banks. Limits apply to the use of some of these instruments, defined as aproportion of the total amount of reserves. Up to 80 percent of reserves can be heldabroad.

2.58 The form of Argentina's liquidity requirements make them flexible andremunerative, and they effectively vary with the riskiness of the bank's liabilities. Banksthat are perceived as low-risk by international banks can use standbys as an alternative toother means of satisfying liquidity requirements. Thus banks face an incentive to limit

49their default risk from the opportunity to substitute standbys for other reserves.

2.59 Argentine capital standards also entail significant incentives for banks to limit risk,since the capital requirement is risk-based. While Argentine capital standards can be muchhigher than under the Basle standards, banks have a great deal of control (through therisks they choose) in determining their effective capital requirements. Minimum capitalstandards are relatively high in Argentina (I 1.5 percent rather than the Basle standard of 8percent). As in the Basle standards, tier 2 capital is limited to a maximum of 50 percent oftier 1 capital. More importantly, they can be raised to a level significantly above 11.5percent in response to increases in bank risk. The minimum required ratio of capital torisk-weighted assets can be set higher than 11. 5 percent as a function of the interest ratereceived on loans, the CAMEL rating of the bank, or the market risk suffered by the bank(using a Value-at-Risk approach).

2.60 The risk-weighted capital requirement based on the loan interest rate caneffectively increase the amount of capital required to back a risky asset by as much as sixfold, if the interest rate on that asset is sufficiently high (a dollar interest rate of 74percent or higher would produce a risk factor of 6). The CAMEL rating of the bank cancause a further increase in required capital, with multiplicative factors that range from0.97 (for CAMEL=I) to 1.125 (for CAMEL=5). Market risk is measured for all publicsecurities holdings as a function of return volatility. Net positions within each instrumentare subject to a capital requirement that produces a strict (I percent) confidence intervalover a five-day holding period. Correlations across instruments are not taken into

49 See Calomiris and Kahii 1991, Caloiniris and Gorlon 1991, and Calomiris and Wilsoni 1998 on theuse of reserves to provide crediblc risk rcduclioui to depositors tlirough their effects on bank portfoliorisk.

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consideration. Thus additional capital holdings of banks required to insulate the bankfrom market risk are given by the sum of VaR in each kind of security.50

The Role of Subordlinated Debt

2.61 One of the various instruments in the Central Bank's arsenal on banking oversight,is the use of subordinated debt. In that respect, Argentina is the first country to adoptregulation of this kind. Since January 1998, Argentine banks have faced a newsubordinated debt requirement in which they offer debts equal in amount to a minimum of2 percent of their deposits, and these debts have a maturity greater than or equal to twoyears. Subordinated debt requirements can reward low default risk by creating a crediblyuninsured component of debt - a component of bank finance for which the cost of funds ishighly sensitive to default risk.

2.62 Banks may place subordinated debt in various ways. To qualify debt must be of atleast two-year maturity. Debt cannot be canceled prior to maturity. Various debtinstruments can be used to satisfy the requirement, including (1) negotiable debtinstruments traded in Argentina or in OECD countries in which 'AAA' rated debts areissued, (2) certificates of deposit placed in foreign banks with ratings of 'A' or better, (3)borrowings from foreign banks that are rated 'A' or better, or (4) loans to localinstitutions that have achieved any of the above three requirements. Foreign-owned bankswith investment-grade ratings are exempt from the requirement. This law effectivelyallows smaller banks to place subordinated debt with the larger domestic banks, who willplace it in local debt markets or in foreign banks. The idea seems to be to ensure fairness- to make sure that the subordinated debt law does not create artificial diseconomies ofscale for small banks because of their lack of access to formal debt markets orinternational interbank lending.

2.63 Banks must issue declarations to the Superintendency showing that they havecomplied with the law. Failure to comply with the law entails significant immediatepenalties, including: (1) an automatic I percent increase in minimum liquidity requirementson debts under one year in maturity, and (2) an increase in the minimum capitalrequirement in the form of a multiplication of required capital by 1.05. If the deficiencypersists for more than three months, the bank risks additional regulatory sanctions,including at a minimum an increase of the liquidity requirement by an additional threepercentage points. To ensure that subordinated debt is held at arms length, the lawrequires all foreign and domestic banks that hold such debt instruments to signdeclarations that they have no other business relations with the issuing banks.

2.64 This system offers a number of attractive features. The essential purpose behind asubordinated debt requirement is the imposition of market discipline; unlike bankstockholders, subordinated debt holders do not benefit from increased default risk. While

For each security, VaR = V*2.32*s*T° , whlere V is the value at risk in that instrumiient, s is dailyvolatility, 2.32 reflects tlic I percent conifideiice intcrval, and T is five days.

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stockholders in the bank gain an implicit put option from increased risk (particularly ifbank debt is insured by the government explicitly or implicitly), subordinated debtholderslose wealth when default risk increases. The goal of a subordinated debt requirement is tocreate a class of bank creditors who (a) clearly bear default risk, and (b) consequentlyhave both the ability and the incentive to discipline banks by charging higher costs or bywithdrawing funds from banks in response to increases in bank default risk. Governmentregulators and supervisors of banks therefore can use subordinated debtholders as acomplementary supervisory and regulatory device - both a source of information forgovernment supervisors and a source of private market penalty for raising deposit defaultrisk.

2.65 The effectiveness of the subordinated debt requirement depends on how it is usedby supervisors and regulators. High yields on subordinated debt could also act as"triggers" for more intense examination of the banks concerned. A high required yieldcould have significant information content on which corrective action may be taken.The Argentine authorities could further strengthen the effectiveness of subordinated debtrequirements by making explicit how excessive bank risk (as indicated by high yields onsubordinated debt) will be penalized. Penalties could, for example, take the form of limitson subordinated debt yields (which would trigger limits on the growth of lending assubordinated debt yields reach excessive levels), or other penalties or punitiverequirements that rise with the level of market yields (e.g., capital requirements, depositinsurance premia, or reserve requirements).. Prevention and early corrective action mustbe in the spirit of policies to limit excessive risk-taking by banks.

Contingent Repo Facility

2.66 The underlying goal of the repo facility is to insulate banks from the illiquidity oftheir asset portfolios for a brief (but sufficiently long) period during an internationalliquidity crisis. Note that the facility does not provide pure interest rate insurance, butrather locks in the Argentine spread over Libor paid by the BCRA.

51 C. Calomiiiris, in "The Post-Modern Bank Safcty Nt", AEI (1997) argues for a subordiniated debtrule that would require 2 percent of subordinated debt rclative to risk-weighted assets, with amaximtumi credit risk spread of 5 percent. According to that proposal, subordinated debt would beplaced in several foreign institutionts operating abroad (clhosen from a list of rouglhly 50 approvediniterniational finianicial inistittutioIns), witli no otlier interbanik relationslhips willt tlhe issuer. Debtwould be placed in overlapping generations of 18 monthii paper (thls, 1/18 of subordinated debtwould coiic due each monitlh). This arrangement has several beneficial features. First, lolders areforeigners and are arms-lenigtlh creditors. That enisures that debt is credibly uninistured and thatcreditors will exercise discipline. By makinig discipline gradual it is more likely to be eniforced.Furthermiiore, discipline is self-stabilizing. If a bank's risk rises and it fails to roll over this month'spaper, it will be able to liquidate its risky assets slowly (at a rate of 1/18 per mionth) and accumulatereserves witlhout violating the subordiniated debt rcquiremieint. That process reduces asset risk andleverage, and thuts reduces default risk. The 5 percent cap on interest paid (whiile somewhat highand arbitrary) is meanit to reflect the hiighi transactions costs of placing suclh debt (at least initially).An upper bound is necessary to make market discipline potentially bindinig oni bank behavior.

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2.67 This facility gives the BCRA the option to sell dollar-denominated governmentbonds and provincial loans (collateralized by provincial government claims on the taxesreceived by the federal government) to international banks subject to a buy-back clause(with an embedded implicit interest rate). In June, 1998, the repo was written on bonds($6.2 bn., 13 banks) and mortgages ($500 m., 1 bank) with a repo on loans to provincesunder negotiation (letter of intent signed). The target is to maintain a repo facility equal to10 percent of the deposit base of the banking system. Repos are over-collateralized 20percent to prevent issuers from bearing the risk of loss from depreciation of the underlyingsecurities during the period they hold those instruments.

2.68 The current government bond facility effectively permits the BCRA to borrow atLibor plus 2 percent for a period of roughly 3 months (the precise period varies acrossindividual repo contracts); that is, the implied interest rate on the facility (the average ofthe 13 different repo contracts with the 13 banks who won the repo auction) is 2 percentplus Libor.

2.69 The duration of the option contracts - that is the period over which the strike pricehas been locked in - varies from 2 to 5 years, depending on the issuing bank. Thecontracts bind both sides over their duration. Extensions to the agreements (beyond thecontracted durations) can be negotiated every three months. The BCRA's strategy is tomaintain a window of option for a minimum of two years.

2.70 The facilities are not priced identically. Rather than determine a single price atauction, the BCRA ranked contracts by price and awarded them until it had reached aprice that it was unwilling to pay. The Central Bank is likely to exercise its options (ifever) on a pro-rata basis for all the options, rather than to exercise on a progressive costbasis (using the cheapest ones first).

2.71 The Central Bank intends to transfer the state-contingent profits from exercisingthe facility to the commercial banks facing the liquidity crisis, which in turn wouldpresumably use the funds to pay deposit withdrawa!s. Banks would transfer theunderlying securities involved in the repo to the BCRA as collateral for the loans offeredby the BCRA to the banks, and the funds lent by the BCRA would be the funds receivedby the BCRA from the exercise of its options. Thus, the options permit the BCRA toengage in discount lending effectively, without "creating money" - the facility permits theBCRA to act as a lender of last resort without violating its current implicit commitment tomaintain a 100 percent dollar reserve against its liabilities.

2.72 Part of the idea of the facility, of course, is that having it in place reduces thelikelihood that it will be necessary. That is, the BCRA hopes that the probabilitydepositors will run banks is reduced by the presence of the facility. It is important to notethat the facility only insures the banking system against liquidity risk, since it provides onlya short-run loan, not a long-run subsidy to banks. Depositors fleeing banks because ofsolvency concerns will not be deterred by the presence of the facility. Moreover, asargued below, the facility could actually increase the probability of a run by depositors byincreasing the riskiness of deposit claims on the bank. The BCRA recognizes the problem

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of effective subordination of depositors (the possibility that giving banks access to thefacility could increase the likelihood of deposit runs based on insolvency risk) and (asexplained below) for that reason intends to restrict the use of funds borrowed by banks tothe payment of depositor withdrawals (a partial solution to the problem).

2.73 The BCRA is expanding the facility and changing the nature of the securitiesinvolved in the repo. In particular, it has set-up a mortgage-backed securities repo. Itsintent is to move down the liquidity and risk continuum from pure government debt toprivate low-risk debt. In doing so, the BCRA seems to have two objectives. One is tomake assets on banks' balance sheets systematically liquid. In other words, in the event ofa systemic problem this repo will offer the possibility of banks selling Argentine mortgagesinternationally for cash (with the Central Bank as intermediary. Incidentally, this alsoincreases the state-contingent value of the repo. If the value of the agreement is to passon a state-contingent gain to banks during a crisis, obviously the power of the repo ishigher if it is linked to private credit spreads (for mortgage-backed securities) rather thangovernment spreads. A secondary objective is to further incentives towards thestandardization of the mortgage market, by rewarding standard mortgage contracts with alower capital requirement. In turn, this would facilitate securitization and the growth ofthe mortgage-backed securities market (issuilng banks may decide to hedge their optionpositions by maintaining some inventory of mortgage-backed securities)..

2.74 The following observations of this experimental facility are now considered:

(a) The contingent loans to banks from BCRA through this facility are not asubstitute for bank capital inclusive of loan-loss reserves, because the loansare not a true buffer against bank loan loss (unlike reserves), but rather thefacility insu!ates banks against liquidity-induced losses (i.e., short-rundepreciation of market debt). This is an important distinction, which ishowever valid of any type of classical lender-of-last-resort facility - bywhich is meant one that requires central bank lending to banks only againstgooa collateral. The value cf such a facility is to protect against depositorsliquidity needs, i.e. runs based on depositors' concerns about the solvencyof banks will not be deterred by the presence of these repos. Theimplication of this is to note that solvency risk (which is usually at the heartof bank runs) is not addressed by the facility, and thus it does not provide aperfect substitute for bank reserves. The Central Bank correctly views thisfacility only as addressing liquidity risks.

(b) Such a facility also might aggravate depositors' concerns about banksolvency by effectively subordinating depositors to the BCRA. If the bankgives its best collateral to support its borrowing from the BCRA, then thatcan increase the risk of its deposits and actually increase the likelihood of a

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run52. The authorities understand this problem, and the consequentdesirability to restrict the use of the funds received by banks through thefacility to the holding of cash and the paying out of depositors'withdrawals. By doing so, they reassure depositors that there will not beany increase in the aggregate risk of a bank's portfolio (via risk shifting)as a consequence of the facility. Of course, there still will be someeffective subordination, since the BCRA jumps the queue of claimants onthe bank by making a collateralized loan.

(c) Arguments have been made that Argentine banks will use "arbitrage" (byengaging in offsetting repos to those purchased by the BCRA) to capturethe benefit of the assistance offered by the BCRA immediately (theexpected value of the implied state-contingent subsidy they would receivefrom the BCRA from the facility). This is a legitimate criticism if banksknow in advance the amountl of repo lending (anid subsidy) they will haveaccess to. The possibility of reverse-repo arbitrage could be used as anargument for "constructive ambiguity" in central bank discount lending.Perhaps even better, the BCRA could make a condition of receiving suchstate-contingent assistance the absence of any offsetting repos withinborrowing banks.

(d) Should the option be exercised, and issuers do not wish to hold thecollateral, they may precipitate a decline in the price of collateral debt,aggravating the impact of the crisis.

(e) Standbys purchased by individual banks (which is another innovationencouraged by the BCRA) may be superior to the BCRA repo facility as asubstitute for individual bank reserves, for two reasons. First, standbysreward individual banks for improving their creditworthiness (theyinternalize the gain through a lower standby cost), in contrast the implicitpooling of cost across banks entailed in the BCRA repo facility. Second,standbys provide real protection against credit risk to depositors (sinceissuers of standbys share losses with depositors). However, the BCRArepo program may create economies of scale (a) making it cheaper forArgentina, and (b) strengthening the signaling effect (i.e. confidencebuilding).

Central (le Deu(lores

2.75 Argentina's BCRA has embarked on an ambitious bank data collection anddissemination effort. This effort entails the collection and distribution of informationabout virtually every individual and corporation borrowing from an Argentine bank.

52 This problem seems to have bcen important in thlc U.S. during the 1930s, when collateralizedlending (through the Fcd or the Reconstnictioii Finance Corpora(ion) may actually have increasedthe likelihood of some banks' failing (Mason 1997).

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Argentine law does not prevent banks from disclosing information about their borrowers(depositors, however, are protected by privacy laws). The BCRA has taken advantage ofthe legal possibility of bank disclosure to promote the collection and dissemination of verydetailed information about bank borrowers. The information is collected and distributedthrough the Central de Deudores which unifies what had been two separate databases: theCentral de Riesgo (which stored information on "major debtors" - firms or individualswith total debts in the system above $200,000); and the Central de Informaci6n Crediticia(which provides information on all loans to individuals and firms).

2.76 The following information is currently available in the Central de Deudores: thename of the firm or individual, the corresponding identification number (QUID), thecumulative debt of the firm or individual with the reporting institution, the value ofcollateral pledged for the loan(s), the classification of the debt (1-6) and the activity of thefirm or individual. This data is accessible to the public via the internet on an individualbasis; credit reports can be requested otne by otte by providing the person or firm's nameor their identification number. Banks requested this type of design so that competinginstitutions could not "cream off' their best customers using database analysis to identifygood credit risks.

2.77 The BCRA does want the financial community to be able to identify the bad creditrisks and, to this end, sells a monthly CD-Rom which contains data on all persons andfirms which have defaulted on loans. The CD includes the information described above forall major debtors, regardless of the standing of their loans, as well as information on anydebtor in default (loans classified 3-6). When the Central Bank began this effort in 1996,the database made available to the public contained only one month of information. At thistime, each CD includes three months of information as well as 24 months of informationon individuals who have defaulted on loans.

2.78 In September 1997, the BCRA expanded the information it collects from banks toinclude such data as the age, marital status, income and property holdings of individualsand balance sheet data and employment figures for firms. Financial institutions initially haddifficulty fulfilling these expanded reporting requirements, but since January 1998 mostreporting entities (over 80 percent) are providing the requested data. This data is notcurrently being distributed and the BCRA is evaluating how this additional informationshould be made available. The distribution of personal data may be handled differentlythan the data on firms, however, it is likely that some of this additional information will beadded to the individual credit reports of both persons and businesses.

