WPS3963

                    FINANCIAL DEVELOPMENT IN LATIN AMERICA:

                 BIG EMERGING ISSUES, LIMITED POLICY ANSWERS


                                           Augusto de la Torre
                                            Juan Carlos Gozzi
                                          Sergio L. Schmukler


                                                  Abstract

This paper argues that the dominant policy paradigm on financial development is
increasingly insufficient to address big emerging issues that are particularly relevant for
financial systems in Latin America. This paradigm was shaped over the past decades by a
fundamental shift in thinking toward market-based financial development and a complex
process of financial crises interpretation. The result has been a richly textured policy
paradigm focused on promoting financial stability and the convergence to international
standards. We argue, however, that there is a growing dissonance between the current
paradigm and the emerging issues, which we illustrate by discussing challenges in three
areas: stock markets, SME loans, and defined-contribution pension funds. We conclude
that the dominant policy paradigm is ill-suited to provide significant guidance vis-à-vis
the big emerging issues. We emphasize the need to take a fresh look at the evidence,
improve the diagnoses, revisit expectations, and revise the paradigm.

JEL classification codes: G15; G18; G20
Keywords: capital market development; financial stability; financial crises; emerging
markets; financial sector reform; financial globalization; access to finance; Latin
American finance



World Bank Policy Research Working Paper 3963, July 2006

The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the
exchange of ideas about development issues. An objective of the series is to get the findings out quickly,
even if the presentations are less than fully polished. The papers carry the names of the authors and should
be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely
those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors,
or the countries they represent. Policy Research Working Papers are available online at
http://econ.worldbank.org.


 Authors are with the World Bank. This paper is based on a presentation made at the Conference "Una
Nueva Agenda de Desarrollo Económico para América Latina," organized by CIDOB and held in
Salamanca, Spain on October 7-8, 2005. We are grateful to conference participants for helpful comments.
Email addresses: adelatorre@worldbank.org, jgozzi@worldbank.org, and sschmukler@worldbank.org.

1.      Introduction

        Imagine a safe and responsible driver going down an unknown highway in a foreign
country who suddenly realizes that she brought along the wrong set of roadmaps. The mix of
frustration and disorientation that she experiences is not unlike that felt by many
policymakers concerned with financial development in Latin America. This paper discusses
such an odd situation. Its main thesis is that the current paradigm for policy thinking on
financial development in the region, while sharpened through remarkable theoretical and
empirical work and rich lessons from experience, is increasingly insufficient to address many
of the big emerging issues and challenges. Like the perplexed driver in our example, the
problem is not that we lack maps, do not know the basic traffic rules, or are driving
irresponsibly. It is not even a problem of not understanding how we got to where we are or
of not knowing where we want to go. The problem is thinking that the "roadmaps" or
intellectual tenets that dominate current policy thinking on financial development are
sufficient for all roads and can help us get where we want to go.               Such tenets and
prescriptions are of course useful and, in many respects, essential. They should not be
thrown away, lest we get lost even in what we consider to be familiar terrain. However, they
are of limited assistance for some of the highways and secondary roads that we have to travel
to reach our destination and for the new roads that will have to be built along the way.

        In this paper, we present, in a stylized fashion, the salient features of the current state
of policy thinking on financial development in Latin America. We argue that such policy
thinking is generally focused on ensuring financial stability (reducing systemic risk) and
improving the enabling environment for financial contracting. This has led to some specific,
operational prescriptions that tend to be dominated by financial stability concerns, focus
intensively on the links between the monetary and financial sectors, and aim at promoting
convergence towards the "best practices" codified in a multiplicity of international standards
and codes.

        We then discuss the main drivers behind the evolution of policy thinking on financial
development in Latin America over the last two decades or so. We argue that these drivers
are (i) an enduring paradigm shift towards market-based development and (ii) an arduous
process of interpreting and reinterpreting financial crises. We illustrate how these drivers
have operated and interacted, creating the richly textured policy paradigm of today.

        To see how the dominant policy paradigm fits into the realities of Latin American
countries, we discuss some of the big emerging issues in financial markets in these
economies. We argue that these issues are, on the one hand, acquiring a high-priority status
among the concerns of policymakers and, on the other, increasingly defying the main tenets
of the current policy paradigm and associated toolkit. In particular, the emerging issues have
much less to do with financial stability and the degree of convergence towards international
standards and codes, and much more with difficulties in completing financial markets in
small economies in the context of financial globalization. To illustrate this basic argument,
we characterize--admittedly using broad brush strokes and being very selective--some of
the emerging issues in equity markets, SME (small and medium enterprises) finance, and
defined-contribution pension funds.



