DF201|Question 3|Chile 73-83

#3. Can the widespread 'financial distress' among banks in the 1980s be explained satisfactorily by 'market failure' within the banking sector? Discuss with respect to Chile or Argentina.

First we need to look at the Financial Distress and "Market Failures" as opposed to Financial Distress arising from the business cycle. This identifies 'market failures' arising within the credit market itself which can be described as a microeconomic approach.

In the Stiglitz-Weiss model, very high interest rates increased the perceived riskiness of returns on loans, reducing expected returns for banks and inhibiting lending at very high rates. This produced an optimum interest rate below the maximum possible.

Credit rationing would avoid the market failures of moral hazard and of adverse selection to banks perceived as less risky.

...there may be circumstances where interest rates for some reason rise above the banks' optimum rate and, at these very hight interest rates, no new equilibrium rate can be found.

'Perverse' Credit Allocation and Loan Concentration
Credit rationing that occurs at very high interest rates creates a perversion by lending to existing borrowers that already have non-performing loans-which then is defined as a 'mis-allocation' of credit allocation. The banks may be afraid that the lender may go bankrupt and thus may lose any chance of getting their principle back.

It results in a phenomenon known as 'loan concentration' among existing borrowers, which goes against the principle of risk diversification. The 'market failure' in question is that of adverse selection, as the mix of borrowers becomes worse at high interest rates.

Business may also create moral hazards by allocating new funds for highly speculative (gambling) investments based on need to create even hight rates of return to pay back the initial loan as well as the secondary, and all in a way to avoid bankruptcy. Prisoners dilemma.

Lastly, the increased perceptions of the riskiness of investments brought about by the difficulties of existing borrowers cold cause the banks to over-estimate the riskiness of projects of prospective new clients who approach them for a loan. This again increase loan concentration and denies credit to some 'worthy' loan applications.

It seems that this implies that banks are judging the macroeconomics of the economy based on a very small sample of their clients.

These kinds of market failures can be exacerbated by the 'interlocking' ownership of directorships of banks and the productive enterprises that borrow from them. If there are special links or relationships which lead banks to favour certain borrowers, both adverse selection and moral hazard are likely to increase in difficult times.

Before discussing the question with regard to Chile let me briefly cover the 'financial distress' arising from the Business Cycles and Money Supply.
The Business Cycles can easily be described as 'self-perpetuating philosophies'. If the business climate is good then everyone assumes that it will continue forever. Unfortunately there are not enough bears in the market when things are good and not enough Bulls when things are bad. This ingrained beliefs creates expectations that overshoot the long term full employment or industrial capacity equilibrium.

Financial Distress and Money Supply

If the monetary authorities tighten the money supply too much, banks run short of the necessary reserves and have to sell of their assets in order to boost their reserve positions.
...
...financial distress in the 1980s was not associated with monetary contraction.

Distress Borrowing

Many of the symptons fo financial distress point to 'distress borrowing', that is, an inelastic credit demand from borrowers attempting to stay liquid though unable to service existing loans. Such borrowing is also known as 'artificial' or 'false' credit demand because the demand does not relate to new economic activity.
...
"The signs for the interest rate and inflation coefficients are the oppposite of what would normally be expected: the estimated coefficients for loans rises in real terms when the real cost of credit goes up.

4 Financial Liberalisation Policy and Financial Distress (Unit 3 Page 18-19)***

You may be puzzled by the fact that the World Bank reading here appears to blame both financially repressive policies, such as selective directed credits to priority sectors, and also financial liberalisation policy.

5.2 Oligopoly and a Bank Holding Company Structure in Chile
From Galbis paper:

The Chilean experience is especially revealing because of the purity of the deregulation model that was followed and the rather serious difficulties that the system generated in the course of time. The Chilean financial reform was initiated in May 1974 with a view to freeing all interest rates, denationalizing the banks, and opening the financial system to competition by foreign institutions. Simultaneously, the authorities focused their policies on pursuing basic stabilization objectives-the reduction of inflation and the achievement of balance of payments equilibrium-starting from an initial position of hyper-inflation (around 500 per cent) and entrenched inflationary expectations.