2.79 The BCRA is investigating the possibility of further expanding the information onthe CD to include tax records, data from provincial credit registries and court records. TheBCRA already collects information on firms' payments of payroll taxes and notifies banksif any firms have not paid their payroll taxes.

2.80 The BCRA views the creation and distribution of a data base containinginformation about the characteristics of Argentine bank borrowers as serving five relatedpurposes, which it views as public goods:

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* First, the dissemination of information about borrowers enhances banks'abilities to control credit risk by observing borrowers' other loans and thevalue of collateral pledged for those loans53.

* Second, the BCRA hopes that recent changes in reporting - which will makethe financial ratios and other characteristics of borrowers available to banks -will permit banks to improve their management and quantification of creditrisk54.

* Third, information about bank borrowers facilitates the supervision of banks."* Fourth, the objectification of bank loan risk would reduce the "systemic" risks

faced by the Argentine financial system.56

* Fifth, Argentine capital markets are poorly developed. The quantification offirms' credit risks could boost the development of bond markets and asset-backed securities (mortgage-backed securities, and accounts receivable mastertrusts). 5 7

53 In an economy currently lacking the central registration of collatcral interests, data on borrowers'loans from eacih bank and the valte of collateral plcdged for each loan strengthienis bank enforcementof loan contracts by enablinig banks to check for coUipetinig claims on collateral. The sharing ofinfonnation about loan amounits also pcrmits banks to enforce covenants restricting borrowers'leverage or borrowing.

54 Baniks will be able to examiuic quaitiiative relationships betwveei borrowers' credit histories andobservable borrower characteristics for the entire sample of banikinig system borrowers, not just theirown borrowers. Furthieriimore, the creation of uniform standards for definiig "importanit" financialratios (collected by the BCRA) iiay facilitate quantitative comparisons across firmis. The dataincluded in the new reportinig schelime are quite richi, and (judginig fromu the sorts of variables thatliave proved importanit in credit scoring models elsewhere) theire is every reason to expect that thenew informationi will be quite uscftil for the quanitificatioln of credit risk.

Information about bank borrowvers (whieni used by thle Superinitenidenicia to quanitify credit risk) can beused to constnict a benchlimiark for gauginig the accuracy of bank loan quality evaliations by bankersor bank examiniers (the interinal ratings usinig tile 1-5 loan quality rating systeimi, or the qualitativejudgmenits of bank examiniers).

56 During an emerginig market financial crisis (like tilc tcquila crisis or the recent Asian crises)concerns over the strengtil of banks' portfolios can lead to disruptive withdrawals of funds. Thestrength of the Argentinie system may not be observable to outsiders, and reassurinig statements of theBCRA and its Superinltenidenicia may carry little weiglht withi the market since governmilenit agenciesgenerally are uniwillinig to reveal weakiiesses in banks. In that event, it could be very useful to haveobjective, quanititative evidence (credit scorcs of bank portfolios) that would reassure financialmarkets that Argentine bankinig regulation and supervisioni has been successftil in maintaining highloan quality withinl the system.

57 In particular, the new subordiniated debt requiremiienit (2 percent of deposits issued with a minimiimmaturity of two years) required for banks will be more effective, and less of a burdeni on banks, ifbank creditworthiniiess is imiore casily observable.

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2.81 Because the existing system provides full access to detailed data about borrowersonly to the Argentine banks who are members of the system, it cannot fully achieve theBCRA's goals. The BCRA's goals of promoting quantification of risk, greater credit risktransparency of the financial system, and supervisory credibility could be enhanced bymaking the new expanded data base available to rating agencies (which currently lackaccess to the detailed data on financial ratios and other borrower characteristics reportedunder the new reporting requirements). Formal credit risk modeling by ratings agencies isstill in its infancy in Argentina, and availability of this information would facilitate theirdevelopment".

2.82 Private rating agencies are already privy to bank loan data through their role ascredit risk evaluators of banks (a role they are required to play under current bankregulations). Allowing rating agencies greater access to system-wide information aboutcredit risk would help them to develop (over a period of 5-10 years) a statistical basis forjudging loan quality, for both private and public purposes. Thus it would be consistentwith the regulatory role rating agencies play, and with their role in private markets, toallow rating agencies full access to the new database on bank loan characteristics. Topreserve some confidentiality and limit public access to sensitive data, the BCRA mightdecide to limit access to a group of "approved" credit rating agencies.

2.83 Despite the potential importance of the public goods created by the creation anddissemination of information about loan customers, the BCRA faces some potentialprc,blems in implementing its information-sharing program.

2.84 Some borrowers object having their information included in the system. Whilemuch of the information (including the new detailed data items) are not available to thepublic on iaser disks, the full data bases are released to all banks. Individuals havecomplained about the dissemination of personal information and judges have allowedborrowers to remove themselves from, the BCRA's data bases. That does not pose asignificant problem for monitoring borrowers. The BCRA notifies all member banks of aborrower's decision to have his name rcmoved from the data base. The higher credit costto individuals from removing themselves from the system will likely lead to few suchrequests. So far, these have beep isolated instances but this may be due irore to the factthat there is little public awareness regaraing th1e Central de Deudores than because publicconsensus favo.s this approach.59 lf borrovwers as al gtrolp become nobilized to oppose

58 For example, Salomoni Brotliers' model of Argentinie bond risk uscs coeffici2nits derived froir, U.S.experience, duc to the lack of available quantification of this risk in Argeitinia. Obviously, theapplication of miodels derived froml fiiancial ratios and defaultl experiences iD other -ountries may beof little use for measurinig Argenline risk. Asset risk, accountiiig systelis that measure financialratios, means of enforcinig contracts, and bankrujptcy l..ws vamy importandlly across countries.

59 In fact, Congress passed a law restricting distributioni of personal informiiationi in 1995 wliict) wouldhave made it virtually impossible to operate credit burcaus. This law, knowii as Habeas Data, wasnarrowly defeated at the executive level of goveriiimienit afler strong lobbying- ny the financialcommYDnlity.

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the BCRA, they could potentially succeed in passing new legislation banning thedissemination of bank data.

2.85 Thus the decision to extend data collection and dissemination to individuals maycreate more risk than it is worth. There are also legitimate privacy concerns behind thatpolitical risk. One way to deal with this problem would be to limit all disclosure ofinformation about individuals to banks and authorized rating agencies and to passregulations preventing the public revelation of such information.60 The regulatoryframework should also address who has access to the data and under what circumstancesand what procedures will be used to ensure accuracy of the data in registries, by requiringinstitutions and registries to respond promptly to consumer complaints regardingerroneous data and would deter further attempts to greatly limit data sharing, such as wasthe case of the defunct Habeas Data legislation.

2.86 The public role in developing credit infornation registries should also be reviewed.Public involvement in the provision of credit data may be useful in the short term, tostrengthen and facilitate the adoption of a new credit culture in Argentina. The rationalefor public investment in what could be a private sector activity should, however, bereevaluated periodically to ensure that the policy is justified.

60 There are also potential economic costs fronii publicizinig iniforiiiationi about borrowers. Indeed, suchpublicity could reduce banks' incent(ive to invcst in buildinig custoiiier relationships, and tbusunidermine a key economiiic funictioni of banks. Banks specialize in the creation of privateinformationi, which they do in anticipation of earinig "quasi reuts" from having developed aprofitable banking relationship. If infornialion about the bank's best customiiers is freely available tocompetitors, theni those competitors may uniderctut the original baniks, after the hlard work ofidentifying, cullivating, and 'seasoniiig" borrowers has becn completed. Original baniks have todefray the costs of buildiing relationships in early years by charging higlher fees in fimtnre years. Ifcompetitors uinderctut tlhose higlher fees (because new cntranits can free-ride on the initial investmentand charge only marginal cost), then that will weaken banks' incentive to develop relationsliips inthe first place.

Thne BCRA is aware of this polenlial problemii. Initially, it deall wilt the problemi by removing goodand "not-so-good" credits (borrowers rated I or 2) fromii the public data base. Balnks couldspecifically request informiiationi about an oitiited firm (a 'punlcttial rcquest") by submitting adiskette to the BCRA. Tlhal policy prevented banks from uniniformiied targeting of each other's bestcustomers. Recently, bowever, this policy has changed. All large borrowers (those in the Central deRiesgo data base) regardless of their ratings are included in thc accessible data base. Furtlhernore,small firms willt ratings of I or 2 can also request to bc included in the accessible data base.

This new policy - along with the ncw dala providing detailed information about bank borrowers -may run the risk of undermininig the quasi rents banks earn from investinig in relationsllips. It maybe wortlhwlhile to poll banks and borrowers to see wlhethcr thley Ihiink the BCRA's policies strike theappropriate balance between tlhe gains fromii greater informiiationi sharinig and thie potentialdisincentives banks face in developing relationships. For example, one alternative would be towithllold detailed inforniation about smal//, noln-publiclv traded borroiiers ithii/i ratings of ] or 2 atthe request of the bank providing the informiiation. Thiat inforimationi could be released with a lag.For such borrowers, only informiiationi on rating, loani amoutiiis, and collateral would be madeavailable in a timiely fashion, and only in responisc to a -punci 2al reques:."

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Bank Regulation: International C'omparisons

2.87 In response to a wave of banking crises, many countries, including Argentina, areraising the cost and limiting the extent of the safety net supplied to banks. Enacting andtightening the regulations that banks confront is a key way to achieve this goal, and cross-country comparisons of bank regulation can help reveal the relative strengths andweakness of the operating environment for banks, as well as keep track of progress madein this respect. This section compares various aspects of bank regulation, using theextended CAMEL (or CAMELOT) framework employed by bank supervisors, andbeginning to be used by market participants. This section draws extensively oninformation supplied by the Argentine authorities and for other countries that compiled byprivate banks, especially JP Morgan, as well as World Bank information.i In particular,the framework of ranking various components of the regulatory framework employed byMorgan is used here, with the information on Argentina updated to January 1998 and withinformation on East Asian countries added for comparative purposes.62

2.88 Just as with ratings of individual banks based on CAMEL criteria (Capital, Assets,Management, Earnings, Liquidity), it is possible to compare the regulation of variousbanking systems by using extended CAMEL standards. These comparisons require somejudgment: although it is simple to compare minimum capital ratios, giving higher scores tocountries with higher requirements, the stringency of these ratios also is affected by thedefinitions, such as whether revaluation reserves associated with asset appreciation areincluded. Also, no attempt was made to compare earnings, as this is subject to differencesin accounting and stage of the business cycle. Management, perhaps the most importantindicator of the health of banks, is difficult to evaluate on a system-wide basis. Given theimportance of management in the health of banks, some proxy for management qualitywas preferred to none, so here it was assumed that foreign banks are better managed --and also likely have greater diversification of assets -- than domestic ones and,accordingly, those countries with a larger percentage of assets under foreign managementwere deemed to be better managed.6 3

61 IP Morgan, "Latin Americaii Banks: How Conservative Regulationis Help Create Profits," January,1997, and Goldmani Sachs, "A Comparison of Prudenitial Norms Across Asia and in the U.S., Usingthe CAMELOT Framework," Janutary 1997. See also tlhe IMF, Framework for Sound Baniking,1997.

62A Bank research project on finianicial sector regulationi, which is just beginninig, will be compilingmore extensive informiiationi on how financial systemis are regulated and supervised.

63 Several caveats are in order. Most importanitly, each category is equally weighted, as is eachsubcategory, an arbitrary rule of thutmiib. Althotuglh capital standards, liquidity ratios, and the shareof (majority owvned) foreign banks in total assets admit to relatively straightforward measuremenit,with some scope for inerpretationis of definitionis, the other variables are more difficcult to measure.Overall asset quality of a bankinig systeii is not observable, so here the metlhod in whiclh non-performing loans (NPLs) are mleastured and the actionis required once a loan becomes non-performing are taken as a proxy for asset quality. And operating environmiiienit, which here is anamalgam of indexes of property rights, creditors' riglhts, and the enforcemiienit of laws, is measured by(separate) surveys and is subjective. Lastly, the transparency of the baniking system is picked up by

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2.89 Table 2.1 104 shows the overall ranking, with lower numbers indicating a higherrating. Without extensive research, it is not possible to tell which of the variouscomponents are the most or least important, but an overall view is that Singapore,Argentina, and Hong Kong stand out as having the strongest bank regulations, with equalweights assigned to each category.6 5 The first two are particularly strong on capitalrequirements and liquidity. Across virtually all categories, Argentina dominates the EastAsian countries that have been beset by financial crises. Still, the comparison in Table2.10 is on bank regulation systems, which may only correspond to the health of the banksin the long run. And supervision, that is the enforcement of these regulations, is notcompared here.

Table 2.10. Suininairy Measures of the Bank Regulatory Environment

Country Total Capital Loun Foreign Liquidity Operating TransparencyScore Position Classification Ownership Environmcnt

(Management)

Singapore 16 1 6 2 5 1 5Argentina 21 1 4 3 4 7 2Hong Kong 21 3 9 1 2 2 4Chile 25 5 1 4 8 5 2Brazil 30 7 3 4 3 8 5Peru 35 5 2 6 1 11 10Malaysia 41 5 9 8 8 3 8Colombia 44 3 4 It 6 10 10Korea 45 7 9 10 It 3 5Philippines 47 4 6 7 7 l 12Thailand 52 7 12 12 8 6 7Indonesia 52 7 8 9 12 8 8

2.90 However, as argued above, the quality of supervision in Argentina hasstrengthened in recent years, along with increases in its ratings for capital, loanclassification, foreign ownership, liquidity, and transparency. Thus whereas no bankingsystem is ever immune to sufficiently large shocks, the Argentine regulatory systemappears to be among the more robust, as it needs to be, given the constraints on officialintervention that is part of the Convertibility Law.

Supervision

2.91 In 1991 BCRA initiated a program of institutional development of theSuperintendency of Financial Institutions (SEFC) whereby supervisory objectives, policiesand procedures, its internal organization, and supervisory staff were to be substantially

wlhether ratings are required (itself a controvcrsial iltel), tlie prevalence of ratings by inteniationalfinns, and an index measiurinlg corrmplion. Anicx I containis thle details belhind each category.

64 In the Appendix are comiponienits of the CAMELOT mrtings for Banking Systemi Regulation

65 Hong Kong's ranking msay unidersiate tlie lhcalth of its system in that official regulationis do notrequire a given amouinit of provisioninig evei once a loan is in arrears by 180 days, yet Hong KongShanghai Bank, a very large part of the 'Hong Kong' bankinig system, may liave miucii stricterstanidards and a first rate miarket and credit risk maniageiiemiet system.

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reinforced. Since then, SEFC has made significant progress in all major areas related tosupervision. The supervisory process and practices, prudential regulations and reportingsystems, have been improved to levels compatible in many aspects with best internationalpractice to become, most probably, one of the most advanced and better structuredoutside the OECD. In general, SEFC's supervisory processes are aligned with most of theelements advocated by the Core Principles for Effective Supervision issued by the BasleCommittee. Furthermore, senior management at BCRA and SEFC are committed tosupport and continue the development of supervisory practices and tools, are devotingresources to that purpose, and attach considerable importance to the quality, developmentand training of supervisory personnel as the fundamental component of supervision. The1995 crisis, however, diverted efforts towards managing the effects of the crisis andslowed the process of supervisory development. Currently, the BCRA and SEFC areembarked in continuing with the development of supervision and improve further theprocesses so far implemented, intended to align them to evolving market realities.

SEFC's Institutional Developnient

2.92 The focal point for the institutional development program of SEFC was theadoption in 1993 of a new supervisory strategy that emphasized a top-down approach tosupervision, focusing on the soundness of bank's credit portfolios and the adequacy ofbank directors and managers. With certain modifications imposed by the effects broughtby the 1995 Mexican crisis, the strategy is still operational today. It is based on a processof continuous supervision by specific supervisory teams assigned to each bank. Thestrategy calls for oni-site full-scope inspections of large banks once a year and of smallbanks every 18 months, as well as periodic targeted visitations towards specific areas ofbank's operations. In addition to conducting inspections, the teams integrate allsupervisory tools, including off-.sie analysis. Inspections are guided by a SEFC'sexamination manual developed with the support of the U.S. Federal Reserve Banks andOffice of the Comptroller of the Currency. Since the introduction of the manual in 1994,SEFC has carried two complete cycles of supervision and assigned CAMEL ratings to allprivate banks in Argentina. Public banks have recently started to be inspected by the samestandards as private banks.

2.93 To implement the strategy adopted in 1993, SEFC hired individuals withsubstantial experience in banking and/or external auditing 66 to serve as senior managers.The existing (150) staff and (130) new junior examiners recruited 67 have been organizedin 4 major departments (Supervision, Control, Analysis, Technical), and banks assignedunder a portfolio management approach to 6 teams of supervisors. Recognizing the weakcondition of banks' systems and controls, BCRA forned also two separate teams (ofabout 50 staff each) to be in charge of EDP Systems inspection, and to control the

66 BCRA decided to pay very competitivc salaries to mobilize t(lc best available professionals in themarket.

67 Throughi competitive exanis from about 1,100 applicants. About 25 also with previous experience inbanking and auditing.