                                                1

         Before moving forward, it is worth clarifying two points on the scope of this paper.
First, although we focus on Latin America, our analysis applies to many developing
countries, especially to those that are usually referred to as emerging markets. Some of the
topics are even relevant for developed economies.              But applying our analyses and
conclusions to countries in other regions requires care and taking into account the intrinsic
features of the local institutional environment, as well as the specific problems and
challenges faced by the financial system in each country. Second, the focus of this paper is
on issues related to domestic policies--i.e., those policies under the control of local
authorities. It thus leaves out the interesting and important field of cooperative multilateral
policies aimed at improving directly the international financial architecture for all countries.1

         The rest of the paper is structured as follows. Section 2 describes the main features of
the current policy paradigm on financial development in Latin America. Section 3 discusses
the main drivers behind the evolution of policy thinking on financial development. Section 4
discusses the selected big emerging issues in financial markets that are increasingly
challenging the dominant paradigm. Section 5 concludes with some final reflections.

2.       Policy Thinking on Financial Development: Where We Stand

         Current policy thinking on financial development in Latin America rests on two key
tenets. The first is that financial markets, when allowed to work freely under a sound
regulatory environment, provide the best mechanism for efficiently mobilizing resources
from savers to consumers and investors, as well as for allocating risks to those that are best
suited to bear them. This tenet highlights the critical function of relative prices under
competition--to capture and signal relative scarcities and relative risks so as to adequately
guide, as if through an invisible hand, myriads of decentralized self-interested decisions
towards the collective good. This first tenet does not, of course, ignore the potential maladies
of finance--such as asset bubbles, herd behavior, self-fulfilling prophecies, contagion, and
crises. But it contends that these maladies notwithstanding, competitive financial markets are
superior to all known alternatives. In part because of these potential maladies, the current
policy thinking rests on an equally important second tenet--that there is an essential and
well-defined role for the government. Such role is to foster systemic stability through sound
prudential regulations, appropriate accounting and disclosure practices, and supervision, so
as to avert unnecessary financial crises and mitigate their cost if and when they occur, all
without unduly raising moral hazard. The government is also called upon to facilitate
financial market development through the establishment of an adequate institutional and
informational environment for writing and enforcing financial contracts. Jointly, these two
tenets highlight the irreplaceable value added of well-managed and well-regulated financial
entities (like banks, insurance companies, investment banks, asset managers, and broker
dealers) that act as intermediaries through financial products (typically loans, bonds,
deposits, stocks, derivatives, investment funds, and insurance policies), which, in turn,
channel and embody contractually the allocation of resources and risks.


1 A cogent and fairly comprehensive discussion of reform issues concerning the international financial
architecture is found in Eichengreen (1999).



                                                 2

         The policy prescriptions that follow from these two basic tenets are, of course,
innumerable and not static. There are nonetheless a few prescriptions that, in our opinion,
command widespread consensus and delineate the basic profile of the current state of policy
thinking on financial development in Latin America and emerging markets in general. Let us
mention four of them in stark--and, hence, oversimplified--terms.

         A first policy prescription is: strive to converge to international standards and codes.
The underlying conviction is that these standards help identify gaps, set the reform objectives
and priorities, and give direction to the reform effort. A battery of standards has emerged in
the recent period, as part of initiatives to strengthen the international financial architecture in
the wake of the financial crises of the second half of the 1990s. International standards and
codes that are relevant to the functioning of the financial system include, among many others,
the following: Basel Core Principles for Effective Banking Supervision, IOSCO Objectives
and Principles of Securities Regulation, CPSS Core Principles for Systemically Important
Payment Systems, CPSS-IOSCO Recommendations for Securities Clearance and Settlement,
IAIS Core Principles for Insurance Supervision, IMF Code of Good Practices and
Transparency in Monetary and Financial Policy, OECD Principles of Corporate Governance,
Accounting and Auditing Standards, and World Bank Principles and Guidelines for Effective
Insolvency and Creditor Rights Systems.2 Given the proliferation of standards as well as the
intensity of efforts to assess the degree of country observance and implement the associated
recommendations, it is not an exaggeration to say that, under the dominant policy paradigm,
the reform agenda for financial development has become largely equated with convergence
toward international standards.

         A second policy prescription is: cautiously allow the international integration of
domestic financial markets. While there is still vigorous debate on the sequencing and speed
of international financial integration, there is much less disagreement on the general
direction, which favors increased integration, at least for a large set of countries. This is as
expected, given the mentioned basic tenet that markets should be allowed to work
competitively under appropriate regulation.               To be sure, it is recognized that financial
integration has often not worked as initially predicted.3 For many emerging economies, the
benefits of financial globalization--greater opportunities for consumption smoothing,
deepening and diversification of domestic financial markets, noticeable reductions in the cost
of capital--have failed to fully materialize, at least to the extent expected at the beginning of
the liberalization process. Moreover, financial liberalization and globalization have in many
cases exposed these economies to capital flow volatility and financial crises. Faced with this
evidence, the prevailing policy thinking puts the emphasis on the institutional and regulatory
pre-conditions for financial liberalization and on sequencing issues to minimize the risks and
maximize the benefits of financial globalization, rather than advocating closing domestic


2 The International Monetary Fund and World Bank have been entrusted with a leading role in assessing the
degree of observance of international standards and codes.           These assessments are often conducted in
connection with the Financial Sector Assessment Program (FSAP), a fairly thorough diagnosis of a country's
financial system also led by these two institutions, and their results are summarized in the so-called Reports on
the     Observance        of      Standards      and      Codes        (ROSC).           For      details    see
http://www1.worldbank.org/finance/html/fsap.html and http://www.worldbank.org/ifa/rosc.html.
3For a discussion of this issue see De la Torre, Levy Yeyati, and Schmukler (2002) and references therein.



