Sound Banks for Healthy Economies: A CGD-IDB Report Four Months Later

January 25, 2021


September 14, 2020

Last fall, CGD and the Inter-American Development Bank (IDB) launched a report by the joint Sound Banks for Healthy Economies working group. The report—chaired by Liliana Rojas-Suarez, director of the Latin America Initiative and senior fellow at CGD, and Andrew Powell, principal advisor at the IDB research department—sets out recommendations for Latin America policymakers on actions to foster a sustainable recovery and ensure financial stability in the wake of COVID-19. Since its release, the report’s analysis and recommendations have been featured at several virtual events. We round up highlights from two of those discussions here, organized by common themes that ran through the events. (The report was also presented in Chile and Honduras and in a private meeting at the IDB.)

Financial systems in the region are sound but threatened

Liliana Rojas-Suarez and Andrew Powell introduced the report and its findings at an event in mid-September, where they were joined by Alexandre Tombini (chief representative for the Americas at the Bank for International Settlement), Alberto Carrasquilla (Colombia’s finance minister), Eric Parrado (IDB’s chief economist), and Masood Ahmed (CGD president). All agreed that despite significant progress in banking regulations in the region—many countries were adopting Basel III standards and banks were well capitalized before the pandemic hit—the COVID-19 crisis poses an enormous challenge for Latin American financial systems. Alberto Carrasquilla stressed that policymakers face multiple tradeoffs due to fiscal space limitations and the need for decisive action. However, he noted that, while dealing with unprecedented uncertainty, the region has been proactive and “homogenously anticyclical.”

The large increase of households’ and firms’ credit risks, related to the enormous loss of income caused by the COVID-19 crisis, was discussed at the CGD event and two weeks later at the Latin American Reserve Fund’s (FLAR) Annual Conference of Economic Studies, where Liliana Rojas Suarez joined World Bank chief economist Carmen Reinhart as guest speaker. The latest World Economic Outlook (October 2020) projects an 8.1 percent recession for the region in 2020—the largest contraction in the developing world by a margin of 3.5 percentage points. The recovery will be slow and uneven—it will take several years to recuperate the pre-COVID income levels and both poverty levels and inequality are expected to rise. These dire prospects, compounded by the pre-COVID high levels of foreign currency denominated debt, could result in a credit crunch, which Carmen Reinhart explained occurs when households and firms do not want to take on more debt, and banks, realizing the weaknesses of their portfolio related to rising credit risks and ratios of nonperforming loans, reduce credit supply. Credit crunches create a vicious cycle where the lack of credit hinders the economic recovery, and the lack of a recovery causes a deeper credit crunch.

As Liliana Rojas-Suarez noted during the FLAR event, inadequate policy responses also threaten financial system stability, with Chile and Peru offering two examples. She explained that the Peruvian congress’ decision to allow significant pension fund withdrawals—without a clear plan to compensate for this—could harm the country’s pension system. In Chile, policy proposals to erase information about defaults from credit bureaus—entities that help to promote financial inclusion by efficiently compiling borrower information—may be counterproductive by weakening pension systems and reducing financial inclusion and credit supply.

Making financial policies effective and ensuring stability

Even adequate policies that aim at mitigating the economic impact of the crisis on households and firms and expanding credit can have unintended effects, as Liliana Rojas-Suarez and Andrew Powell highlighted in their comments at the report’s launch.

Most countries have implemented guarantee programs, but their uptake has been modest because the guarantees are partial. Of course, if the guarantee were 100 percent, banks would have no incentive to evaluate risks, and the fiscal cost and risk for the government could be very high. So, how can policymakers ensure that firms and households receive the necessary credit to overcome this crisis? Drawing on the working group’s findings, Andrew Powell argued that guarantees should be directed to medium-sized solvent firms that are not over-indebted. For smaller and informal firms, grants may be more effective, and for larger firms, equity instruments may be the way to go (when there is good public governance and with potential assistance from private sector arms of multilateral organizations). Adequate targeting is crucial to ensure policies’ success and minimize their risks.

Allowing or enforcing the postponement of loan payments through loan moratoria offers necessary liquidity relief but might also conceal important information about the financial situation of borrowers. Banks and supervisors need to assess which companies are solvent and which are not to properly evaluate risks. Moratoria have now lasted over six months in many countries and, as Liliana Rojas-Suarez discussed, the lack of information about the quality of banks’ loan portfolio may exacerbate the already complex challenges that financial systems and regulators are confronting.

More broadly, the region also needs to protect the independence of key institutions. In the last two decades, appropriate monetary and macroprudential policies have been associated with a higher independence of central banks and supervisory bodies. Facing extreme challenges, governments may be tempted to interfere in the operations of these institutions, but, as Alexandre Tombini of the Bank for International Settlements stressed at the report’s launch, both “de jure” and “de facto” independence must be preserved. While inflation and inflation expectations remain generally subdued, central banks need to maintain credibility to be able to raise interest rates and control inflation expectations if these were to increase in the near future.

Reasons for optimism

At the different events where the CGD-IBD report was featured, participants agreed that even in the midst of the current crisis, there are opportunities that may offer grounds for optimism.

First, in countries like Chile, Colombia, Dominican Republic, Panama, Paraguay, and Uruguay, innovative measures that could foster financial inclusion are being implemented. Some of these countries have used digital methods (mobile banking and e-wallets) to make monetary transfers to vulnerable populations, while others have used ID cards as a delivery method. Latin America still lags significantly behind in terms of financial inclusion and these programs can be an initial step towards further inclusiveness. Moreover, a broader use of financial services would strengthen the underdeveloped domestic financial markets, decreasing their external dependence. As IDB chief economist Eric Parrado explained, this crisis may serve as a “wake-up call” for the region about the importance of financial inclusion and digital infrastructure.

Second, as Colombian finance minister Alberto Carrasquilla argued, “firm-based initiatives” offer an opportunity for policymakers in the region to tackle informality. Measures like stipends to assist with the payment of salaries can serve as “a strong incentives for viable, yet informal, firms to quickly formalize.” To the extent that these policies support a move towards formality, they will also help previously informal firms to establish strong financial relations with banks. This would be an innovative way of addressing another key issue for the region, where informality is extremely high.

In coming months, it will be essential to continue monitoring financial systems’ fragilities and analyzing the policies that are being adopted to effectively fight this crisis and prevent a financial downturn. Stay tuned for more work from CGD on Latin America by subscribing to our newsletter here!


CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.

Image credit for social media/web: IMF Photo/Joaquin Sarmiento