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adequacy of external and internal auditors at banks. These two groups do not form partyet of the Integral Supervision Department, which may be causing certain coordinationproblems SEFC is aware of and intends to remedy soon.

2.94 Along its process of institutional development SEFC has demonstrated increasedemphasis in improving not only supervisory processes and practices, but more importantlyacquiring and training qualified personnel. A new system of periodic evaluation,promotion, and salary programs was adopted, with pay grades raised to competitivelevels. SEFC also adopted an ethics policy and a training program assigned to a full timetraining coordinator. Many seminars have been organized since 1994, including trainingof exiting staff in use of the new inspection procedures. New entrants were also subject toa five-week introductory program, and the training efforts have been integrated withSEFC's job grading, employee performance evaluation, and promotions systems. Specifictraining has been associated with each job level, and completion of the elements of thepermanent program is mandatory for promotion.

2.95 Finally, the SEFC upgraded its facilities and equipment, and invested substantiallyin computers. The EDP team was in addition assigned the responsibility of providingsupport to the inspectors in the use of computer an software, and for developingelectronic inspection tools

Current Superi'isory Issues

2.96 In spite accomplishments, SEFC and BCRA still face--as many other supervisors inmuch more developed countries-- several important challenges in order to dischargeefficiently with their responsibilities and continue developing their capacity to supervisethe constantly evolving Argentine financial system. The overriding requirement at this timeis for the established processes and supervisory personnel to mature, and evolve in termsof efficiency and enhanced public trust and recognition. The following ten pointssummarize the most important challenges that would need to be faced in the followingyears, although it should be mentioned that the Central Bank is making major strides inmeeting these challenges:

(i) Planning: formalize a systematic process to plan future developmentsin banking and financial services in Argentina, to envision the necessarysteps to provide adequate supervision and regulation, and to foster thestability, efficiency and fairness of intermediation;

(ii) Personnel: halt the high turn-over rate experienced among middle-range supervisors (exceeding 20 percent per year over the last two years),through compensation that is competitive to the private sector, and careerdevelopment, in order to retain the best supervisory staff available;

(iii) Policies:develop, communicate and enforce detailed management standardsfor prudent and professional banking, in which directors and senior

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management of banks are held effectively responsible for following prudentprofessional practices and best risk management standards;

(iv) Processes: renew and reinforce internal supervisory processes, movingthe emphasis from a "rule-book" towards a risk-based approach tosupervision whereby the quality of systems and processes for riskmanagement and controls are rated and remedies enforced. The CentralBank's supervisory work would benefit enormously from improved internaland external auditing, and significant upgrading of electronic system ofbanks that improve the accuracy and transparency of information;

(v) Procedures: update the inspection manual, improving tools andproviding guidance to inspectors on how to assess not only the quantity ofcapital, but that of risk, its direction, the quality of processes used tomanage it, and control structures within banks;

(vi) Plan Contingencies: develop a strategy to consolidate the lower segmentof smaller banks, and those adversely rated (composite CAMEL below 3),including a contingency plan to act expeditiously in case that a individual orseries of individual crises erupt;

(vii) Projections: provide inspectors with tools to project financial conditionsunder alternative (stress) scenarios, and prepare them to engage into adialogue with bank management regarding business prospects, products andunits returns, and financial plans;

(viii) Part: consider separating (within or outside SEFC) crisis management andresolution activities from normal and problem bank supervision (see belowunder "crisis resolution);

(ix) Prepare: supervisors' skills and tools for assessing core banking functions,risk management processes, business prospects, governance and controlstructures, so that the quality of management is more effectively rated --inaddition to the quantity of risk and capital.

(x) Priorities: assign priorities to the actions required for further fine tuning theregulatory and supervisory frameworks, and establish a three year rollinginstitutional development program where priorities are established. Bettercommunication and advocacy of change with the industry, Government andlegislators is desirable.

2.97 The above measures would ensure that supervision becomes a pro-active tool thatcould mitigate the emerging crisis in one institution, or the accumulation of potentialthreats to systemic stability.

2.98 While the originally adopted strategy called for a top-down approach tosupervision, that style is still somewhat static for several reasons. Inspectors tend to focus

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on compliance, and attach enormous attention (and time) to the review of asset quality.This is desirable and appropriate, specially for banks with poor systems of control and riskmanagement, and where moral hazard is high and independent directors are not availableto oversee senior management. But, it may be less appropriate for banks well rated andthose whose systems of audit, control and risk management are much better developed.One could envisage, therefore, the need to revitalize the adopted supervisory strategy, andapply a qualitative judgment regarding the intensity and focus of supervisory effort byindividual bank. This approach would free scarce resources to focus in the more forwardlooking supervision of problem banks.

FURTHERING INSTITUTIONAL/STRUCTURAL CHANGE

2.99 The ever difficult process of dealing with problem banks, merits the review ofdifferent steps in the supervision and problem resolution processes. As indicated above,the supervisory process would be greatly strengthened if inspectors adopted strategies thatenabled them to provide advance warning to the Superintendency of emerging problems,before they became critical. Nevertheless, it is inevitable that individual bank problemswill emerge, under the best of supervised systems. Therefore, it would be useful toexamine further institutional factors that might prevent the emergence of such problems,such as bank governance, and, for those cases where critical problems emerge, thefunctioning of failure resolution mechanisms. This section evaluates three institutionalchanges that could help facilitate the further deepening and development of the financialsystem -- bank failure resolution mechanisms, the legal protection of BCRA staff, andbank governance.

Failure Resolution Mechanisms

2.100 In the wake of the Tequila Crisis the Argentine government established acapitalization fund to support weak financial institutions and a deposit insuranceprogram.68 The deposit insurance program was established on April 4, 1995 and isadministered by a private institution (SEDESA). The central bank, the Ministry ofEconomy, and commercial banks participate in SEDESA's board. The financialinstitutions absorb the cost of the fund. Each bank pays between 0.03 and 0.06 percent ofits deposits, according to its risks. The insurance covers up to $10,000 for each personwho holds money in a checking account, savings account, and/or time deposits up toninety days. Individuals receive up to $10,000 in additional coverage for deposits of atleast ninety days. The insurance, however, does not cover deposits that receive an interestrate more than 2 percentage points higher than the rate published by the central bank. Anydeposits motivated by incentives beyond the interest rate are also exempted fromcoverage.

2.101 While SEDESA's role appears to be well-specified, in practice its role in bankclosures and restructurings has been problematic. Experience shows that "least cost

69 The capitalization fiuid was establislhed witli assistanice froimi the World Bank.

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resolution" can provide a mechanism for bailouts (perhaps more than once for a giveninstitution). While bailouts have been less than in other countries, they still have occurred.Moreover, when weak banks' mergers are subsidized, the argument that this constitutesleast cost resolution can be questioned, since weak banks are liable to return for furtherresolution. As noted above, there is some limited evidence that some of the restructuringin the banking industry (some presumably promoted by government merger subsidization)has not produced greater post-consolidation stability or efficiency in the merged entity. Apolicy of supervisory forbearance and dishonest accounting followed by subsidizedmergers will discredit the consolidation movement (which the government would like tobe viewed as promoting efficiency), and the supervisory process. Yet, the alternative tothese mergers -- bank closures -- may be more costly on a cash flow basis,. at least in theshort term, and SEDESA's resources are quite limited (the recent difficulties of a smalland a medium size bank could have practically exhausted SEDESA's resources).

2.102 If the only goal were to insure the integrity of the merger process, an idea that isconsistent with BCRA's emphasis on market discipline would be to restrict bank acquirersto A-rated banks. However, it seems likely that BCRA is trying to meet additional goals.In particular, if additional private domestic banks face serious problems, which is notunlikely, and BCRA needs to address them using very limited SEDESA resources,subsidized mergers may be BCRA's one way to buy time. It seems quite likely, however,that many of the merged entities will re-emerge with difficulties in the near future.Determining the constrained optimal solution to this problem is not easy. Our analysissuggests that further structural change is likely to occur, and that BCRA will be forced tomake a number of these "lesser of two evils" calculations regarding the closure versus themerger of troubled entities. While many banks may be involved in this process, we re-emphasize that they tend to be small ones relative to total banking assets or capital.

2.103 It might be objected that restricting the identities of acquirers to high-quality banksmight lead to closures of highly risky banks that otherwise would have been acquired. Asnoted above, however, the test of any regulatory and supervisory system is its tolerancefor excessive risk. A regulatory and supervisory system that is unwilling to allow riskybanks to close cannot succeed in limiting the fragility of the banking system or thepotential costs to taxpayers of bank bailouts. ln light of the central importance ofregulatory and supervisory credibility, concerns over "systemic risk" and "contagion"(although sometimes legitimate) should not be used as an excuse to avoid discipliningbanks. Furthermore, history has shown that the closure of individual banks in recognitionof problems that are specific to those banks do not produce systemic runs on solventbanks.

2.104 Market based solutions where residual franchises are properly valued andtransferred to reputable investors might be better defined and implemented by experts notinvolved in supervision. In the medium term, it might be preferable if failure resolutionbecame the responsibility of a structure separated from supervision, and most preferableshifted to a different institution. Separating the roles of BCRA and SEDESA, andpossibly that of the Superintendency, would reduce potential conflicts between supervisionand resolution goals, ensure that supervisors evaluate objectively the durability of

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resolution transactions, and that they dedicate their attention and resources to preventproblem banks from falling to the failure category. Nevertheless, those arguments shouldbe weighted against the credibility that the Central Bank brings to this process, its fairlywell established independence (the lack of which is a key argument for separation of suchfunctions), and the synergy of banking supervision and liquidity policy-making in the caseof Argentina, on information grounds. In conclusion, there are arguments on both sides,and the Central Bank will want to maximize the attainment of its proclaimed primaryobjectives.

Liability of BCRA Personniel in Failure Resolution

2.105 A number of lawsuits suggests BCRA personnel may lack sufficient statutoryprotection to pursue closures forcefully. While there exists a legal principle in Argentinathat one cannot apply criminal sanctions to technical or managerial decisions, most suitsagainst BCRA personnel are filed under penal code. This appears to make cases muchmore difficult and costly to defend as the defendant is then burdened with the implicitrequirement to prove. innocence. Even if such suits are eventually found frivolous, thedistraction and monetary and other costs must be borne solely by the affected official. Italso appears that any supervisory or BCRA action is subject to review, and reversal, underthe legal process.

2.106 It would be preferable if the Executive branch proposed draft legislation andencouraged the government's Legislative body to enact the protection of public officialsacting in good faith to carry out their legally prescribed public duties. Such protectioncould take various forms including: prohibition of bodies other than the Judicial branch toinitiate criminal proceedings against public officials; allow ministry level (and otherspecifically designated entities) to maintain a properly governed internal fund to be used toassist officials who have been sued for performance of legally authorized acts; and toallow the use of such funds in the officials' defense against media publications printedwithout due diligence. Better legal protection of BCRA management in the execution oftheir official duties, could improve the disposition of failure resolution cases, and expeditethe restructuring of the banking system.

Bank Governanice

2.107 The current Argentine Banking Act contains little, if any specific reference to bankcorporate governance, or to the fiduciary responsibilities of directors, significant owners(more than 10 per cent) owners and the executive management towards depositors, othercreditors and the general public. In line with the best international standards, it would beworth amending the law to make reference to the responsibility of such insiders forensuring the stability and strengths of their own institutions. In addition to theresponsibilities assigned to directors and managers by general law (Company Act orCommercial Code), the Banking Act should explicitly place an overriding obligation onthem to follow best prudent practices (qualitative standards) and to comply with the law(quantitative rule-book regulations). In addition, it is crucial to codify "white collarcrime".

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2.108 Without an appropriate and sufficiently explicit legal framework it is difficult forSEFC to assess and enforce standards of best international practice; for the moment allthat can be done to promote such practice is to set out recommended guidelines. But,without clear legal support, it is impossible to intervene problem banks or to prosecutethem for unsafe and unsound business practices. There are other deficiencies in the lawthat may inhibit the authorities in their attempt to combine the benefits of market discipline(BASIC) and enhanced prudential supervision (CAMEL), with improved corporategovernance and the qualitative enforcement of safe and sound standards of businessbanking practice:

2.109 First, the Banking Act (Art. 10) should include a requirement for adequateprofessional qualifications standards and experience for directors and senior managementto qualify as "fit and proper". While such requirements may be in the process of beingimplemented through enhanced licensing policies and procedures, the lack of legal basis inthe Banking Act leaves the authorities subject to challenge.

2.1 10 Second, there should be specific rules in the Banking Act regarding the respectiveroles of both bank directors and executive management, and their responsibilities tooperate their banking licenses witlh adequate business policies; risk management processes;internal audit function, controls and information systems. The Act does not require anyspecific structure within the board of directors for overseeing executive management,approving business plans, and be informed of internal supervision of the banks they serve.Moreover, the Banking Act does not recommend internal board committees--composedexclusively on non-executive directors-- to deal with insider transactions, ethics, andexternal and internal auditors. Both aspects can be critical for banks of higher moral risk(e.g. with concentrated ownership involved in executive management, and withoutbanking experience).

2.111 Third, the enforcement powers granted to BCRA (Art. 41 to 42) should be moreprecise. There is neither an objective graduated criterion for breaching the Act, nor acodification of what crimes, conducts and situations merit a given proportional reaction.In addition, while the Act empowers BCRA to regulate the economic sanctions that can beimposed, these appear to be conditioned by the relevant Administrative Procedures, andcan only be imposed through administrative venues. Moreover, the Criminal or PenalCode do not codify the miscellaneous conducts by omission and breach to businesspractice simulated transactions, etc. that are present in all banking crises where insiderabuse and fraud manifest themselves as a major source of loss. We would recommendthat, in conjunction with the update of the resolution and intervention mechanisms of theBanking Act, attention be given to establish better and more objectively defined breaches,and criminal acts, related to banking and the proportional means available to the BCRA.

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3. CAPITAL MARKETS

3.1 The Argentine capital markets have developed significantly in recent years but arestill less developed than the banking system. Despite the difference in the speed ofdevelopment, they form an integral part of the Argentine financial system, particularlysince financial holding companies provide both investment and banking services. The firstpart of this chapter attempts to assess the growth of equity and bond markets byexamining the causes and consequences of their development. While the development ofthe capital markets has been slow, the future prospects for capital markets growth areexcellent, particularly in view of the emergence of institutional investors, which couldbecome the defining factor in the development of the capital markets. Since 1994, theemergence of such investors has been spearheaded by the new capitalized private pensionfund system, and more recently by the increased participation of mutual funds. Thesecond part of this chapter assesses the evolution of and prospects for institutionalinvestor in Argentine capital markets.

EQUITY AND BOND MARKETS

Introduction

3.2 This section looks at the recent performance of the Argentine equity and bondmarkets. The analysis begins by describing the recent performance of both markets andcomparing several characteristics of the Argentine markets with others in Latin America,Asia, and Europe. We then study the co-movement of Argentine stock and bond priceswith those of foreign markets and among Argentine securities. Finally, based on empiricalevidence and discussions in the field, we discuss alternative policy options.

3.3 The results can be summarized as follows. Even though the markets have grownover time, the equity and bond markets have developed unevenly. Growth has been mainlydue to the sale of equities of large companies and government bonds; Consequently, bothmarkets are fragmented. The evidence suggests that small companies rely on the bankingsystem for financing. Nevertheless, an increasing number of companies are participating inthe debt market. We also find that most of the trading activity has shifted from BuenosAires to international markets. Bonds are traded over the counter, while 14 largecompanies trade their stocks through American Depository Receipts in New York.

3.4 On the "co-movement" section, the analysis suggests that Argentine equity pricestend to move together with those of foreign markets. In addition, different types of bondand stock prices (from diverse sectors of the economy) also seem to be highly correlated,particularly during crisis periods. Consequently, external shocks have large internal effects

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on equity prices. We also find that stock prices seem to be more volatile in Latin Americathan in East Asia or in developed countries.

3.5 These results underscore the importance of strong macroeconomic fundamentalsto avoid the potentially negative effects of external shocks on Argentina's financial system.The recent shock from the Asian crisis presents such a case. While Argentina's equity andbond prices declined after the crisis spread to Hong Kong in October 1997, the shock didnot affect other variables like bank deposits.

3.6 Our policy implications focus on how to develop the capital markets and how toincrease the participation of small companies in them. We expect that a furtherdevelopment of the equity and bond markets will increase opportunities for diversification.At the same time, the equity market will be less dependent on a small number ofcompanies, and the correlations among the prices of Argentine securities might decreaseonce the market becomes more diversified. The increasing importance of institutionalinvestors will likely play a crucial role in developing Argentina's capital markets.

Recent Performance

The Equity Market

3.5 During the 1990s, the equity market has developed unevenly. A partial picture ofthe recent performance of the equity market can be obtained by looking at four indicators:market capitalization over GDP, value traded over GDP, number of listed companies, andmarket capitalization over the Merval general stock index (which can be interpreted as anindex of the quantity of traded equities).