                                                        3

financial markets permanently. Financial isolationism is seen as undesirable and unfeasible
in practice, at least for those economies that are already partially open, given the incessant
changes in information technology and financial product innovation.

         A third policy prescription is: move towards inflation targeting cum exchange rate
flexibility. This prescription reflects a sea of change in recent years.4 It would not have been
the dominant view less than a decade ago. At that time, hard-pegs or dollarization, on the
one hand, and exchange rate flexibility, on the other, were seen as competing, albeit equally
respectable, alternatives open to emerging economies seeking a safe integration into
international capital markets.5 But the view in favor of exchange rate flexibility has come to
dominate policy thinking in the region and for most emerging economies in general (except
of course in the case of the few countries that can be reasonably considered to meet "optimal
currency area" conditions).6 This regime is seen as the best alternative for countries trying to
cope with the perils of financial globalization and capture its benefits. This intellectual
convergence is the consequence of a major contrast between the current and previous waves
of financial globalization. In effect, the current wave of financial globalization is unfolding
in an environment where the major currencies in the "center" float freely against each other,
rendering inadvisable for countries in the "periphery" to peg their currencies unilaterally. By
contrast, the previous wave of financial globalization--from the mid-1800s to 1914--
unfolded under a fixed exchange rate international arrangement, the gold standard, which
was protected jealously and through a strong mutual commitment by the "center," thus
making it safer for the periphery to adopt pegs.7 Note that the prescription to move towards
inflation targeting cum exchange rate flexibility is underpinned by other policy prescriptions
regarding macroeconomic (especially fiscal) and institutional fundamentals (ranging from
central bank independence to the rule of law). There is a strong consensus that without such
fundamentals in place, the benefits of actions focused on the monetary and exchange rate
areas would not endure.

         A fourth policy prescription is: foster the development of local currency debt markets.
This is increasingly seen as a necessary condition to mitigate the vulnerability associated
with un-hedged currency mismatches in debtor balance sheets, a vulnerability that has
brought several financial systems in the region to their knees (e.g., Argentina 2001, Ecuador
1999, Uruguay 2002). This prescription arises partly in response to what is now seen as
excessive pessimism in the "original sin" literature and is linked to the previous prescription
on exchange rate flexibility. The "original sin" literature focuses on the inability of emerging
economy sovereigns and corporates to issue long-term domestic currency-denominated debt.
In its earlier stages, it tended to recommend the adoption of formal dollarization as the
preferred route to overcome the "original sin" and develop domestic financial markets more
safely within a financially globalized context (Calvo and Reinhart, 2002; Eichengreen and

4 Cogent assessments of the conceptual and empirical arguments behind this change can be found, for instance,
in Goldstein (2002), Larraín and Velasco (2001), and Mishkin and Savastano (2001).
5See, for example, Calvo and Reinhart (2002), Eichengreen and Hausmann (1999), Fischer (2001), and Frankel
(1999).
6See Mundell (1961).
7 Bordo, Eichengreen, and Irwin (1999) present a detailed account of the characteristics of the current wave of
financial globalization compared to the one before 1914.



                                                      4

Hausmann, 1999). In light of the collapse of the Argentine "convertibility" system, however,
the "original sin" literature has tended to join the ranks of the proponents of exchange rate
flexibility while advocating a "road to redemption" through the development of the markets
for domestic currency denominated debt, which some argue should be achieved before
completely opening the capital account (Eichengreen and Hausmann, 2002; Eichengreen,
Hausmann, and Panizza, 2005). In all, various strands of thought have converged, so that we
can safely claim that at present there is a broadly shared consensus on the policy prescription
to give priority to the development of local currency debt markets.

         Note that the mentioned policy prescriptions aim at linking appropriately key macro
and microeconomic dimensions of financial development. In one way or another, they seek
to achieve what we have called elsewhere (De la Torre, Levy Yeyati, and Schmukler, 2002)
the "blessed trinity" for safe financial globalization. That trinity consists on the mutually
reinforcing coexistence of: (i) a flexible exchange rate to enable efficient shock absorption;
(ii) a local currency that is intensively used as a store of value for savings (at least at home
and hopefully also abroad), around which financial contracts can be reliably organized; and
(iii) a sound informational, contractual, and regulatory environment where the writing and
enforcement of financial contracts can flourish.

         But, how did we reach the current consensus around these policy prescriptions? What
are the factors behind the evolution of policy thinking on financial development in the
region? Understanding how we got to where we currently stand can help us to better assess
the validity of the dominant policy paradigm and its potential limitations and can also guide
any reformulation of policy thinking. We now turn to these issues.