For a long period of time, the achievements of these policies appeared to be considerable. Since interest rates were freed in 1975, deposit interest rates stayed at highly positive real levels, facilitating thereby a rapid real growth of the financial sector. Previously nationalized banks were quickly returned to private ownership and control and in order to moderate their market power, were increasingly subject to a degree of competition from foreign banks. At the same time, with the reduction in the rate of growth of domestic credit and inflation (from over 500 percent in 1975 to 29 percent in 1979) it became possible to eventually fix the exchange rate with respect to the U.S. dollar in July 1979, thereby making growth of monetary aggregates endogenously determined by money demand responses. In this connection, the authorities also began to remove capital inflow controls in order to integrate the domestic financial market with external markets and increase domestic competition.

Paradoxically, measures designed to increase competition in financial markets had only limited effect on reducing the high interest rate levels and spreads prevailing in the Chilean domestic financial markets. With the benefit of hindsight, it appears that the restoration of the bank holding company structure that resulted from the de-nationalization policies, together with the unbounded pressures of domestic and foreign competition, created an unrestrained drive on the part of the groups for market shares in order to finance the group's projects. The maintenance of abnormally high real interest rates contributed to the eventual illiquidity and bankruptcy of large segments of the Chilean business sector. With widespread bankruptcy in the business sector component of the bank holding companies, bad and doubtful loans and arrear accumulated in the financial sector, and created an unprecedented financial sector crisis (1982.83). A number of banks and other institutions had to be liquidated and the remaining ones had to be supported with central bank funds.

The collapse of the Chilean economy was also participated by rapid real wage increases and the overvaluation of the peso. However, it is important to realize that these macroeconomic disturbances which contributed to the deteriorating position of the nonfinancial firms, should have led, under competitive conditions, to a decline in the demand for the credit on the part of the firms, and also to a more selective approach in the supply of credit by financial institutions, because of the higher risks involved in lending during a cyclical downturn. In these circumstances, the rate of interest should have tended to decrease especially after the authorities abolished all capital inflow restrictions, a measure which was directly intended to increase the supply of credit and thus to reduce the domestic rates of interest to the international level. Finally, it is possible that, despite the success already achieved in reducing inflation to a very low level and the maintenance of extremely tight fiscal and monetary policies, market participants might have continued to hold relatively high inflationary expectations in relation to actual inflation during the post-1980 period, just as they had during the period until 1980, But, as Mathieson has pointed out, this behavior was only consistent with an interest-inelastic demand for bank loans on the part of nonfinacial sector portfolio owners and a relatively slow adjustment on the part of banks towards increasing the real supply of bank loans. In turn, these characteristics of the credit market are consistent with the pressure generated by the bank holding company groups to attract aggressively financial resources to finance nonfinancial firms of their respective groups.

Some more important considerations are "Insider Transactions" and "Interlocking Directorates".

The conclusion that the problem of financial repression in LDCs (or alternatively instability) would not necessarily go away by lifting existing regulation means that different and better regulations, unleashing new market forces must be relied upon to achieve needed corrections. Banking concentration and the bank holding company structure are realities which, however unsettling, cannot easily be altered. Indeed, the attempt to a free market policy by eliminating those structural obstacles to market competition would involve the seeming contradiction of attempting to free markets by means of more policy decisions and regulations. Of course the nature of these regulations would be of the market-making type as against the market-destroying type.

References:
"Stabilization with Liberalization: an Evaluation of Ten Years of Chile's Experiment with Free Market Policies, 1973-1983" Sebastian Edwards (PDF)

Galbis, V. (1986) 'Financial Sector Liberalisation under Oligopolistic Conditions and with a Bank Holding Company Structure', Savings and Development, Vol X No. 2

The World Bank 1993 The East Asian Miracle

The World Bank (1989) 'Financial Systems in Distress', World Bank Development Report, Ch 7 pp 70-83.

[url=http://www-wds.worldbank.org/external/default/main?pagePK=64193027&piPK=64187937&theSitePK=523679&menuPK=64187510&searchMenuPK=64187283&theSitePK=523679&entityID=000009265_3961214175618&searchMenuPK=64187283&theSitePK=523679]Bank restructuring : lessons from the 1980s-World Bank[/url]