Table 3.1

Date Market Capitalization over GDP Traded over GDP Number of Listed Market Capitalization over StockEnd-of-Month Average Yearly Value Companies Market

(percentage) (percentage) End-of-Month Average Index .End-of-Month Average

1990 2.3 0.6 181 1.01 :T

1991 4.7 2.5 174 1.061992 9.7 6.9 175 1M01993 10.4 4.0 176 2.181994 15.8 4.0 159 2.811995 12.0 1.6 150 2.901996 13.9 1.5 149 3.001997 17.5 8.0 147 3.08

Source: Authors calculations from IFC's monthly Data

3.6 Market capitalization grew steadily from 1990 to 1997, with the exception of 1995and 1996 due to the tequila effect. During 1990, the average market capitalization overGDP was 2 percent, while in 1997 it reached 17.5 percent. The ratio of value traded overGDP peaked in 1992 and 1997, but has fluctuated significantly during this time period.

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The number of listed companies however, declined steadily during the 1990s, going from181 to 147. Market capitalization over the stock market index (or quantity index) hasincreased threefold. This index reflects the increase in new stock issues, includingprivatizations and other new listings.

3.7 Equities are traded on the Mercado de Valores (Merval), at the Rueda Continua(Continuous Trading System), and at the SINAC (Computer Assisted Trading), alloperated by the Bolsa. However, equity trading faces strong competition from overseas;14 large companies trade their stocks in New York through American DepositoryReceipts (ADRs).

3.8 The volume of ADR trading on the "New York floor" greatly exceeds the volumeof equity trading on the "Buenos Aires floor." Daily floor trading in Buenos Aires doesnot exceed 40 million pesos on average for all stocks and coupons. The daily averageduring 1996-98 has been around 30 million pesos. On the other hand, YPF (petroleumcompany) alone accounted for a daily average trading of 30 million dollars in the NewYork market during 1997, and the value traded for Telefonica de Argentina was around19 million dollars during 1995-97.

Table 3.2 Stocks And Coupons Traded Value In The Stock Market

(Daily Average in Pesos)

- 11111 9 1995 1 996 1997 1998(*)Floor trading 24,978,221 28,173,008 39,962,227 30,729,573

Continuous Trading 102,601,565 95,475,042 100,383,757 72,370,341SystemComputer Assisted N/A N/A 10,961,360 13,985,483

iT rading I _ _ __ _ I_ _ I__ _ _ _ _ _ I__ _ _ _ _ _ I___ _ __I_ _Stocks and coupons (total) 127,679,786 124,129,122 151,307,344 117,085,397

(*) Average for January andFebruary

Source: B.C.B.A.

Table 3.3 Adr Traded Value In New York

Daily Average -- Selected Companies

Date YPF TELECOM TELEFONICA BANCO RIO TOTAL

1993 41,373,371 N/A N/A N/A 41,373,371

1994 25,137,163 4,370,673 17,455,114 N/A 46,962,951

1995 26,018,289 6,374,043 18,916,718 N/A 51,309,051

1996 18,565,752 6,884,443 19,027,329 N/A 44,477,526

1997 29,576,439 8,072,625 19,110,940 12,846,555 69,606,561Source: Own calculation based Bloomberg data.

3.9 With respect to the brokerage industry, its structure has changed over the pastyears with the entry of new players. Traditional brokers have been squeezed by the entryof large international investment firms and local commercial banks, the emergence ofmutual funds, and competition from ADRs. As a consequence of the increasing relativeimportance of ADRs, the price of a seat at the Bolsa de Comercio has decreased from 1.2rnillion dollars in 1992/93 to 600,000 dollars nowadays.

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3.10 The local stock market is dominated by a small number of big companies. Forinstance, by October 31, 1997, YPF, Telefonica de Argentina, Perez Compac, Telecom,and Siderca accounted for 59 percent of the total market. The first three companiesaccount for 45 percent of the market, while the first 25 companies account for 90 percentof the market.

International Comparisoni

3.11 The evolution of Argentina's equity markets can also be studied by comparingArgentina with other emerging markets in terms of four indicators. We compare Argentinato the following countries: Indonesia, Korea, Malaysia, Thailand, Czech Republic, Greece,Israel, Poland, Turkey, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.

3.12 Argentina's market capitalization is very low compared to countries from theregion. During 1997 it was below 20 percent of GDP, while Brazil's and Mexico's werearound 40 percent, and Chile's was around 110 percent. When compared to Colombia,Peru, and Venezuela, there are no significant differences for most of the 1990s. However,during the last part of 1997, all countries' market capitalizations exceeded Argentina's by8 or 9 percentage points. With the privatizations in Peru, the stock market capitalizationhas surpassed 100 percent.

3.13 When compared to countries in other regions, Greece and Turkey had marketcapitalization rates below Argentina's in the early 1990s. However, since mid-1996 bothcountries' market capitalization rates greatly exceeded Argentina's, with Greece's ratebeing above 30 percent and Turkey's close to 90 percent.

3.14 Among Asian countries, market capitalization has declined dramatically due to theAsian crisis of 1997. When we compare the pre-crisis period, all countries had a highercapitalization rate than Argentina. Indonesia and Korea had values below 50 percent.After the crisis, Korea has dropped to values similar to Argentina's, while in othercountries the rate remains higher.

3.15 The difference in monthly value traded for Argentina and for the other LatinAmerican countries does not look as sharp as the difference in market capitalization,particularly during the period prior to 1994-96. During 1994-96, Argentina's monthlyvalue traded over GDP became similar to Chile's and Venezuela's (both below 1 percent)and not very different from Mexico's (which is between 1 and 2 percent) or Colombia's(which is below 1 percent). In contrast, Brazil's and Peru's value traded over GDP isabove 2 percent.

3.16 When compared to countries in Asia and Europe, Argentina's monthly valuetraded over GDP is much lower. Greece, Israel, and Turkey have larger trading activityrelative to GDP than Argentina, with Israel and Turkey reaching values between 4 percentand 12 percent during 1997. Indonesia's and Korea's value traded are currently between 1percent and 3 percent. Malaysia's value traded has declined to 5 percent due to the Asiancrisis, but during 1996 and 1996 its value traded was between 10 and 20 percent.

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3.17 Within the Latin American group, Argentina has fewer listed companies than theother countries, except Venezuela. For instance, Argentina has less than 150 companies,while Mexico has close to 200, Chile has close to 300, and Brazil has more than 500during the 1990s. Regarding trends, the number of listed companies has declined inArgentina, Brazil, and Peru, while it has risen in Chile, Colombia, and Venezuela. Insummary, Argentina not only has fewer listed companies when compared with the otherLatin American countries, but the number has also been declining.

3.18 The Asian and European markets show a different picture. Israel has over 600listed companies, while Greece and Turkey have been increasing their numbers every year--passing Argentina in 1994 and reaching levels above 200 after 1995. In Indonesia,Korea, Malaysia, and Thailand the number of listed companies increased during the 1990s(except in Thailand since 1996). At the beginning of 1990, Thailand had the same numberof companies as Argentina. Since 1996, Thailand has had around 450 listed companies. Inthe period 1990-1997, Malaysia experienced an increase from around 250 listedcompanies to 700, while Korea went from around 630 to 770.

3.19 The quantity index (market capitalization over the general stock price index) yieldsa different result relative to the previous measures. This index is a proxy for the increase inthe number of equities, as the consequence of new IPOs and the issuance of new equitiesby existing companies. All markets are set to I when the data begins, so we can comparethe evolution of each market. Argentina shows a strong growth relative to Brazil, Chile,and Mexico. Argentina's quantity index jumps in 1993 and reaches values above 3, whilethe other countries remain below 2. On the other hand, Colombia and Venezuela havediscrete large jumps (probably due to the privatizations), and reach levels above 30. Whencompared to countries in Asia and Europe, Argentina's quantity index has increasedsimilarly to Thailand's and Malaysia's, but more thani Korea's. Argentina has increasedless than Turkey and about the same as Greece.

Conclusions from the Equity Market

3.20 In the Argentine equity market, both market capitalization and trading activity areconcentrated in the big companies. These companies are also the ones that trade ADRs inNew York, where trading activity is substantially higher than in Buenos Aires. Althoughthe quantity index has increased, the number of listed companies has declined. This trendintensified the concentration of the Argentinie equity market.

3.21 The development of Argentina's equity market lags behind other emergingeconomies. Market capitalization over GDP and the number of listed companies is higherin most of the other emerging markets in Latin America, Asia and Europe. Over time,some of the other markets have developed substantially. For instance, the other countrieshave, in general, increased the number of listed companies and their quantity index--suggesting that their new companies are the ones that have increased their participation inthe equity issue. In sum, relative to the other countries, the growth of Argentina's equitymarket has not taken off yet, even though the big companies participate very actively inthe local and foreign equity markets.

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Bond Market

3.22 The bond market has grown continuously during the past years. The marketcapitalization of government bonds increased from 3 percent of GDP in December 1992 to14 percent in October 1997. During December 1993, 1994, and 1995 marketcapitalization was already around 11 percent. In contrast, the capitalization of thecorporate bond market grew from 0.2 percent to 1.3 percent of GDP over the sameperiod.

3.23 During 1991-1996, the value traded of public debt grew more than 14 times, thevalue traded of stocks grew more than 6 times, and the value traded of corporate debtgrew 4 times. Partial data for 1997 shows that, during the first 11 months, tradedcorporate debt increased 81 percent with respect to the total value traded in 1996, whilethe public debt declined 13 percent during the same period.

3.24 Both public and private debt securities now face more liquid markets. However,Argentina's capital markets trade basically public sector bonds. Trading in governmentbonds accounted for 85 percent of total trading in 1991, rising to 91 percent in 1997. Onthe other hand, corporate bonds accounted for 0.4 percent of total trading in 1991 and 0.3percent in 1997.

3.25 In Buenos Aires, bond trading takes place both at the Bolsa de Comercio and atthe Mercado Abierto Electronico (MAE). However, most of the trading is concentrated inthe MAE. During 1997 (excluding December), the value traded of public debt andcorporate bonds at the MAE were 4.96 times and 2 times the value traded at the stockmarket. As in the case of equity trading, bond trading faced strong competition fromoverseas trading in the over-the-counter market. The value traded in the foreign marketexceeded the value traded domestically throughout the 1990s.

3.26 The amount of corporate bonds authorized increased significantly between 1991and 1993. The amounts authorized stayed at around 5.6 billion dollars during 1993, 1994,and 1996, while it rose significantly in 1997 to close to 9.8 billion dollars. However, theamount issued peaked in 1993. In 1995, the amount authorized declined but not theamount issued, the mean maturity decreased, and the number of issues rose (probably tocompensate for the shorter maturity). The average maturity increased in 1997, reaching anaverage of 50 months.

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Table 3. 4: Corporate Bonds (Obligaciones Negociables)Authorized And Issued. 1990-1997

Thousands of dollars

YEAR AMOUNTS AMOUNTS MONTHLY MEAN NUMBER OF

AUTHORIZED ISSUED MATURITY ISSUES

1990 83,223 48,382 37 4

1991 522,160 374,486 55 1 1

1992 1,951,960 1,552,950 34 45

1993 5,596,650 4,287,650 36 63

1994 5,688,000 3,546,408 30 62

1995 4,087,000 3,319,065 20 88

1996 5,614,250 3,259,573 34 69

1997 9,782,600 2,550,000 50 30

MEAN

ACROSS YEARS: 4,165,730 2,367,314 37 47

* Up to 30-11-97

** Up to 30-06-97

Source: Own calculations and Gerencia de Emisoras - CNV

3.27 The sectoral composition of authorized bonds has changed over time. However,the banking sector has always been the most important sector in terms of authorizationsfor bond issues. The oil, communications, electricity, steel, and gas sectors have beenrelatively important during the 1990s. These are the sectors that have big companies thathave been privatized. Other sectors like services, construction, commercial, andpetrochemicals started to participate in the bond market mainly in 1997. A new feature inthe bond market is that approximately 30 small and medium size companies have beenissuing debt in the last two years.

Conclusionis firom the Bond Mairket

3.28 The bond market has developed, although the public sector continued to play thedominant role in that market. The private sector incr-eased its absolute participationsignificantly relative to the previous year only in 1997. Moreover, during 1997, newsectors started to issue bonds. Among the private sectors, the big companies are the onesthat have been issuing the bulk of private bonds. However, small and medium companieshave started to participate in the bond market more recently, probably encouraged by a taxincentive, lower costs to trade, and the lack of rating requirements.

3.29 The 1994 World Bank Capital Markets Study raised other issues with respect tothe bond market. The report mentioned that the Negotiable Obligations Law provided taxexemptions only to public issues of corporate debt. Up to now, private placements receivea different tax treatment and are not eligible to receive the tax benefits. Part of therationale behind this tax treatment is that private placements do not help develop thecapital market. Nevertheless, the new tax law might remove this difference.

3.30 The previous report also mentioned that two ratings were required for all issues ofbonds. The rating requirements still exist except for small and medium companies bonds

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and provincial bonds. Finally, the 1994 report pointed out that the "accion ejecutiva"

permitted the fast enforcement of financial instruments, except the floating ratesinstruments. Right now, the accion ejecutiva works for all types of instruments.Nevertheless, we need to consider that the enforcement of legal contracts is lessaggressive in French civil law countries (such as Argentina) compared with common lawnations.

3.31 The issuance of short term commercial paper required public listing and ratings,since commercial paper was not distinguished from corporate bonds, which was costly forthe commercial paper issuers. The capital gains of "habitual" traders were taxed, while thecapital gains of other individual traders were not taxed.

The "Co-movement" of Argentine Equity and Bond Prices witli Foreign Marketsand among Argentine Securities.

3.32 This section studies the behavior of equity and bond prices across countries andamong Argentine securities. The purpose of this section is twofold. First, it would beuseful to know to what extent the Argentine stock market price index is correlated withother countries' indexes. Second, to what extent there is co-movement among Argentinesecurities prices. No attempt ins made to distinguish among the different types of factorsthat may be driving the co-movement of securities prices. Given that we work with dailydata, we are unable to control for fundamentals. In the analysis, a comparison is made ofunconditional correlations across countr-ies and among securities prices within theArgentine market. A finding of high correlation during market downturns might suggestthe presence of "contagion," since market fundamentals do not tend to be more correlatedduring downturns than during upturns. The policy lessons from this analysis are discussedin the last section.

Cross-Country Co-movemnent

3.33 The potential for contagion, both at the country and company levels should inducepolicymakers and company officials to disclose and disseminate information about theircountry's sound fundamentals. High correlations (or co-movements) among the prices ofArgentine securities reduce scope for a reasonable diversification of risks, and haveimplications for the regulations of institutional investors.

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A Comparison with Trends in Latin America.6 9

3.34 When looking at expansions during the 1990s, Argentina has an average durationof expansion of 366 consecutive days. This average duration is similar to that of othercountries' in Latin America, although it is higher than Mexico's (which has an averageduration of 243 days). During expansions, Argentina's stock market grows at an average0.66 percent per day ,which is similar to the average amplitude of daily stock priceincreases in other Latin markets. However, the standard deviation of daily returns inArgentina is quite large, implying a high volatility. Argentina, Brazil, and Venezuela havethe largest volatility in the region. Argentina's volatility is close to 4 percent, while Chile'svolatility is 1 percent.

3.35 Excluding the Mexican crisis period, Argentina's average duration of contractionsis 99 consecutive days. These contractions are shorter than the average for other LatinAmerican countries; for example, Chile's contractions last for an average of 290 days.Even though Argentina's contractions are shorter, their amplitude is relatively large. Themean difference between peak and trough (divided by their average value) is 52 percent indollar terms, while Chile's decline is 29 percent on average. Other markets have largeraverage declines - Brazil's is 142 percent.

3.36 Do Stock Markets Co-Move Differently along the Cycles? Looking atexpansions and contractions allows not only to look at the characteristics of financialcycles, but also to see whether peaks and troughs coincide across countries. Resultsindicate that expansions and contractions in the Argentine and Brazilian stock markets

69 Contractions in Latini Amierican stock market prices are shorter-lived episodes than expansions,and the amplittide of expansionis is larger than thc amplituide of contractionis. The average andstandard deviation of daily price chaniges are similar in contractions as in expansionis, altlhoughexpansionis are slightly higher in absolutc valtue. This pattern reflects the upward trend of thesestock market indexes over timiie.

These results arc similar to the ones obtained for Asia. Ncvcrtlheless, some differences arise whenwe compare the Asian contractions and expansions with the Latin Amiiericani ones (excluding theMexican crisis pcriod). Latinl Anecrican expansions in thle 1990s liave a loniger duration andhiglher amplitude than thc Asiaii ones. At th(e same inme, the meani and standard deviations ofdaily price chaniges in Latini Ainerica are bigger than in Asia. However, not only are expansionsmore marked in Latin Amiierica, but the average duratioii of the contractioni is also shorter, with adeeper amplittude, and hliglher absolute mcani and standard deviation of daily price changes. Thatis, durinig the 1990s and up to tihe Asiani crisis, Latin Amierican stock market cycles were morevolatile thami the Asian ones.