3.       Policy Thinking on Financial Development: Where We Come From

         The dominant policy paradigm on financial development in Latin America described
in Section 2 is relatively new when seen from a long historical perspective. In effect, it took
form over the past twenty-five years or so. It is, therefore, useful to recount the intellectual
highlights of its historical evolution. We argue in this regard that there have been two key
drivers shaping the recent evolution of policy thinking on financial development in the
region. The first is the paradigm shift towards market-based financial development. The
second is financial crises hermeneutics--i.e., the complex process of interpreting and
reinterpreting crises. Lets us briefly discuss these drivers, their interactions, and implications
for the policy debate.

         The paradigm shift towards market-based financial development was part of a
broader transformation in economic development policy thinking away from the state
dirigisme that had prevailed in Latin America and many other regions during the 1960s and
1970s. In the financial sector, this shift can be interpreted in part as a reaction to what
Ronald McKinnon called, in his influential 1973 book, "financial repression"--i.e., the
underdevelopment and smallness of financial markets resulting from excessive public sector
intervention.8 Accordingly, the main premise of the paradigm shift was that government


8For discussions on the pitfalls of excessive governmental ownership and dirigisme in financial markets see, for
instance, Barth, Caprio, and Levine (2001), Caprio and Honohan (2001), and La Porta, Lopez-de-Silanes, and



                                                      5

interference--through directed credit schemes, credit ceilings, public banks, administered
interest rates, and other tools--is a fountainhead of distortions that repress financial
contracting, cause resources to be misallocated, and lead to unsound risk management by
unduly raising moral hazard. The new paradigm thus called for a move away from state
interventionism and towards regulated laissez-faire in financial markets.

         This paradigm shift led initially to a generic and rather simplistic policy prescription:
liberalize the domestic financial system and the capital account to achieve efficiency via
competition. Policy actions unfolded quickly and liberalization swept throughout the Latin
region starting in the late 1980s and early 1990s, as the systems of directed lending, credit
ceilings, and controlled interest rates were dismantled, and public banks were privatized.9 By
the late 1990s, Latin America had reached levels of financial market liberalization
comparable to those in the developed world (Figure 1).

         This initial prescription was subsequently shaken by the modest results of
liberalization in terms of financial depth and, especially, by the recurrence of financial
crises.10 As a result, policy thinking shifted towards questions regarding the speed and
sequencing of financial liberalization and placed greater emphasis on the enabling
environment--e.g., regulatory institutions, legal frameworks, accounting and disclosure
practices, debtor information systems, market infrastructures, safety nets, creditor rights, and
contract enforcement (Caprio and Hanson, 2001; Caprio and Honohan, 2001; Klapper and
Zaidi, 2005; Rajan and Zingales, 2001).

         Even as policy thinking broadened from a narrow focus on liberalization towards a
multi-dimensional emphasis on institution building, it was all along guided by a quest
towards freeing financial markets and making them work better, both at home and across
borders. In particular, capital accounts continued to open up--as efforts to attract foreign
financial entities and portfolio investors to the local market required allowing greater
freedom for capital and financial services to exit the local market. Later on, the reform
agenda geared at achieving regulated laissez-faire and international financial market
integration was boosted by the program of convergence towards international standards
mentioned above.




Shleifer (2002). A number of studies have also analyzed empirically the impact of financial repression on
economic growth, finding evidence of a negative effect (see, for example, Easterly, 1993; Galindo, Micco, and
Ordoñez, 2002; Roubini and Sala-i-Martin, 1992; and World Bank, 1989).
9 Some Latin American countries (Argentina, Chile, and Uruguay) liberalized their financial systems in the
1970s, but these reforms were reversed in the aftermath of the 1982 debt crisis and financial systems throughout
the region remained repressed during most of the 1980s.
10A pioneering investigation into the linkages between liberalization and financial crises is the classic paper by
Carlos Diaz-Alejandro (1985), cleverly entitled "Good-Bye Financial Repression, Hello Financial Crash." A
number of more recent theoretical papers show that financial liberalization may be associated with crises (see,
for example, Allen and Gale, 2000; Bachetta and van Wincoop, 2000; Calvo and Mendoza, 2000; and
McKinnon and Pill, 1997). Empirically, several papers have found links between financial deregulation, boom-
bust cycles, and banking and balance of payments crises (see, for example, Corsetti, Pesenti, and Roubini, 1999;
Demirguc-Kunt and Detragiache, 1999; Kaminsky and Reinhart, 1999; and Tornell and Westermann, 2005).



                                                      6

        The second driver shaping financial development policy thinking in the region has
been the onslaught of recurring financial crises and, in particular, the policy lessons that
emerged from the hermeneutics of financial crises.11 To illustrate this, we briefly discuss
three major lessons and the associated policy prescriptions that flowed from the process of
interpreting and reinterpreting financial crises.

