LATAM liberalisation: Does financial freedom lead to growth?

Article based on research by Alejandro Santana

Removing government intervention from financial markets has long been considered a relevant tool to stimulate the economy. But a study of 16 Latin American countries by Esade’s Alejandro Santana has found that the so-called financial liberalisation does not result in a positive relationship between financial development and economic growth.

The study, which examines the effects of banking crises and financial liberalisation over the period 1973-2005, found that emerging and recurring banking crises not only prevented economic growth, but the financial liberalisation process itself actually generated banking crises, especially in developing countries.

“The influence of financial liberalisation has proved to be a controversial issue in the research on the relationship between financial development and economic growth, particularly in developing countries,” explains Santana.

The study shows that emerging and recurring banking crises not only prevented economic growth, but the financial liberalisation process itself actually generated banking crises

“Latin American countries experienced both a significant liberalisation of their financial systems and the banking crises from 1970 to 2000. At the beginning of the 1990s, most Latin American countries implemented a new strategy of financial liberalisation to expand and enhance the scope and depth of their financial systems and promote diversification and growth. However, deregulation and the resulting financial policies applied in the 1990s contributed to the emergence of new banking crises, such as the ones in Mexico in 1994 and Argentina in 2002, and severe capital account reversals in Brazil in 1998.”

Brazil banking

The role of reforms

The results from the sample studied by Santana bring into question the theoretical approaches that support the positive effect of financial development and liberalisation in developing countries. Reforms aimed at opening up the financial system play a relevant role in fostering economic growth, he acknowledges. “But financial liberalisation does not contribute to promoting a positive relationship between financial development and economic growth.

“On the contrary, the evidence supports the theory that liberalisation of the banking process generates excessive risk-taking and leads to recurrent banking crises.”

Liberalisation of the banking process generates excessive risk-taking and leads to recurrent banking crises

Two important features which explain this negative effect are credit boom and bust cycles. A consequence of optimistic expectations regarding the financial liberalisation process, reforms contributed to deteriorations in lending standards. And, because financial liberalisation eliminated legal restrictions and prompted a reduction in screenings by banks, insolvency risks remained high.

“Three important examples of this were Chile in 1983, Mexico in 1994, and Colombia in 1999,” says Santana. “Another was Bolivia, which suffered episodes of hyperinflation in 1986, resulting in a banking crisis. In these countries, financial liberalisation promoted enormous quantities of credit for the private sector with no adequate and effective prudential regulatory framework to avoid the accumulation of non-performance loans and de-capitalisation of banks in the region.”

Bolivia
Bolivia suffered episodes of hyperinflation in 1986, resulting in a banking crisis (Photo: R.M. Nunes/Getty)

Banking fragility

The financial liberalisation process focused on systemic risk management and gave priority to the achievement of financial stability, rather than efficiency and wide access to financial products and services for all people.

“This means that financial liberalisation did not improve the efficiency of credit allocation or availability of diverse financial products and services in the Latin American countries,” says Santana. “This situation contributed to the emergence of banking crises, which provoked a constraint in the demand for private credit. In that sense, the findings of this research suggest that the financial systems in Latin American countries displayed what can be termed banking fragility.”

The result, he explains, is that policies implemented by Latin American countries to achieve financial stability and avoid banking crises did not have the desired results. The financial development process was implemented without sound or adequate legal regulations to promote efficiency, making countries more, rather than less, vulnerable to banking crises.

Policies implemented by Latin American countries to achieve financial stability and avoid banking crises did not have the desired results

“It may be argued that the market view paradigm motivated Latin American banks to behave in an imprudent manner,” says Santana. “They were not concerned with applying effective mechanisms to control insolvency risks and regulatory and supervisory frameworks were not effective.”

Good governance for growth

Santana’s research demonstrates that Latin America has never fully recovered from past banking crises – a situation which affects financial development and restricts its positive effect on economic growth. Policy reforms to open up the financial system did not focus on avoiding insolvency risks and improving the efficiency of the banking sector to foster market discipline.

“What’s more,” he adds, “they confirm that effective financial liberalisation in developing countries requires the inclusion of reforms to improve the efficiency of banks, the implementation of effective mechanisms to eliminate insolvency risks and to promote good banking practices. It is not sufficient to focus on the stability of the banking sector.”

Given the relevant role that financial development can play in the economy, he concludes, it would be appropriate to establish prudential and supervisory regulations to promote effective good banking practices and reduce vulnerabilities in the banking sector.

“It’s important to focus future research on institutional arrangements related to insolvency procedures, bankruptcy regulation, and risk-based supervision. These banking governance issues would shed light on the relationship between financial development and economic growth and foster good banking practices and sound institutions, which create an environment that promotes economic growth.”

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