Wlheni lookinig at the G-7 countiries, expansioiis hlave a higlher durationi and amplittude thanicontractionis. But the difference betweeni tlhe upiturins and dowinltirins is mutclh smialler thaii in Asiaand Latini Amiierica. Moreover, wheln we contrast expansions and regular contractions in Asiawith the G-7, ilte latter group prcsents a higlher mcani durationi, lower anplitude, and lower meanand standard deviation of daily prices Ilian Asiani markcis. In ollter words, stock markets cyclesare oni average smootlher in the G-7 counitries than in Asia.

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coincide; the peaks and troughs for both markets are concentrated around the same dates,with at most a month and a half difference. This degree of coincidence is less commonbetween Argentina and the other Latin American markets.

3.37 Given that certain stock market cycles coincide, we look at whether the downturnsshow more co-movement than upturns*70 . The correlation matrices show that LatinAmerican markets tend to have higher co-movement during contractions than duringexpansions. Furthermore, the correlations are even higher during crisis periods. Forinstance, during the 1990s contractions (expansions), the correlation for the firstdifferences between the Argentine and Mexican stock markets was 0.30 (0.18). During theMexican crisis period the correlation rose to 0.58. This suggests spillover effects acrossmarkets during downturns. The correlation between the Merval and the Brazilian stockmarkets is 0.73 during the crisis period, while it falls to 0.45 during regular contractions.

Cross-Bond and Cross-Firm C(o-movements of Prices.

3.38 The study assessed whether bond prices of companies belonging to differenteconomic sectors have a distinct reaction to external shocks, and whether their co-movement varies during tranquil periods and crisis periods. If there is "contagion", weexpect that stock prices will move more closely during contractions than during expansionperiods. If there is no contagion, we should see some differentiation among the stockprices.

3.39 The analysis focuses on the correlation among bond prices during three sub-periods: the Mexican crisis period (1/1/95-6/30/95), an intermediate period (7/3/95-7/1/97), and the Asian crisis period (7/2/97-12/30/97). The matrices show thatcorrelations between the short-term dollar bonds and the other types of bonds increaseduring crisis relative to calm periods. For instance, the correlation between short-termdollar bonds and the short-term peso bonds is 0.55 in the first sub-period, 0.37 in thesecond one, and 0.90 during the Asian crisis period. The correlations among the otherbonds do not show a similar pattern, rather, they seemn to have increased over time.

3.40 The analysis of stock prices distinguishes among four sub-periods: the three sub-periods used for the bond market, plus an initial period (1/8/90-12/19/94). Thecorrelations among Argentine stock prices are in general higher during the Mexican crisisand Asian crisis periods, than during the other two periods. The correlations increaseamong all companies, even among the ones that produce tradables and non-tradables. Forinstance, the correlation between YPF and Telefonica is 0.70 and 0.65 during the twotranquil periods, and it rises to 0.78 during crisis periods. Moreover, the correlations seemto have been slightly higher during the Asian crisis than during the Mexican crisis. Amongthe companies considered, IRSA presents the lowest correlations with the rest, whilePerez Compac presents the highest correlations with the other stock prices.

70 We use correlations during expansions, duriing conitractions, and durinig ilhe Asiaii anid Mexicancrisis period

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Conclusions froin the Co-Movement Analysis

3.41 The above results can be summarized as follows. Declines in the prices ofArgentine stocks have shorter duration and smaller amplitude than in other LatinAmerican countries. Argentina's expansions are of average duration. During the 1990s,financial cycles in Latin America have been more accentuated than financial cycles inAsia.7 ' Within Latin America, Chile seems to be less volatile than the other countries.During the 1990s financial cycles have been smoother in the G-7 countries than in Asiaand Latin America.

3.42 With respect to the correlations among Argentine assets, the results can besummarized as follows. Bond price correlations seem, in general, to have increased overtime. In the case of the short-term dollar bonds, their correlations increased during crisisperiods. In the case of equity prices, the correlations generally increase during the crisisperiods. As mentioned, this evidence suggests that asset prices may be subject tocontagion from external shocks.

Conclusions and Policy Issues

3.43 Our previous analysis has shown that trading concentrates in large companies,which are also the ones that issue bonds and have access to the New York market. Thelocal market has become illiquid relative to the New York market for Argentine equitiesand bonds. A further development of the local market is needed to facilitate the issuanceof equities and bonds by new companies, in order to make second-tier companies lessdependent on the banking sector.

3.44 Another alternative would be to promote the participation of small companies ininternational markets. In this case, Argentine investors would be able to purchasesecurities of small Argentine companies directly in the international market. Chile haschosen to pursue this alternative by lowering the requirements to list abroad. The Chileanauthorities chose this route because the Chilean equity market became illiquid after the bigcompanies started trading ADRs. It is still too early to make a definitive assessment of thispolicy.

3.45 The high correlation among stock returns may suggest that there are limitedopportunities for equity and bond diversification, especially during market downturns.Although Argentine bond and stock prices seem to move together, especially during crisis

71 The recent crisis in Asia is different fromi the previous contractions in tlhe Asian stock market.Even thoughi the recenit crisis secems to bc a new episode for Asia, the magniitude of the crisis isnot new. Thie receit decline does nol appear to be different from wlial happened in Latin Americaafter the 1994-95 Mexican crisis. Thc miain diffecrcnce between Ithe Mexican and Asian crises isthat thie former caded iiiuclh earlier, particularly wvlcn %vc comlpare Mexico witli Indonesia, wherepolitical factors have played a major role in accenituiating tlhe crisis.

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episodes, they may still have significantly different volatility (or variance). In other words,bonds and stocks may move up or down simultaneously, but the magnitude of thesefluctuations may be different across companies. A higher number of listed companies and awider variety of bonds might give more scope for diversification and might reduce thecorrelations among company asset prices.

3.46 The Argentine authorities have already started taking an active role in deepeningthe securities markets. The measures taken include the promotion of new listings, thedevelopment of new instruments, the creation of new markets, as well as measures tostrengthen the transparency and integrity of the markets.

3.47 The Comision Nacional de Valores (CNV) is carrying out a campaign toencourage the participation of investors in the bond and equity markets. The CNV isundertaking an effort to help medium and small companies determine when it isworthwhile to go public. This type of campaign has been carried out elsewhere. Forinstance, in Morocco an educational campaign showed small companies how much theywould have grown by going public and how much they would gain by remaining small andprivate, thus, retaining a stricter control of the company.

3.48 Even though the CNV and the stock market are making efforts to develop thecapital markets, government officials perceive that a "cultural factor" has prevented themarkets from developing. The owners of small companies are reluctant to lose control oftheir companies.

3.49 "Supply-side" and "demand-side" factors also prevent the development of theequity markets. On the supply side, financing in the equities market is at a disadvantageover bank financing, since corporate interest payments are tax deductible. In addition,firms do not need to pay the cost of issuing debt or equity when they borrow from banks.On the demand side, the fact that no taxes are paid on interest received from banks biasesinvestors again towards banks and against equity purchases. Investors do not pay taxes onbank deposits but their investments on equities are taxed.

3.50 New Listings. Despite the listing of many new firms, including the newlyprivatized corporations, including utilities, the total number of listed companies hasdeclined because delistings caused by mergers and closures of firms exceeded new listings.To encourage listing by smaller firms, the Bolsa has simplified the listing process and hasreduced the cost of listing by 70 percent, reaching approximately 2 percent of the value ofshares listed. The Bolsa now actively seeks to provide technical assistance to expedite theprocess. However, results in the form of increased IPOs are likely to take time tomaterialize. Owners of family groups are concerned about the dilution of control and thegreater transparency, and perhaps also heavier taxation, that public listing might entail.

3.51 In Chile, 43 IPOs have taken place since 1991. This experience suggests that newlistings may be encouraged by the following factors: an ongoing economic recovery, agrowing demand for equities by new institutional investors, a likely reduction in the costof capital from issuing new equity, and the presence of investment banks. Chile offered tax

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incentives to individual investors buying equities in IPOs, but these incentives had only alimited effect since 80 percent of new equity was acquired by companies that did notbenefit from these tax incentives. The Chilean experience also points out that even thoughnew companies start listing, the trading activity might be concentrated in New York. Thepersistent macro stability, the facilitation of the listing procedures, and the participation ofunderwriters might generate a boom in IPOs. New listings may also be encouraged byallowing banks to establish and operate venture capital funds and by giving greater leewayto pension funds to invest a greater proportion of their total assets in diversified venturecapital funds.

3.52 The 1994 World Bank Capital Markets Study pointed out that Argentina sufferedfrom the underdevelopment of investment banks, and lack of market makers in all but ahandful of stocks. Some improvement has been accomplished since then, particularly sincenew investment banks have entered the market.

3.53 New Instruineiits. The Bolsa introduced two new instruments. One, calledCertificado de Deposito Argentino (CEDEAR), is the local equivalent of AmericanDepositary Receipts (ADRs). This instrument is a certificate of deposit that DeustcheBank is authorized to issue, backed by shares of 40 well known US and Latin Americancompanies (such as Coca-Cola, Microsoft, and Petrobras). The other is the ADR ofArgentine companies, which will be allowed to be traded in Buenos Aires. Thesemeasures are intended to provide increased activity to the Buenos Aires stock market, butneither CEDEARs nor ADRs have started trading.

3.54 Securitization. A major development has been the recent growth ofsecuritization. This includes mortgages, credit card receivables, and other forms ofconsumer credit. Securitized instruments are issued by new financial trusts (fideicomisosfinancieros) and are sold to pension funds, insurance companies, and mutual funds as wellas other investors, including foreign investors. Securitized instruments change the riskcharacteristics of underlying assets and require greater vigilance by supervisoryauthorities. They also create valuation and reporting issues that need to be addressed. TheCNV has authorized new issues worth 5 billion pesos. I billion has already been issued,mostly for credit card and consumer credit receivables, and 300 million are currently heldby the pension funds.

3.55 New Markets. A new financial futures and options market will start to operate inSeptember 1998, with the assistance of the Chicago Board of Trade. Up to now, only afew options for some equities are being traded in the Bolsa. Futures and options forshort-term (30 or 90 days) and long-term interest rates, foreign exchange (peso-dollar,peso-real), and stock index contracts are expected to be traded soon. The new marketwill provide greater liquidity to the local market and will reduce the volatility of assetprices.

3.56 Market Integrity. In terms of regulation, the previous World Bank CapitalMarkets Study mentioned that the principal problems were the promulgation andenforcement of a modern insider trading law. One can observe positive advances in this

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area. The CNV has adopted strict rules on insider trading, insider reporting, and self-dealing, which now seem to be adequate. It has recently initiated successful action againstinsider trading and market manipulation by some prominent corporate executives.Takeover rules are also quite adequate, requiring acquiring firms to make public anyholdings above a 5 percent threshold, including any changes in intent. Enforcement of thisrules, however, is still lagging.

3.57 Transparency, Information Disclosure, and Corporate Governance. Lack oftransparency and inadequate information disclosure as well as weak corporate governancestructures are emerging as major obstacles to further capital market development. Theformer is linked to the absence of consolidated accounts, which are required ascomplementary information rather than as basic corporate disclosure. Company lawrequires the publication of audited accounts for individual companies and for holdingcompanies, but not for groups of companies on a consolidated basis. It seems that changesin these requirements have implications for corporate taxation and for company law andface strong opposition. However, audited consolidated accounts would be essential for thefurther development of the marke.ts. Argentine companies issuing ADRs already conformto the tougher disclosure requirements imposed on companies listed in US markets.Corporate governance structures of large listed companies need to be strengthened. Oneway to achieve this is to assign a greater role to independent directors and to authorizeinstitutional investors to exert more influence in corporate affairs, through collectivebodies and specialized monitors that publicize data on corporate performance.

3.58 Quality of Audits and Ratings. There is widespread concern about the poorquality of audits and ratings, both of which are required by law. In the case of audits, it isnecessary to raise standards and impose sanctions on auditing firms that fail to qualifymisleading reports and accounts. The poor quality of ratings raises more difficult issues.2 ratings are compulsory for issuers of corporate bonds and commercial paper, whilepension funds are only allowed to invest in rated securities of listed companies. Butcompulsory ratings have created an artificial demand for ratings and have led to theestablishment of 9 rating companies. Strong competition for rating business hasapparently resulted in a lowering of standards. The current situation is unsatisfactory.Attempts to apply a common evaluation approach have not been fruitful. Unless aneffective way of raising standards can be found, consideration should be given to makingratings voluntary. Companies would obtain debt ratings if they entailed a lowering of theirborrowing costs. Pension funds could still be required to invest in rated debt securities.

3.59 Regulation of Capital Market Inter-mediaries. The main issues here concernthe taping and time stamping of market transactions to prevent trade allocations andraising capital adequacy requirements to ensure that market makers and brokers have thenecessary capital to back their risk exposures. Individual investors need also to beprotected against fraud and gross negligence.

3.60 Lessons from the Co-movemiienit Analysis. That analysis provides several lessonsand analytical tools for policymakers. First, the description of financial cycles in Argentina

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and in other countries provides a useful international comparison. The description helps tounderstand how the Argentine cycles compare to other countries' cycles.

3.61 Second, it also provides an estimate of the duration and amplitude of the cycles. Inthe future, it would be possible to know whether future fluctuations are within historicalnorm.

3.62 Third, the above analysis demonstrates that the Argentine stock market is verysensitive to external shocks. That sensitivity increases during market downturns, when thecorrelations increase relative to the expansion periods. The analysis also confirms theimpression that the stock market cycles in Argentina and in Brazil are very closely related.

3.63 Fourth, increasing the participation of other companies in the capital markets willdeepen the market and will increase the scope for diversification. The large companies thatdominate the stock market will have a less important role. As a consequence, a deepermarket for the second-tier companies might disentangle their prices from the largecompanies that now dominate the equity market.

3.64 Fifth, having a strong and credible financial system, substantially reduces thespillover from external shocks. The shock from the Mexican crisis generated a decline inArgentine asset prices, and a withdrawal of bank deposits. The recent Asian crisis alsogenerated a decline in Argentine asset prices, but it did not produce a withdrawal of bankdeposits.

3.65 Sixth, the different reaction of bond prices and equity prices (relative to bankdeposits) during the recent Asian crisis suggests that participants in the capital marketshave a distinct behavior than depositors. These differences might be due to the types ofinvestors participating in the capital markets and in the banking system. For instance, thedifferences in reaction might be the consequence of a wider participation of internationalinvestors in emerging markets, which helps link these markets with developed markets andamong each other.72.

3.66 Seventh, the fact that national stock price indexes and different stock prices havehigher co-movement during market contr-actionis stresses the importance of the role ofinformation. International investors might not be distinguishing Brazilian equities fromArgentine equities because they do not have sufficient information about both countries.

72 It is likely tiiat (lhe participationi of international investors lias increascd the co-movemiienit amongemerging finanicial markels, particularly durinig crises. Differciat aspects of itheir participation mighitbe explaining tile lhigher co-movemiienit. For exainpie, if niutlal futid managers need to keep abalanced portfolio across emerging markets, tiley mighit be induced to buy and sell assets of differentcotutries simitilanieotisly. Also, if small international investors--who buy the new finanicialinstruments--face a cost to acquire infornation about eacih particular country, thley would be lesslikely to distingtuishi across emerginig markets. Tlien, Iliey wotild tend to sell Argenitinie assets whenBrazilian asset prices fall, just as a precautionary mcasure. Lastly, knowing that international capitalmighit be fickle, domestic investors would discounit foreign inivestors' reaction and would actconsequienitly.

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3.67 Eighth, the current regulations on mutual funds and pension funds restrict theirinvestments to assets from Argentina and other Mercosur countries. However, resultsshow that the Latin Anerican markets are more volatile than other markets, and they aremore highly correlated among themselves. This suggests that this restriction on mutualfunds and pension funds is leaving investors with few opportunities for diversification. Atthe same time, it is forcing investors to have their assets in the most volatile equities. As aconsequence, investors will benefit from diversifying their portfolio by investing in moredeveloped equity markets.

INSTITUTIONAL INVESTORS AND SECURITIES MARKETS

Introduction

3.68 Institutional investors are an emerging major force in the Argentine financialsystem. Pension funds, insurance companies and mutual funds collectively mobilize nearly22 billion pesos, representing close to 7 percent of GDP. This constitutes a fundamentalchange in the structure of the financial system and reflects both reforms in the legal andregulatory environment and the benefits of stable macroeconomic conditions.

3.69 Institutional investors have become major players in the financial systems of manycountries, especially where unfunded social pension systems offer modest benefits andgovernment policies have promoted the growth of private pension funds. There areseveral countries, mostly Anglo-American but also some Continental European ones (suchas Switzerland, the Netherlands and Sweden) where institutional investors mobilizefinancial resources equivalent to well over 100 percent, even over 150 percent, of annualGDP. The investment policies and operating practices of institutional investors haveaffected the structure and functioning of capital markets and have provided a strongstimulus for their modernization and for financial innovation.