        First, recurrent crises confirmed that poor macroeconomic fundamentals are
particularly dangerous in open financial systems. This central lesson was conceptually
enshrined in the so-called first generation models of financial crises.12 Krugman's seminal
1979 article on balance of payments crises paved the way in this regard and was followed by
an avalanche of theoretical work that clarified the dynamic processes whereby fundamental
imbalances can set the stage for a sudden attack on the currency or the banking system. This
type of attack is deterministic, in the sense that it anticipates the inevitable (i.e., the
devaluation of the currency or the collapse of the banking system will come with or without
the attack), even if its exact timing is difficult to predict and is not associated with
appreciable changes in fundamentals.13 Subsequent empirical work (e.g., Kaminsky and
Reinhart, 1999) found that a deterioration in fundamentals preceded financial crises in most
countries. This led to efforts to identify early warning indicators that could signal in advance
the probability of a financial crisis and could, thus, allow policymakers to take
countermeasures to avert it.

        In all, a first and enduring lesson of financial crises was that financial openness
dramatically raises the importance of strong liquidity and solvency (fiscal and financial)
positions. The associated policy prescription was thus to avoid bad macro and financial
policies that generate imbalances. In particular, the policy advice was to closely monitor
certain indicators that have been empirically found to precede financial crises--
fiscal/external disequilibria, real exchange rate overvaluation, large amounts of short-term
debt, rapid money printing and accelerating inflation, fast credit growth, and real estate price
bubbles, among others. Such an early detection of problems would have to be followed by
the earnest adoption of preventive actions.

        A second lesson that financial crises drove home was that such phenomena as
multiple equilibria, self-fulfilling attacks, and contagion are not just theoretical curiosities;
they are real threats, especially as domestic financial markets become exposed to large flows
of international capital and to investors that can diversify risk across countries. Again, these
phenomena received significant theoretical attention in the so-called second generation


11Latin America was the region with the highest incidence of banking crises during the 1974-2003 period. The
1990s and early 2000s constituted a particularly turbulent period for the region, with many twin (currency and
banking) crises, including Venezuela 1994, Mexico 1995, Brazil 1999, Ecuador 1999, Argentina 2001, Uruguay
2002, and Dominican Republic 2003. See Caprio and Klingebiel (2003) and IADB (2004).
12A succinct but lucid discussion of models of financial crises is found in Eichengreen (1999).
13In this connection, see also Dooley (2000), who argues that, where there is fear of floating, international
reserves provide a "double guarantee," for bank deposits and the currency, which heightens the country's
vulnerability to runs engineered at a time where there are no perceptible changes in fundamentals by agents that,
to avoid capital losses, anticipate the inevitable.    See also Aghion, Bacchetta, and Banerjee (2001) and
Burnside, Eichenbaum, and Rebelo (2001).



                                                        7

models of financial crises.14 A central message of these models is that the occurrence of a
crisis is subject to indeterminacy, making crisis prediction an inherently elusive undertaking.
To be sure, fundamentals continue to matter in these models too, as self-fulfilling attacks
appear more likely in the case of countries that have already slipped into a zone of high
vulnerability as a result of poor macro and financial fundamentals.15 But whether the crisis
occurs or not will not only depend on the state and trajectory of fundamentals, but on a
complex interplay between market expectations, the government's willingness and capacity
to defend the currency or the banking system in light of its own evaluation of the costs and
benefits of such an action, and the overall degree of macro and financial fragility. For
instance, where the banking system and public finances are weak, the balance between the
potential benefits of mounting a defense (reaffirmed credibility, price stability, avoidance of
adverse balance sheet effects) and the potential costs (high interest rates, rising public debt,
increased moral hazard, economic contraction, and the associated weakening in repayment
capacity among debtors) is difficult to ascertain, with expectations hard to pin down. Such
circumstances create a fertile ground for multiple equilibria, as different constellations of
interest and exchange rates become compatible with the same fundamentals, with the actual
outcome depending on expectations regarding the resolve of the government (and its
multilateral supporters) to put up and prevail in a defensive fight. As a result, speculative
attacks can become self-fulfilling, creating a financial crisis that would not have otherwise
occurred, with the disturbing feature that markets cannot learn from the counterfactual (as the
outcome only validates their expectations).

         In the face of the threats posed by multiple equilibria, self-fulfilling prophecies, and
contagion, policy prescriptions naturally aimed at counteracting financial market
imperfections and avoiding the slide into high-vulnerability zones. The latter objective
further boosted the importance of sound macroeconomic and prudential policies. The former
added a new set of policy implications that emphasized increasing transparency (to reduce
information asymmetries) as well as establishing or strengthening fiscal and financial sector
buffers (so as to compensate for revenue shortfalls in bad times, and to dim bubbles and
cushion bursts in the financial sector). The threat of multiple equilibria also gave sustenance
to prescriptions favoring the undertaking of credible pre-commitments--i.e., policy actions
whereby governments tie their hands in order to minimize time inconsistent behaviors--
which in turn led to the temporary popularity of hard pegs.