3.70 Among developing countries, institutional investors have traditionally been verylarge in South Africa and Malaysia, although their impact on the capital markets has beenconstrained by local regulations and practices. In recent years and following the pensionand capital market reforms of the 1 980s, Chile has emerged as a country with a largesector of institutional investors, while several other Latin American countries will benefitin this area as a result of the implementation of systemic pension reforms in the 1990s.Other developing countries with large institutional investors include Korea and India(mostly mutual funds and insurance companies), Egypt (funded public pension system),Cyprus and Zimbabwe. Brazil has large private pension and mutual fund sectors inabsolute terms, but they are still small in relation to GDP.

3.71 Given the potential scale of resources managed by institutional investors they canbecome a major countervailing force to the dominant role that commercial banks haveenjoyed in the Argentine financial system. Institutional investors can provide liquidity tothe local capital markets, stimulate financial innovation, exert pressure for betteraccounting, auditing and rating standards as well as more meaningful and timely

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information disclosure, and help modernize the functioning of securities markets byupgrading trading, clearing and settlement facilities. Institutional investors may over timebecome major shareholders of Argentine companies and may play a crucial role inimproving corporate governance structures and practices. However, depending on thedegree of concentration in the sector, they may themselves acquire large economic andpolitical clout. Regulators need to ensure that institutional investors are properlyregulated and supervised, meet satisfactory standards of accountability and transparency,and face adequate competition in the market.

Pension Fundls

3.72 Recent Performance. The reform of the pension system that took place in July1994 represents one of the most important changes in the institutional structure of theArgentine financial system. The private sector responded with vigor to the opportunitiescreated by the reform. 25 companies spent over S600 million in preparing for the newsystem. Although the pace of worker affiliation was initially slow, it picked up over timeand at the end of 1997, the 18 AFJPs that were still in operation (following a series ofmergers) had 6.3 million affiliates. This is close to 70 percent of all eligible workers, whileanother 2.3 million workers are affiliated to the defined benefit unfunded public pillar,giving a total affiliation coverage of nearly 95 percent of eligible workers. However, onlyabout 50 percent of affiliated workers are active contributors, resulting in an effectivecoverage of slightly over 45 percent, with around 35 percent contributing to the privatepillar.

3.73 The 18 pension fund management companies mobilized 8.8 billion pesos at the endof 1997, equivalent to 2.8 percent of GDP. Of these, 43 percent were invested in publicsector bonds, 3 percent in corporate bonds, 24 percent in bank deposits, 22 percent inequities, 4 percent in investment funds, and the rest in miscellaneous assets. The totalassets of pension funds are projected to grow at a fast pace and to reach 20 percent ofGDP by 2010.

3.74 The pension funds have already stimulated financial innovation and capital marketmodernization and efficiency. Most of their holdings of bank deposits are in syntheticinstruments offered by large banks, where the return is linked to the performance of anunderlying bond or equity index, while they have also invested in securitized instrumentsfor mortgages and consumer credit. The funds have actively promoted the establishmentof an automated clearing agency for securities transactions.

3.75 AFJPs earned vety high real investment returns, amounting to over 15 percent ingross terms (i.e. before deducting commissions) during the first 3.5 years of operation.However, as in most other Latin American countries, the private pillar has beencharacterized by very high operating costs. In addition to the high start-up costs, theprivate pillar incurs annual recurring expenditure in excess of 600 million pesos. Thiscorresponds to 100 pesos annually per affiliated worker or 200 pesos per activecontributor.

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3.76 In percentage terms, commissions (excluding the premiums charged for term lifeand disability insurance) amount to a front load fee of 24 percent per collection.However, as no other fees are collected, this corresponds to an average fee in relation toassets over a 40-year period of slightly more than 1.3 percent. This is not unduly high andis much lower than the fees charged by Argentine mutual funds. With increasing scale,fees are likely to fall, whether they are expressed as front loads or as asset managementfees.

3.77 Nevertheless, the policy of allowing only collection fees and prohibiting asset feesdiscriminates against workers with shorter contribution periods. A 25 percent collectionfees corresponds to 192 basis points for a 30-year contribution period and to 302 basispoints for a 20-year contribution period (assuming the contribution period is concentratedat the end of a worker's active working life). This creates disincentives against joining thesystem for workers with interrupted careers. Added to the broader disincentives facinglow income workers, they may explain the low effective coverage of the new system.

Table 3.5 Operating Costs of Private Pension Funds

Country % of Covered Pay % of Collection % of Assets*Argentina 2.41 24.1 1.33

Chile 2.29 18.6 0.99Mexico 1.92 22.5 1.22

Peru 2.29 22.2 1.21* Assumiiig nio otlier fees, a collectioni fee of 24.1 perccnt imiiplics that the flnal accumulatedbalance would be lower by thlat amontiii. If wages are assumcied to grow by I percent per year and the rateof retuni is equal to 3 perceiit, suichi a reduction ini iihc finial value over a 40 year period would correspondto an ainual managemiient fee of 1.33 percent in thle case of Argentina. The implied asset fee would behigher, the lower the rate of returni, the lower thle differenitial between inivestmen)it returni and salarygrowtlh, and the slhorter the period of accumulation.

Source: National Superintendencies and own calculations

3.78 As in the case of Chile, the private pillar has suffered from very high marketingcosts and an unexpectedly high level of account switching. In 1997, nearly I millionworkers transferred their accounts. This corresponds to 16 percent of all affiliatedworkers, but to 32 percent of active contributors. Although total marketing costs are notreported separately, realistic estimates put them at over 40 percent of total operating costs(excluding insurance premiums).

3.79 Regulatory Framework. To safeguard the interests of workers, overcomepolitical opposition to the reform progr-am, and avoid any early failures that could havereversed the reform process, the new pension system is subject to a robust regulatoryframework that includes not only prudential and protective regulations but also manystructural and operational controls.

3.80 The prudential and protective controls include asset segregation and safe custodyof funds, professional asset management, external audits and actuarial reviews, transparent

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valuations and extensive information disclosure. These controls are not controversial andresemble similar controls imposed on banks and insurance companies.

3.81 The structural and operational controls, which are of a more controversial nature,include special authorizations and market segmentation, "one account per worker" and"one fund per company" rules, uniform pricing and other non-discrimination provisions,upper limits on investments by instrument and issuer as well as by various classes ofassets, and minimum levels of relative profitability.

3.82 Policy Issues. The growth of pension funds has stimulated financial innovationand financial deepening, although some of the new products give rise to concern becauseof their more risky structure. The pension funds may also have exerted a positivedemonstration effect on the rest of the financial system. They have a solid institutionalstructure that does not suffer from the fragmentation that characterizes the banking andinsurance sectors. They are highly transparent and robustly regulated and provideextensive information and data to both their supervisors and their affiliates. The strongregulatory framework has ensured a smooth launching of the new pension system with nocasualties during the Tequila and Asian crises of 1995 and 1997.

3.83 Despite these positive features, the private pension funds are faced with severalchallenges. These include the low effective coverage, the high marketing costs andaccount switching, the high concentration of the sector, the strong links between pensionfunds and affiliated insurance companies, and the regulation and riskiness of investments.The authorities need to address these issues and to take steps to change the structure andregulation of the new pension system with a view to eliminating costly distortions andimproving its net benefits for participating workers and the economy at large.

3.84 Low Effective Coverage. This is caused by the low level of affiliation and thelarge discrepancy between affiliates and active contributors: The former is attributed tohigh unemployment and the large size of the informal economy, while the latter is largelyexplained by the movement of workers in and out of the labor market (unemployedworkers, housewives, students, etc.). The low level of effective coverage may result inlow pensions for workers with interrupted and short contribution histories, although it willbe a bigger problem if family breadwinners rather than second income earners are affected.

3.85 The implications of low effective coverage for the finances of the pension systemwill be different from those of evasion under the old system. Workers with less than 30years of contributions will not be entitled to the universal basic pension, while theirpension from the private pillar will also be lower. The long vesting period may be actingas a disincentive against joining and actively contributing to the system. The governmentoffers a lower advanced age pension to those reaching 70 with at least 10 years ofcontributions, but this benefit provides no incentive to contribute for 15, 20 or 25 years.

3.86 Another potential disincentive against joining may be the high total contributionrate for the two pillars. The offer of the universal basic pension and a pension from the

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private pillar may result in very high replacement rates for low income workers and, byimplication, very high forced, but not easily affordable, savings.

3.87 As already noted, a further reason could be the high operating fees, which arelevied in the form of collection fees, and discriminate against workers with shortcontribution periods.

3.88 Three structural measures could be taken to encourage greater participation in thesystem. Although not mutually exclusive, it would be unlikely, because of their potentialfiscal costs, that all three would be simultaneously used. A fourth measure would involvechanging the structure of permitted operating fees. In addition to their fiscal implications,these measures will also have implications for the relative size of the first and secondpillars. By encouraging greater participation in the formal labor market, they could alsogenerate positive externalities in economic efficiency and tax revenues.

3.89 First, a proportionality element and an integration with the social assistancepension could be introduced in the determination of the basic pension. The basic pensioncould consist of two parts: a flat component equal to, say, 15 percent of the averagecovered wage and a variable component equal to 0.5 percent of the average covered wagefor every year of contribution. A worker with 20 years of contributions would receive a25 percent basic pension; this would rise to 35 percent for a worker with 40 years ofcontributions. Workers with fewer than 5 years of contributions could be subject to anincome and asset test.

3.90 This approach would avoid poverty traps as well as discrimination against workerswith less than full contribution records. The exact values for the various parameters wouldneed to be set after careful actuarial calculations. For instance, the potential fiscal costwould be significantly smaller if the flat component was equal to 12 percent of the averagecovered wage and the annual accrual factor amounted to 0.4 percent. Thus a worker witha 40-year career would receive a 28 percent public pension, while a worker with 20 yearsof contributions would receive a 20 percent public pension. The decision is financial aswell as sociopolitical.

3.91 The second measure could involve use of the Swiss concept of "coordinatedearnings". Earnings below a level to be set annually but corresponding to the level of thefull basic pension (say, around 35 percent or 28 percent of the average covered wage)could be exempt from contributing to the private pillar. To maintain the same amount oflong-term capital accumulation, the nominal contribution rate for the second pillar wouldneed to be raised, but as contributions would be calculated on "coordinated earnings", i.e.earnings above the threshold and below the currently applied ceiling, the effectivecontribution rate could broadly be kept the same.

3.92 One argument against the use of "coordinated earnings" is that it forces lowincome workers to rely primarily, if not solely, on the public sector for their pensions.Although undesirable from some points of view, such an outcome may be economically

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preferable if account is taken of the high operating costs of Latin American privatepension funds.

3.93 The third possible measure would be to follow the Mexican example and pay agovernment subsidy to be credited to individual accounts. Such a payment could belimited to low income or low balance accounts. It would increase total retirement savingsand be used to offset the impact of operating costs of private pension plans that areparticularly high for such workers, A government subsidy would result in higher fiscalcosts, although some of these might be offset by spending less on social assistance.

3.94 The fourth measure would involve allowing asset fees as well as collection fees tobe charged. A combination of a 5 percent collection fee and a I percent asset fee wouldcorrespond over a 40-year period to 124 basis points (very close to what is currentlycharged). As operating efficiency improved with greater scale, both the collection andasset components of operating fees could be lowered. But the combination of a 5 percentcollection fee and I percent asset fee would correspond to 133 basis points for a workercontributing for 30 years and to 152 basis of a worker contributing for 20 years. Theywould thus cause a smaller discrimination against workers with short careers.

3.95 For the sake of completeness, it should be noted that the authorities could alsoconsider replacing the explicit unfunded public pillar paying a universal basic pension withan implicit public pillar providing a minimum pension guarantee. This is not so much afinancial as a political and social decision. Moreover, the four measures discussed abovecould also be considered in the context of an implicit public pillar in the form of aminimum pension guarantee.

3.96 These four measures would weaken any existing disincentives against activeparticipation in the compulsory scheme. Coupled with greater policing of compliance,they could increase substantially the effective coverage of the pension system.

3.97 High Marketing Costs and Account Switching. The private pillar suffers fromhigh marketing costs and an unexpectedly highi level of account switching. A study by theSAFJP has found that the main factors explaining the winners and losers from accounttransfers have been the number of selling agents and spending on marketing rather thanexpectations of better performance or lower fees. Although two account transfers peryear are still permitted, the authorities have made account switching more cumbersome byrequiring physical visits to the branches of AFJPs. The authorities have two different andcontrasting options in dealing with the high frequency of account switching. One is tofollow the emerging pattern in Chile and Mexico and r estrict account switching to one peryear. The other is to make switching easier by removing restrictions and relaxing otherregulations such as in particular the uniform pricing rule.

3.98 Moving away from uniform pricing would allow discounts for loyalty (alreadypermitted but not very effective), for group contracts, for high volumes (discounts offeredto high income or high balance workers), and for direct selling (i.e., to workers whobypass selling agents in opening or transferring accounts). Differential pricing might imply

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higher fees on low income or low balance workers. Such an outcome would strengthenthe case for a government subsidy to such workers. At the same time, AFJPs could begiven greater leeway to charge asset and/or performance fees as well as collection fees. Afreer regulatory framework could also allow workers to have more than one account andcould authorize AFJPs to operate more than one fund, though it would make sense toplace upper limits on the number of multiple accounts and multiple funds.

3.99 High Concentrationi. Pension fund management companies must be speciallyauthorized and must be set up as corporations by any group of shareholders, includingbanks and other financial institutions, large corporations, trade associations, labor unions,and groups of workers. In line with the prevailing pattern in other Latin Americancountries, most of the 18 companies that are currently in operation have extensive foreignparticipation from major multinational banks and insurance companies as well as fromleading Chilean AFPs.

3.100 The reliance on specialized entities, and the resulting market segmentation, weremotivated by the fragility of both the banking and insurance sectors in the early 1 990s andthe underdevelopment of mutual funds. It is doubtful that the pension reform programcould have been successfully implemented in 1994 if a more relaxed regulatory regime andan integrated approach (i.e., allowing banks, insurance companies and mutual funds tooffer various types of retirement saving facilities) had been followed.

3.101 Unlike other segments ofthe financial sector, which suffer from highfragmentation, the pension fund sector is characterized by high and growingconcentration. The 4 largest companies have 64 percent of all affiliates and assets undermanagement, with the largest 6 accounting for over 80 percent of both. At the other endof the spectrum, 5 small companies have each less than I percent of affiliates and assets,representing collectively less than 2 percent of the market. The long-term survival ofthese companies must be in doubt. They will either be absorbed in future mergers orforced to withdraw from the market.

3.102 Because of the small size of the sector, the high level of concentration is notcausing immediate concern. However, over time, the large private pension funds mayacquire considerable economic and political clout. To avoid such problems, the regulatoryframework could be gradually changed to encourage greater integration with the rest ofthe financial system by authorizing pension funds to hire external asset managers, bypermitting multiple accounts per worker and multiple funds per company, and perhapsalso by allowing banks and other financial institutions to provide retirement savingfacilities in direct competition to the AFJPs. Such an approach would bring the Argentinesystem closer to the emerging and evolving structure in advanced OECD countries, butthe phasing of any such changes in rules would need to be shaped by the strengthening ofbanks, insurance companies and mutual funds.

3.103 Links betweeii Peuisioii Funds and Insuraiice Companies. The private pensionpillar has major implications for the development of the insurance industry. It has alreadygenerated a large demand for term and disability insurance and will create a huge demand

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for annuity products when the new system matures and workers start retiring with largecapital accumulations.

3.104 In the context of the close relationships between pension funds and insurancecompanies, the premiums for term life and disability insurance appear to be determinedarbitrarily, fluctuating widely across companies and over time. Moreover, an apparentdecline in average insurance premiums has yet to be reflected in lower operating feescharged to affiliated workers. The market for annuities is at an early stage ofdevelopment. However, there is likely to be growing demand for differentiated products,which the currently highly fragmented insurance sector may be ill equipped to provide.

3.105 Consideration needs to be given to strengthening the insurance sector and tocreating conditions for a more competitive determination of insurance premiums. Equallyimportant is a framework that encourages product innovation and access to foreigntechnology in terms of product design, pricing and reinsurance. This is particularlyrelevant for the annuities market, which is likely to experience far-reaching changes as aresult of demographic aging and the worldwide shift toward defined contribution pensionplans, but it is also important for term life and disability insurance.

3.106 Regulation and Riskiness of Investmenits. In a compulsory decentralizedfunded pension system, investment assets need to be protected both from theft and misuseand from imprudent investment policies. The requirements for asset segregation andexternal custody aim to achieve the first objective, while investment limits, minimumprofitability requirements and state guarantees underpin the second objective.

3.107 The Argentine private pillar, like that of most other reforming countries, is subjectto an array of rules. Investments are mostly authorized in listed and rated securities, aresubject to individual limits by instrument and issuer, and are also subject to limits by assetclass. With some qualifications, the first two types of rules do not raise many objections.However, the third type is of a more controversial nature.