         A third lesson from financial crises has been that major mismatches (maturity,
duration, currency) in debtor balance sheets are "ticking bombs." While mismatches were
driving factors in many crises, including the South East Asian crises in the second half of the
1990s, the darkest side of mismatches was best illustrated in Latin America by the
devastating crises in Ecuador (1999) and Argentina (2001). Subsequent work (e.g., Calvo,
Izquierdo, and Mejia, 2004) has found empirical evidence suggesting that liability
dollarization increases the probability of a sudden stop in capital inflows. The case of
Argentina, furthermore, illustrated the deep drawbacks of a rigid currency pre-commitment,

14See, for instance, Obstfeld (1996), Ozcan and Sutherland (1998), and Wyplosz (1998).
15 Second generation models of financial crises do not discard, however, the possibility of pure contagion
leading to a crisis in a country with initially strong fundamentals, which deteriorate vastly and instantaneously
as a result of the crisis.



                                                         8

including the troublesome feature that such pre-commitments exacerbate currency
mismatches.16 The lessons that emerged from these devastating experiences led to important
revisions in policy prescriptions. A salient one was, as noted above, the swing in favor of
exchange rate flexibility to avoid one-sided bets (Goldstein, 2002; Mishkin, 2003) and
discourage liability dollarization (Ize and Levy Yeyati, 2003). Other policy prescriptions
called for reducing those systemic risks that breed mismatches (De la Torre and Schmukler,
2004a); enhancing public debt management to focus on risk, not just costs, and fostering the
development of local currency debt markets (Eichengreen and Hausmann, 2002;
Eichengreen, Hausmann, and Panizza, 2005); and developing prudential regulations
specifically designed to ensure that banks internalize appropriately the risks of lending in
foreign currency to local-currency earners (Ize and Powell, 2004).

         These two factors--the shift in paradigm towards market-based financial
development and the hermeneutics of crises--have interacted in complex ways over the last
decades. This interaction has resulted in heated debates and contrasting opinions but, beyond
their differences, warring parties have usually been united by a strong pro-market orientation.
The love affair with free financial markets has gone through ups and downs, but has not
resulted in divorce. Views on exchange rate policy have been wide ranging and, as noted,
subject to large oscillations, yet focused on reducing risks and maximizing the benefits of
integrating into international financial markets. Vigorous efforts have been made to upgrade
the regulatory and supervisory frameworks, but always trying to enhance the
complementarities between prudential regulation and market discipline. Tense debates have
surrounded the discussion of policies to address financial market imperfections, with some
emphasizing that the main problem to be corrected is moral hazard (due to expectations that
investors will be bailed out by the local government or multilateral agencies) while others
arguing that the main culprit is globalization hazard (the negative externalities of a faulty
international financial architecture, with large exogenous shifts in the returns required by
international investors to hold emerging market assets).17 Similarly, debates have raged
concerning sequencing issues in financial market liberalization, with some advocating
throwing "sands in the wheels" of international integration and postponing it until local
markets and institutions are strong, while others doubting the effectiveness of efforts to block
financial integration and rather emphasizing that liberalization is needed to dislodge
resistance to reform.18 But again, those taking sides in these debates have generally shared a
common desire to ensure that financial markets work properly.



16See, for instance, De la Torre, Levy Yeyati, and Schmukler (2003), who argue that Argentina did not adopt
policies to mitigate currency mismatches because that would have undermined the credibility of the
commitment to the one peso-one dollar peg.      Moreover, fixed exchange rate regimes might induce agents to
underestimate the possibility of future currency changes, leading to excessive foreign exchange borrowing
(Eichengreen, 1994), and might also generate moral hazard in the presence of implicit or explicit bailout
guarantees (Burnside, Eichenbaum, and Rebelo, 2001; McKinnon and Pill, 1998; Schneider and Tornell, 2004).
17See Broner, Lorenzoni, and Schmukler (2004); Calvo (2002); Eichengreen (1999); and Obstfeld (1998).
18Ocampo (2003), Stiglitz (1999, 2000), and Tobin (2000), present renditions of the view that favors
sequencing and even suggest that financial integration should be managed on a permanent basis. For the
contrasting view that emphasizes the role of liberalization in promoting financial reform see, for example, Rajan
and Zingales (2003).



                                                         9

        The paradigm shift towards market-based financial development has endured in large
part because it has constructively internalized the hard lessons from financial crises. This
process, however, has understandably tilted the emphasis of policy thinking in favor of
systemic risk management and consequently priority has been given to the achievement of
financial stability.    To be sure, other dimensions of financial development--efficiency,
depth, diversity, and breadth of access--have not been ignored but they have not occupied
the center stage. The dominant policy paradigm, furthermore, has grown richer to the extent
that it has strived to take into account the crucial role of uncertainty and incentives in markets
characterized by asymmetric information and incomplete contracts. This has balanced the
paradigm's confidence in the power of market competition with a growing emphasis on the
institutional environment. However, the strengthening of institutions has been largely (and
increasingly) seen through the dominant lenses of convergence towards international
standards. The mentioned emergence of numerous international standards and codes, while
initially motivated by financial stability concerns, has in effect provided a basic framework
for policymakers to combine stability and developmental issues in policy formulation. The
centrality of stability concerns and the institutional benchmarks set out by international
standards have driven policy thinking on financial development.              Are they, however,
sufficient to address the emerging, and rather daunting, challenges that Latin financial
markets face going forward? To this question we now turn.