3.108 Investment limits by asset class are probably necessary and effective in countrieswith weak capital markets and a limited supply of suitable instruments. In such countries,even without limits, pension funds are likely to invest predominantly in governmentsecurities and bank deposits. But as markets become stronger, more transparent and moresophisticated and as the supply of financial instruments expands, investment limits by assetclass become less appropriate and less effective.

3.109 There are three reasons for this. First, unless they are extremely detailed,investment limits on government bonds and corporate equities fail to distinguish betweeninstruments that belong to the same asset class but have very different risk/return profiles(e.g., coupon-carrying five year and zero-coupon thirty year government bonds or equitiesin small technology companies and large utilities). Second, sophisticated financialinstitutions are able to develop synthetic instruments that may be classified as one type ofjnstrument but have the risk and return characteristics of another. And, third, investmentlimits avoid excessive concentration of instruments in specific types but do not necessarily

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ensure adequate diversification. It is for these reasons that OECD countries with strongcapital markets rely on the "prudent person" rule, which involves implicit investmentrestrictions, but is more flexible, evolves with changes in market practice (and fashion),and implies adequate diversification.

3.110 The Argentine system has asset class limits that are more liberal than those ofalmost all other Latin American countries. Moreover, financial innovation has allowedpension funds to observe the letter of the rules, while diversifying into instruments with amore attractive risk/return tradeoff. For example, the vast majority of bank deposits (2billion pesos or 23 percent of total assets) are now placed in certificates of deposit with avariable return linked to an underlying bond or stockmarket index. Also, 300 millionpesos (representing 3 percent of assets) are invested in securitized instruments offered bythe new financial trusts (fideicomisos financieros) and involving structured packages.

3.111 Although these innovations involve products with embedded options that aredifficult to price, they benefit pension funds by limiting their downside risk, while allowingthem to share in the upside potential of the underlying index. Nevertheless, they exposethem to counterparty risks, which can be very large if the financial institutions offeringsuch instruments are not consistently and at all times properly hedged. These innovationsrepresent early examples of the dynamic interaction that is likely to emerge betweenpension funds and the capital markets and suggest that investment regulation shouldbecome more flexible over time and lean more toward the "prudent person" rule andeffective internal control systems that are prevalent in the more advanced OECDcountries.

3.112 Investment policies are also influenced by the minimum relative profitability (MRP)requirement. This stipulates that pension funds must earn at least the lower of 70 percentof the nominal average rate of return of all pension funds on a 12-month rolling basis orthe industry average less 2 percentage points. Pension fund management companies mustmake up any shortfall below this minimum from their own resources (once any profitabilityfluctuation reserve has been exhausted). Any company that is unable to do so is liquidatedand the accounts of affiliated workers transferred to other companies. The MJRP rule issupported by a state guarantee to make up any remaining shortfall once a company isliquidated.

3.113 The MIRP requirement aims to protect affiliated workers from a wide dispersion ofinvestment returns and from the losses that aberrant managers may cause, but it has beenwidely criticized because it induces pension funds to have uniform asset portfolios andmay discourage competition and innovation in asset management. However, the criticismtends to be exaggerated.

3.114 First, broadly uniform, well balanced and diversified portfolios may be appropriatefor a compulsory pension pillar, especially if their returns do not fall substantially short ofthe returns obtained from an appropriate market index. In the United States, indexedmutual funds have outperformed the vast majority of actively managed funds. Forcompulsory pension funds, net returns may benefit more from containing costs than from

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granting more investment choice to individual funds. Given the preponderance of debtinstruments and the underdevelopment of equity markets, even the issue of promotingage-specific portfolios may not be relevant in the short to medium run, although it is likelyto become important in the longer run.

3.115 Second, the uniformity of investment portfolios has resulted in limited variability ofreturns across individual funds. in 1997, the rate of return ranged between 9.9 percentand 16.6 percent when the industry average was 14.8 percent. The historical rates ofreturn for the whole period of operation ranged between 12.4 percent and 18.4 percent,with an industry average of 16.7 percent. These differences would be unduly large if theywere to persist over a whole career, but the range is much smaller than the dispersion thatis observed in mutual funds (see below).

3.116 Third, the MRP r equirement forces pension funds to move in tandem by inducingsmall funds to mimic the policies of large ones, but it does not prevent innovation as thegrowing use of synthetic products and securitized instruments underscores. In the longerrun, the MRP could be linked to a benchmark index, such as a balanced fund comprising amix of bonds and equities. Using a benchmark index rather than the average return of allpension funds would provide greater freedom to smaller funds, which would not longerneed to mimic the behavior of the large funds.

3.117 Fourth, the tendency of pension funds to engage in excessive marketing is notnecessarily a result of the regulation of investments. A more credible case argues that theculprit for excessive marketing and account switching may be the uniform pricing and"one fund/one account" rules. However, neither of these possible explanations has beenempirically tested. Experience from the US mutual funds industry suggests that the retailend of the market is not very sensitive to either price or return differentials. Intensivemarketing and selling may be inherent factors in explaining the success of individualpension funds.

3.118 Major changes in the regulation of investments, like those concerning the loweffective coverage and high account switching, will require intensive study to ensure theirappropriateness and effectiveness. There are, however, two less fundamental regulatoryissues that can be more easily resolved. The first is to allow pension funds to invest inrated mutual funds that hold unrated securities, This would encourage greaterdiversification as pension funds could invest in mutual funds specializing in small firms,venture capital, and infrastructure projects. If the regulation of mutual funds is alsoamended to permit mutual funds specializing in non-Mercosur securities, it could stimulatediversification in overseas securities, which is at present discouraged by the high costs oftransacting directly in major international markets rather than through international mutualfunds offered in the local market.

3.119 The second is to require AFJPs to absorb the bid-ask spread in OTC trading.Existing regulations prohibit managing companies from passing to the underlying pensionfunds their trading costs. AFJPs have been unable to charge their pension funds for

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brokerage commissions incurred in trading on the main market, but failure to absorb thebid-ask spread in OTC trading has resulted in the pension funds incurring trading costs.

Insurance Conmpanies

3.120 Recent Performance. Despite the deregulation of the early 1990s, which replacedpremiums and product controls with solvency monitoring, put into liquidation the statereinsurance company, privatized the Caja de Ahorros y Seguros (the largest insurancecompany), and opened the market to greater competition, the insurance sector continuesto suffer from high fragmentation and operational inefficiencies. Insurance businesssuffered in the 1980s from the adverse effects of hyperinflation, extensive regulation, andthe presence of many small and weak companies with little technical expertise. It receiveda major boost in the 1990s from the implementation of pension reform and the newinsurance law covering workers compensation.

3.121 Total premium income has fluctuated in recent years between 1.5 percent and 1.8percent of GDP, while total assets amounted to 7 billion pesos (2.2 percent of GDP) inJune 1997. Reflecting the positive impact of pension reform, the share of life andretirement insurance premiums in total premiums increased from 21 percent in 1993 to 28percent in fiscal 1997. Life insurance accounted for only 7 percent of total premiums in1989. In Chile, life premiums (including annuity products) represented 40 percent of thetotal in 1995.

3.122 The impact of the new pension system is evident from the large growth ofretirement insurance, which increased from a monthly average of 15 million pesos duringthe last quarter of 1995, to 25 million pesos in the corresponding period of 1996, and 50million pesos in 1997. Retirement insurance is likely to increase very fast as the newpension system matures.

3.123 Automobile insurance accounts for 41 percent of the total market. Other nonlifebranches have small shares, except for workers compensation insurance, which generates10 percent of total premiums. Premiums ceded to reinsurance companies absorbed onaverage 18 percent of total premiums. Reinsurance is little used in automobile, workerscompensation and life business, but is very large with over 60 percent of premiums inindustrial risks, fire and theft policies.

3.124 The industry has high operating and marketing (acquisition) costs, while its lossratios are low by international standards. The expense ratio for nonlife business was over50 percent in 1997 against less than 30 percent for well run insurance sectors in Canadaand the United States. The loss ratio, i.e. the ratio of claims settled to net premiums, was60 percent on average for all lines of business against around 80 percent in Canada and theUnited States. In general, the higher the loss ratio, the higher the efficiency of theinsurance sector from the perspective of consumers.

3.125 Total investment assets amounted to 3.6 billion in June 1997, representing 51percent of total assets. Another 25 percent is accounted for by claims on agents for

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premiums receivable and on reinsurers. Although still high, this ratio has fallen from over30 percent in the early 1990s. There is, however, significant variation across differenttypes of insurance companies. For property and casualty companies, investment assetsrepresent only 35 percent of total assets and claims on agents and reinsurers 36 percent,while for retirement insurance companies investment assets are 90 percent of total assets.

3.126 Investment assets are predominantly invested in government bonds (30 percent)and bank deposits (45 percent). Corporate securities. including equities, represent lessthan 22 percent of the total. As in the case of pension and mutual fund investments, thisreflects the conservative investment policies pursued in Argentina as well as the limitedsize of the equity market and existing problems with regard to transparency, informationdisclosure, and perceived lack of complete market integrity. However, the pattern ofinvestment portfolios also highlights the large potential for corporate securities.

3.127 Insurance companies report relatively high equity capital ratios of close to 25percent. Life and workers compensation companies have higher capital ratios at 34percent and 49 percent respectively. The ratio for nonlife companies is close to theaverage, but retirement insurance companies operate with a capital ratio of only 8.7percent, perhaps because their liabilities are not only long-term but also subject to a well-defined and predictable schedule. The capital ratios of property and casualty insurancecompanies need to be adjusted downwards for the high level of claims on agents andreinsurers. Despite the low level of loss ratios, most types of insurance companies reportlosses, even after allowing for investment income earned on reserves. The total reportedloss was of the order of 15 percent of book equity, although given the many subjectivefactors that affect reserving and other accounting policies, it is difficult to know whetherthe reported losses reflect accurately the performance of the sector.

3.128 The insurance industry has experienced significant qualitative change in recentyears. The asset structure has improved (claims on agents and reinsurers have declined,while investment assets have increased), the capital base has been strengthened, and lossratios have improved. Although there seems to be aggressive competition in some lines,sometimes emanating from foreign companies wishing to establish a foothold in the localmarket, the larger and stronger companies have been able to resist this trend, charginghigher premiums while stressing better service, such as faster payout records and betteradvice with risk management and accident prevention. The generally low level of lossratios (despite the recent improvement) suggests that, contrary to the prevailing view,premiums have not been unduly low. Foreign companies, which have a strong direct andindirect presence in the market, have been rather erratic in this respect, sometimescompeting aggressively to gain market share and on other times retrenching or supportingthe status quo.

3.129 The generally high commissions paid to agents help explain the very high expenseratios, but attempts to develop direct selling have been constrained by the control thatagents have on existing customer relationships, especially in commercial and industriallines. The prospects for the development of direct selling are more promising in personaland household insurance, which is still grossly underdeveloped.

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3.130 Despite the closure of nearly 100 companies in the 1990s, there are still over 260companies operating in Argentina, mainly because of the authorization of new companiesfor retirement insurance and workers compensation. The new lines of business have highcapital requirements (respectively, I and 3 million pesos), but traditional non-life lines stillrequire as little as 250,000 pesos for single line operations. Many companies operatemore like brokers rather than primary insurers. As long as they obtain adequate and validreinsurance and do not undermine the market by offering deceptively low premiums, thisshould not be a cause for concern. However, even if they do not offer deceptively lowpremiums, an unduly large number of small firms may contribute to the high level ofoperating and marketing costs.

3.131 Regulatory Framework. Creating a sound regulatory framework with correctincentives for managers is more difficult in the insurance sector than in any other part ofthe financial system. Insurance companies, especially life and retirement companies, arelong-term institutions that can be insolvent but not illiquid for a long time. Insurancebusiness suffers from major information problems and is bedeviled by widespread mistrustbetween insurance companies and their customers, not only in developing countries butalso in countries with large and well developed insurance sectors. The capital structure ofinsurance companies, the adequacy of reserves, and the level of profitability and taxliabilities are affected by reserving and other accounting policies as well as by prolongeddelays in settling claims and large court awards. The use of reinsurance contracts is oftendeceptive with companies relying on weak reinsurers rather than on well established andrespectable entities. For all these reasons, an effective regulatory framework for theconduct of insurance business is essential, although it is very difficult to achieve a finebalance between effective regulation and freedom to innovate and compete.

3.132 The new regulatory approach emphasizes solvency monitoring. Premiums are nolonger set by the regulators, but insurance companies are required to file their tariffs andtheir plans for new products for regulatory approval. Argentina has adopted the EuropeanUnion approach of setting two solvency margins - one based on retained premiums andthe other on retained claims. This approach allows insurance companies to compete onpremiums and new products, while preventing aggressive companies from offeringdeceptively low premiums since they would have to maintain adequate capital reserves inrelation to their loss experience from retained claims. One remaining problem is that theimpact of aggressive competition on solvency margins is not shown immediately as claim-based solvency margins take account of losses over a three year period. To cope with thisproblem, international insurance regulation is leaning toward adopting a higher capitalbase for fast growing firms.

3.133 The emphasis on solvency monitoring requires the development of more effectivesupervision that should cover both off-site surveillance through frequent and meaningfulreporting and on-site inspection to verify the truthfulness of reports and compliance withinvestment and solvency regulations. A regulatory approach that encourages healthycompetition among financially solvent insurers implies the creation of a contestable marketsubject to a credible threat of potential competition from qualified new entrants as well asa policy facilitating the exit of insolvent firms that might undermine quality standards. One

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way to discourage excessive entry, and to encourage mergers among existing firms, wouldbe to raise the minimum capital requirement.

3.134 The regulation of investments is nowadays quite liberal in Argentina. There are nominimum investment requirements and insurance companies are encouraged to diversifytheir investments while taking account of the nature of their liabilities. Productinnovation, especially in life and annuity business, is encouraged by the more liberalregulatory approach, the increasing importance of foreign companies, and the renewed andmore vigorous development of the capital markets.

3.135 Policy Issues. The insurance sector appears to be lagging behind the growth andmodernization of other types of institutional investors. The sector faces several importantpolicy issues, ranging from the need for greater consolidation to improved transparency.Despite the challenges, insurance companies are expected to be major beneficiaries ofpension and other reforms and of the continuing economic recovery.

3.136 Consolidation. The challenge is to consolidate the sector, but without creating anoligopolistic, noncompetitive structure. To this end, capital requirements could be raised,while the BASIC approach that is applied on banks could also be extended to insurancecompanies. Consolidation would require a more vigorous and effective supervision.Insolvent companies should be closed down and mergers could be encouraged. Theauthorities announced increases in minimum capital requirements effective October 1998.For newly established companies, these range from 5 to 10 million pesos, depending onthe type and number of lines in which they participate. Existing firms will face lowercapital requirements, although the required increases will be very substantial (for instance,from 550,000 pesos to 3 million pesos for companies offering 3 lines) and are likely tostimulate a consolidation of the industry througlh mergers. In the longer run, existing andnew companies should face the same minimum capital requirements.

3.137 Insurance Company Rating. Insurance companies appear to be the only type offinancial institutions that are not subject to a rating requirement. Although mandating theuse of rating agencies has created problems in other industries and may have contributedto a lowering of rating standards, the authorities could encourage the development ofvoluntary rating, similar to the pattern prevailing in the United States and other OECDcountries.

3.138 Insurance Informationi Bureau. One of the problems facing insurancecompanies at present is the lack of reliable information on loss experience. An insuranceinformation bureau should be established to collect data on loss experience throughout thecountry and facilitate more efficient pricing.

3.139 Structural Improveinents in Autoinobile Insurance. As in most otherdeveloping 'countries, automobile insurance suffers from expensive litigation, prolongeddelays in claim settlements, and excessive court awards. To expedite settlements, avoidexpensive litigation and place objective limits on1 court awards, automobile insurance could

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benefit from the introduction of "no fault" insurance as well as the use of a baremizationschedule similar to that applied for workers compensation.

3.140 Consumer Complaints Office. Following the example of Scandinavian and otheradvanced countries, an ombudsman office could be established collectively by all insurancecompanies. The duty of the office would be to examine complaints by consumers,Decisions by this office should be binding on participating insurance companies, whileconsumers would have the option to accept them or seek redress in the courts.

Mutual Fundls

3.141 Recent Performance. The development of the mutual funds industry was heldback in the past by the macroeconomic instability of recent decades, the inadequacy of theregulatory framework, and the high level of intermediation costs., Mutual funds allsosuffered from the requirement to place 80 percent of their assets in equities, whichprevented the development of money market and bond funds that could provide greatercompetition to deposit banks.

Table 3.6: Structure of Mutual Funds, end 1997

Type of Fund Number Assets percent(mn pesos)

Argentine Equity 54 331.2 6.2Latin American Equity 10 153.0 2.8

Peso Bonds 25 305.6 5.6Dollar Bonds 38 1721.1 32.0Peso Deposits 22 770.6 14.3Dollar Deposits 15 1027. 1 19.1Balanced Funds 22 649.0 12.1Closed Funds 3 100.8 1.9

Peso Money Market 5 154.3 2.9Dollar Money Market 4 166.6 3.1

All Funds 198 5379.3 100.0Source: Camara Argcnlina dc Foindos Coiniiiiilues de Iniversion and staff calculationis

3.142 The restoration of macrostability and the streamlining of the regulatory frameworkhave stimulated demand for mutual funds, which have grown very fast in recent years.From 70 funds with less than 300 million pesos in 1994, their number reached 200 andtheir assets 5.4 billion at the end of 1997. Most of the 200 funds operated by 62management companies specialize in bonds and fixed term deposits with 71 percent of thetotal. Equity funds represent 9 percent, mixed ftunds 12 percent, and money markcet funds6 percent. Dollar denominated funds account for slightly over 54 percent of total assets.No index tracking funds are currently offered (Table 3.6).

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3.143 The strong preference for bond and bank deposit funds is probably explained bythe high real rates of interest obtainable in such debt instruments (although theperformance of bond funds was not very strong in 1997) and by the continuing lack ofconfidence in the equity market. Except for the actively traded equities of some largeprivatized companies, most company equities continue to suffer from illiquidity, extensivefamily control, and lack of transparency.

3.144 Mutual funds used to charge a 2 percent entry commission plus annual fees rangingbetween 8 percent and 12 percent. Currently, most funds are no-load funds but theycontinue to charge rather hefty (though significantly reduced) annual management fees.These range from between 1.5 percent and 2.5 percent for bond funds to between 3percent and 7 percent for equity funds. Fees for money market mutual funds are lower atbetween 50 and 60 basis points. Some funds charge exit fees that decline with the lengthof investment holdings. Minimum investment requirements are often as low 1,000 pesos,although in some cases a higher minimum (e.g., 50,000 pesos for a money market mutualfuind offered by a leading bank) may be applied.

3.145 Bank-managed funds continue to dominate the market. Among managers, Bank ofBoston has a 21 percent market share, followed by Banco Santander with 17 percent,Banco Frances with 13 percent, and 4 other large banks with between 4 percent and 7percent each. Thus, 7 fund managers control nearly 72 percent of the market. The bankdomination is attributed to the importance of distribution costs. Large banks already havewell established networks. The large international fund management companies, such asFidelity and Vanguard, have not entered the local market.

3.146 Only 13 management companies have more than 100 million pesos in assets undermanagement, with another 15 having between 10 and 100 million pesos. 20 companieshave each less than I million pesos under management. This underscores the tendency ofthe Argentine financial system toward fragmentation even in a relatively new and modernsector. It should, however, be noted that a similar pattern is observed in other countries.For instance, in Canada, 76 companies operated 799 mutual funds in 1994 with totalassets of 130 billion CAD. However, 39 of these companies controlled less than $250million in mutual fiund assets.

3.147 The performance of mutual funds is reported daily and mutual funds are rankedrelative to other Argentine funds. In general, 1997 returns have been far from spectacular.Financial results for funds that were in operation for the whole year are summarized inTable 3.7. The highest returns were achieved by 2 funds investing in Latin Americanequities.

3.148 Returns on Argentine equity funds ranged widely from -51 percent (for a verysmall outlier fund) to +31 percent, but those of the 5 largest funds ranged between +2percent and +9 percent. The average weighted return was 10.2 percent, the arithmeticmean 5.8 percent and the standard deviation 14.2 percent.

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Table 3.7: Mutual Fund Returns, 1997

Type of Fun*d NLuniiber Wciglhlcd AriIliniictic Standard Mill muMcan Mcan Deviation

Argentine Equity 49 10.19% 5.76% 14.20% -50.86% +31.40%Latin American Eqtuity 5 35.32% 23.76% 18.87% - 1.27% +44.35%Peso Bonds 17 5.77% 2.90% 9.58% -28.93% +14.28%Dollar Bonds 21 4.34% - 1.44% 22.14% -97.32% + 8.14%Peso Deposits 21 6.03% 6.02% 1.38% + 2.58% + 8.83%Dollar Deposits 14 5.13% 5.10% 0.40% + 4.04% + 5.54%Balanced Funids 12 14.26% 9.05% 4.35% + 2.68% +16.70%ClosedFunds 2 9.50% 9.50% 0.11% +9.42% + 9.57%Peso Money Market 1 6.07% 6.07% + 6.07% + 6.07%Dollar Money Market 1 5.65% 5.65% + 5.65% + 5.65%All Funds 1, 143 7.52%° 5.30% 13.43% -97.32%/ +44.35%

Source: Cainara ArgeDtina de Foondos Conuniunes de Iniversioii and stafl calculationis

3.149 Returns on fixed income instruments were also generally low and exhibited highdispersion. They varied from -28.9 percent to + 14.3 percent for peso bonds and between+2.5 percent and +8.8 percent for peso deposits. The weighted means were respectively5.8 percent and 6 percent. Balanced funds produced a weighted return of 14.3 percentwith a smaller dispersion.

3.150 For all the 143 funds that were in operation during 1997, the weighted averagereturn amounted to 7.5 percent, the arithmetic mean 5.3 percent and the standarddeviation 13.4 percent. Although no strong conclusions can be drawn from theperformance of only one year, the available data indicate that mutual funds suffer ifromhigh fees and a wide dispersion in returns. On average, mutual fund returns were belowmarket levels.

3.151 Comparison of mutual fund returns with those of pension funds is not easy becausethe latter are reported gross of expenses, whereas the mutual fund returns are after thededuction of asset management fees. For calendar 1997, the average weighted return ofpension funds amounted to 14.8 percent, the arithmetic mean to 13.4 percent and thestandard deviation to 5.2 percent. Returns ranged from a minimum of 9.9 percent to amaximum of 16.6 percent. Arguably, balanced mutual funds produced higher net returnsthan the pension funds but it is worth noting that they accounted for only 12 percent oftotal mutual fund assets.

3.152 Regulatory Frainework. As in the case of pensions and insurance, the prospectsfor mutual funds have been boosted by the extensive regulatory reform of the Argentinefinancial system. Mutual funds are now allowed to invest in fixed income securities andmoney market instruments as well as to specialize in different equity sectors or to havespecialized objectives (income, growth, or mixed). However, mutual funds continue to beheavily constrained in their overseas investments. Only up to 25 percent of assets can beinvested outside Mercosur.

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3.153 The regulatory framework emphasizes registration and disclosure with specialmeasures to protect investors from potential misuse of funds. Mutual funds must becreated and managed by a managing company, which can be either a corporation or afinancial entity authorized by the banking law to act as portfolio manager. The minimumcapital is set at 50,000 pesos and managers are subject to the "fit and proper" test.Managing companies can create several funds, but they must raise their minimum capitalby 25 percent for every additional fund and they must ensure the financial independence ofeach fund. All securities in which assets are invested must be deposited with a custodiancompany, an authorized financial entity, based in Argentina, chartered as a corporationand with a minimum capital of 100,000 pesos.

3.154 Funds must deliver a prospectus to all investors. This should include, inter alia, adetailed description of the different types of investments to be carried out by the fund, theterms and conditions for the subscription and redemption of quotas, and the limits onmanagement expenses, commissions and fees charged by the managing and custodiancompanies. Each fund must be registered with the CNV and any changes in rules need tobe approved by its shareholders and to be duly registered. Mutual funds must publishvarious regular reports as part of their disclosure obligations. These include daily reportson the value and total number of units issued, monthly reports on the composition ofinvestment portfolios, quarterly profit and loss statements, and annual balance sheet andprofit and loss statements.

3.155 Although each mutual fund is free to determine its investment policies, there aresome general limits that are applied by law. These stipulate that no investments can bemade in bearer securities issued by the managing and custodian companies or in quotas ofother mutual funds. However, mutual funds may acquire up to 2 percent of thecontrolling stock of the managing or custodian companies. Investments in shares, debt orconvertible securities cannot exceed 10 percent of the securities of a single issuer. Limitsrelating to the total assets of a mutual fund stipulate that no more than 30 percent can beinvested in a single security issued by the Argentine state, no more than 20 percent inbearer securities issued by a single company or group of companies, and no more than 10percent in fixed term deposits with authorized banks. Moreover, 75 percent of assetsmust be invested in securities issued by Mercosur entities (governments, banks andcorporations). This limits investments in non-Mercosur securities to 25 percent of assets,a requirement that prevents the emergence of mutual funds specializing in US, European,or East Asian securities.

3.156 Policy Issues. The main policy issues facing the mutual fund industry cover thefollowing: improved investor education; greater transparency, especially of fees andexpenses; relaxation of some unduly restrictive rules; and expanding the scope of mutualfunds. These changes will help stimulate the development of mutual funds, although theirfuture prospects will also depend on changes in securities and pension fund regulation aswell as in market developments, such as for instance a decline in the level of interest ratesthat will likely boost demand for equity funds.

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3.157 Improved Investor Education. Mutual funds allow small investors to benefitfrom professional fund management and diversification of investments. But like otherfinancial institutions, they require a robust regulatory framework to protect small investorsfrom potential theft and misuse of funds as well as other practices that benefit fundmanagers at the expense of investors. Mutual funds, although long standing, have becomeimportant financial institutions only in recent years. The industry is evolving and manyissues, such as the proliferation of funds and fund managers, the use of "incubator" funds,and the underdevelopment of index funds, have yet to find a satisfactory resolution even inadvanced countries.

3.158 Registration, custody, and disclosure can go a long way toward tackling many ofthe above problems, but they need to be supplemented with more intensive efforts atinvestor education. This would aim to encourage greater sophistication and discriminationamong small investors and greater reliance on "buyer beware" approach. This could becombined with the "prudent person" rule that emphasizes fiduciary duty on the part offund managers to address those issues that are not amenable to strict and watertightregulation.

3.159 Greater Transparency. The current regulatory framework requires a significantamount of disclosure of all material information covering the operations of a mutual fund.In addition to the prospectus, this includes reports on daily values and total numbler ofunits plus less frequent reports on asset composition and financial results. Daily availabledata now include the performance of a fund over the last day, month and year as well asthe 3-year and 5-year peiformance, a ranking of the fund against other funds of the sameclass, the total assets of the fund and its market share of the particular class of fuinds.

3.160 What is lacking from these data is an indication of the fees and expenses of eachfund, the trading volumes and turnover, and its volatility. Publishing expenses on aregular basis may provide a strong stimulus for the development of index funds, whichadopt a passive investment management policy and often have low volumes of trading.The Association of Mutual Funds is playing a very useful role in making available dailydata on fund performance but it could expand its role by adding information onmanagement expenses and risk profiles.

3.161 Relaxation of Unduly Restrictive Rules. Mutual funds are subject to someunduly restrictive rules. These include the minimum investment requirement of 75 percentof assets in Mercosur securities and a I percent limit of the capital of an investee companyfor their individual holdings of equities--in contrast to 2.5 percent for pension funds.

3.162 Both of these rules could be relaxed. Removing the first rule would allow thecreation of mutual funds specializing in US, Canadian or Chilean companies or in differentsectors of economic activity but on a global basis. This would allow mutual fundsoperated by international banking groups to diversify internationally and it would alsoencourage nonbank-based international fund management companies, such as Fidelity andVanguard, to create Argentine funds linked to their global master funds. Their presence in

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the local market would bring the benefits of consolidation and international diversificationthat are already evident in the banking and insurance sectors.

3.163 Relaxing the second rule would allow mutual funds to expand their equityinvestments in Argentine companies and would put them on a par with pension funds.

3.164 Expanding the Scope of Mutual Funds. Argentine mutual funds also call forgreater flexibility in offering new products, including permission to incur leverage, to offerguaranteed return products, and to launch "funds of funds". Removing these regulationsmay be premature at this stage, although in the longer run, it will bring mutual fundregulation in Argentina more in line with prevailing practice in OECD countries. Inparticular, permitting the operation of "funds of funds" will allow local fund managers tointegrate their operations with global funds, saving on investment management fees andmaximizing the utilization of local distribution networks.

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Appendix A.Components of the CAMELOT Ratings for Banking System Regulation.'

CapitalCountry Definition Minimum Ranking

RatioSingapore Only Tier I eligible 12 1Argentina Capital ratio geared to CAMEL rating and interest rates; capital 11.5 1

req. for market risk added, with bonds of duration over 2.5 yearsrequiring higher capital

Hong Kong 70% of revaluation reserves eligible for inclusion. Minimum can 8 3be raised up to 12% for licensed banks, 16% for restricted licenseor deposit-taking company; institutions required to observe a'trigger' 1% above the minimum. Capital requirement for marketrisk as of late-97.

Chile Only LT sub debt, up to 20% of capital; risk weight for mortgages 8 5above Basle nonn.

Brazil Reval. reserves, loss reserves, included tier 2 8 7Peru No revaluation accounts, sub. debt permitted; min. capital ratio 8 5

raised by 150-200% for overdue loans.Malaysia Only tier I in 8% 8 5Colombia 150 % risk weight for loans, only 50% of revaluation assets. 9 3Korea Up to 45% of revaluation gains included in tier 2 capital 8 7Philippines No tier 2, unweighted (all at 100%/o) 10 .4Thailand Tier 2 includes revaluation accounts, provisions, unrealized 8.5 7

securities profit/loss, subordinated debtIndonesia Sub. debt up to 50%, 8 7

Loan ClassificationCountry Days to NPL Min. initial Comments Ranking

status provision*Singapore sub. risk loan value- 6

.8*collateral (50%mill.)

Argentina 90 25% 1% provision on 4nonral loans,Max. single, 15%

Hong Kong 180 no general rule Max. single, 25% 9Chile 30/90 600/ofn.a. IBrazil 60 100 3Peru 60/90 50-60% 2Malaysia 180 0/1% gen. provisions 9Colombia 90 50% 4Korea 180 20% 9Philippines sub. risk 25% 6Thailand 360 15% 11Indonesia 90 10% 8* On unsecured balances.

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Management (Foreign Ownership)Country % of assets in Rank

foreign banksSingapore 61.6 2Argentina 42.9 3Hong Kong 65.6 1Chile 33.1 4Brazil 316 4Peru 28.0 6Malaysia 14.6 8Colombia 5.3 11Korea 8.0 10Philippines 15.0 7Thailand 1.8 12Indonesia 10.8 9

LiquidityCountry Ratio(s) Forex Remuneration RankingSingapore 24% Watched closely 5Argentina 20% oni liabilities up to 89 Watched closely Mostly 4

days, 15% for 90-179, 10% for remunierated,180-365; and 0 for over 365 half offshoredays. Approx. 9.7% additionalas Repos.

Hong Kong 25% of liabilities Watched closely Mostly 2reemunerated

Chile 9% on demand, 3.6% on time 8Brazil 78/15/20 3Peru 9% 36% added Mostly dollar I

required deposits, so45%

Malaysia 13.5% No restrictions 8Colombia 21%,10% 6Korea 5% oni demand, 2% on time 11P-hilippines 13% 7Thailand 7% 8Indonesia 3% 12

Note that in ranking for operating environment, those with a "I" on property rights, get ranked first (hencea 4-way tie); those with a 2.5 get a 5 (2-way tie), and those with a 2 come next, etc. Creditors' rights areranked in the same manner (except that ratings range from a low of -2 to a higlh of 1, and enforcement ofthe legal system is ranked linearly from the higlh of Sinigapore to the low of the Philippines.

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Operating EnvironmentCountry Property Creditor Enforcement"* Ranking

Rights* Rights"*Singapore I 1 8.715 1Argentina 2 -I 5.13 7Hong Kong I 1 8.52 2Chile I -1 6.91 5Brazil 3+ -2 6.31 8Peru 3 -2 3.59 11Malaysia 2 1 7.105 3Colombia 3 -2 4.55 10Korea I 1 6.97 3Philippines 2 -2 3.765 11Thailand 2.5 1 6.91 6Indonesia 2.5 1 5.035 8* 1998 Index of Economic Freedom..** Levine (1997) and La Porta, Lopez de Silanes, SWleifer and Visluny (1997).

For transparency, those countries requiring banks to be rated get a 1, those without this requirement get a 0;the number of top 10 banks and the comrptioni measure are ranked as above, and rankings then totaled inthe same manner, with the lowest score getting a first place, etc.

TransparencyCountry Bank Rating Top 10 Banks with Corruption*' Ranking

Required* Int'l Ratings*Singapore No All 8.22 1Argentina Yes 10 6.02 2Hong Kong No 3 8.52 4Chile Yes, 2 10 5.3 2Brazil No 9 6.32 5Peru Yes 6 4.7 10Malaysia No 2 7.38 8Colombia No 5 5.0 10Korea No 10 5.3 5Philippines No 8 2.92 12Thailand No 9 5.18 7Indonesia No 10 2.15 8*BIS Annual Report, 1997, and World Bank data** Laporta, et. al

i In addition to various national sources and those noted following various tables, sources included: JPMorgan (1997), Ramos (1997), Hong Kong Monetary Authority (1997) and IMF (1997).

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