4.      Big Emerging Issues, Limited Policy Answers

        It should be clear from the foregoing discussion that the growth in knowledge that has
underpinned the evolution of policy thinking on financial development in Latin America has
been impressive. For all its richness, however, the dominant policy paradigm is being
increasingly outstripped by some big emerging issues. We do not have a strong view on
whether a paradigm shift will be required to address these issues adequately, or if a flexible
adaptation of the existing paradigm will suffice. In the remainder of this paper, we only
attempt to illustrate few of the many ways in which emerging issues are exposing the limits
of the dominant policy paradigm.

        Before getting to specifics, however, we note that a prima facie indication that
something is wrong or missing in the current policy paradigm is the gap between, on the one
hand, the intensity of financial sector reforms undertaken in Latin America and the
expectations they generated and, on the other, the low level of observed financial
development in the region. This gap is a feature that cuts across the emerging issues
discussed below. We have discussed elsewhere and at length the nature of this gap with
respect to the state of development of Latin American securities markets (De la Torre, Gozzi,
and Schmukler, 2006a; De la Torre and Schmukler, 2004b), showing that these markets,
especially those for private sector securities, score poorly by international comparison and
are below of what can be expected (in terms of commonly used measures of size and
liquidity) after controlling for per capita income, economic size, macroeconomic policies,
indices of legal and institutional development, and reforms.19 The reader is, thus, referred to
that research.


19See also Borensztein, Eichengreen, Panizza (2006).



                                                    10

         For the purposes of this paper, it suffices to put forward a few exhibits. The intensity
of financial sector-related reforms in Latin America is reflected in Figure 1, which makes it
hard to argue that there was a reform shortage in the region. In effect, this figure shows that
Latin countries not only liberalized their financial systems extensively, but also implemented
significant reforms in areas considered key for the adequate functioning of capital markets,
such as custody arrangements, clearing and settlement systems, trading platforms, and insider
trading regulations.        Contrasting the intense reform effort is the comparatively low
development of financial markets in the region, as depicted in Figures 2 to 5. Figure 2
provides a snapshot that displays the depth of domestic financial markets in Latin American
countries compared to those in other emerging economies and developed countries, at year-
end 2004.       Financial depth is measured by credit to the private sector by financial
intermediaries, stock market capitalization, and the amount outstanding of private sector
domestic bonds, all as a percentage of Gross Domestic Product (GDP). As this figure shows,
although there are differences among Latin American countries, most countries in the region
have significantly smaller financial markets than G-7 and East Asian countries. Chile is the
only exception, as the size of its financial markets, especially its stock market, vastly exceeds
that of other Latin American countries and also compares favorably with financial markets in
developed and East Asian countries. However, analyzing measures of actual stock market
activity, such as value traded, shows that Chile's stock market remains underdeveloped
compared to markets in East Asia and developed countries.20 Figures 3, 4, and 5 show the
evolution of these indicators of financial depth over time, comparing the average of the seven
largest Latin economies with that of East Asian and G-7 countries. Again, the pictures of
these time series are disappointing--with Latin America clearly falling behind (i.e.,
diverging) from the comparator trends. The divergence in terms of stock market activity
(both in terms of capitalization and trading) and corporate bonds outstanding (Figures 3 and
4) is even more concerning in light of the virtual stagnation of credit to the private sector in
the region (Figure 5). Indeed, credit to the private sector in Latin countries has hovered
around 30 percent of GPD over the past 25 years, in sharp contrast with raising trends in East
Asian and G-7 countries, where bank credit to the private sector has by now reached levels of
around 76 and 126 percent of GDP, respectively.21

         The question of why Latin America shows such low levels of financial development
by international comparison despite extensive reforms (including rapid market opening and
significant legal and regulatory strengthening) challenges the adequacy of the dominant
policy paradigm. Telling policymakers to "be patient and redouble the reform effort" does
not seem to be a convincing answer any longer, especially considering the vigorous financial
development trends in other emerging markets. Having made the general point that the
current policy paradigm is challenged by disappointing outcomes, let us now turn to


20Value traded over GDP reached 12.4 percent in Chile in 2004, compared to 65.5 percent in France, 74.2
percent in Japan, and 165.9 percent in the U.S. The East Asian countries presented in the figure also had
significantly higher levels of trading activity than Chile, with value traded over GDP reaching 94 percent in
Korea, 50.8 percent in Malaysia, and 66.7 percent in Thailand.
21The Latin average in credit to the private sector shown in Figure 5 masks the very high volatility of this
variable in individual countries over time. Moreover, in some countries, such as Mexico, there have been long
periods of declining and/or stagnant credit to GDP ratios following financial crises.



                                                       11

illustrations of dissonance between this paradigm and emerging issues in three areas: local
equity markets, SME financing, and defined-contribution pension systems.

         4.1. The Future of Small Domestic Stock Markets

         A key policy challenge for financial sector reformers in Latin America, especially in
the smaller countries, is the need to revamp their vision for the development of local stock
markets. This was not perceived as challenge until recently because of the implicit view--
shared between local policymakers and advisors from multilateral institutions (among many
others)--that domestic financial market development in emerging economies should be
measured against the benchmark of financial markets in industrialized countries and that the
reform agenda, though difficult, is clear. Growing evidence suggests, however, that things
are not as clear as initially believed and that the implicit vision of building a "mini Wall
Street" at home is misguided and in need of major revision.22

         In effect, the conventional wisdom among reformers has been that local equity
markets would grow through reforms focused on strengthening the enabling environment,
particularly accounting and disclosure standards, minority shareholder protection (and
property rights, more generally), corporate governance practices, tax enforcement, trading
and securities clearing and settlement infrastructures, and stock market regulations and their
enforcement. Corporate governance and tax reforms have been typically considered the most
difficult ones in Latin America, given the high concentration of wealth as well as the high
degree of tax evasion, which hinder the willingness to "go public," as this entails a dilution of
control and having to disclose the true financial condition of firms. No sensible policymaker
thought that the reform path would be easy, but most tended to think that the technical
aspects of the reforms were well understood. Again, several relevant standards and codes
emerged (e.g., on securities markets regulation, corporate governance, accounting and
auditing), giving policymakers clear points of reference for convergence-oriented reform
efforts. The associated expectation was that, as reforms succeeded and convergence to
international standards progressed, domestic capital markets in the region would increasingly
resemble those in developed countries.

         Like the main character in the popular film Field of Dreams, who heard a voice ("if
you build it, they will come") that inspired him to build a baseball field on his land in the
hope of bringing back legendary baseball players, Latin reformers worked hard at building
the enabling environment for their local stock markets in the hope that "they"--that is,
corporate issuers and local and foreign investors--"would come."                       What has actually
happened in many countries has rather been the opposite. "They" actually left, as the number
of stocks listed in local exchanges shrunk over the past decade or so in most Latin stock
markets (Figure 6). This reduction in the number of listed firms has been associated with the
increasing migration of Latin American firms to international financial centers, such as New
York and London.23 An important element of the globalization trend over the last decades


22See De la Torre, Gozzi, and Schmukler (2006a) and De la Torre and Schmukler (2004b) for more discussion
on this issue.
23 Merger and acquisition activity as well as majority shareholders trying to increase their controlling stakes
have also been brought forward as possible explanations for stock market delistings in Latin America. A



                                                     12

has been the internationalization of financial services, which has meant the use of
international financial intermediaries by issuers and investors from emerging economies.
Latin firms have actively participated in this process by listing in foreign exchanges and
issuing depositary receipts.24 In fact, the internationalization of equity issuance and trading
in Latin America is significantly higher than in other regions (Figure 7). In many Latin
countries, activity abroad now exceeds activity in local exchanges. Even domestic investors
have started trading stocks from their own countries in the more liquid and less costly
international markets, bypassing local exchanges. This is easy to achieve in a world where
trading can be done electronically from anywhere. In addition to the growing migration and
delistings, domestic equity markets in the region are highly concentrated, with only a few
stocks dominating market capitalization and trading (Figure 8). Moreover, these markets
remain illiquid, in part as a result of very low "float" ratios (a low proportion of listed shares
available for trading).

         These outcomes do not imply that reforms have been ineffective or should not be
undertaken. They do mean, however, that the expectations associated with reforms should be
revised and that a fresh look at the reform agenda is needed. In effect, recent empirical work
shows that improvements in macroeconomic and institutional fundaments, as well capital
market-related reforms, have had a pro-internationalization bias. While these factors have
indeed promoted local stock market development, they have spurred even more the
internationalization of stock issuance and trading (Claessens, Klingebiel, and Schmukler,
2006; De la Torre, Gozzi, and Schmukler, 2005). There is, in addition, interesting empirical
research that suggests that the below-expectations development of local stock markets is not
independent of their internationalization--as the migration of stock issuance and trading
abroad has been found to have had an adverse effect on the trading and liquidity of local
markets (Levine and Schmukler, 2006a,b).

         To be sure, the reformers of the 1990s were not dismissive of the globalization
process; they rather supported it. But they tended to expect that the effect of reforms would
be to attract foreign investors and global liquidity to their domestic markets. They did not
anticipate that the fruit of their efforts would be an increased tendency for the best equity




regional comparison of stock listings data over the last decade shows that, in contrasts with the delistings in
Latin markets, stock markets in East Asia have been recording a strong listings increase. Different explanations
have been put forward to explain these diverging trends. On explanation is that, unlike the American and
European stock markets, which performed well over the 1990s, stock markets in Hong Kong and Tokyo, the
natural candidates for migration in Asia, have not done well in recent years (World Bank, 2004).
24There are different ways to "list" domestic stocks in international financial markets. A traditional way is to
cross-list the share in another exchange. European companies tend to use this method of internationalization
most often. A popular way to internationalize among emerging market firms has been through depositary
receipts (DRs), called American Depositary Receipts (ADRs) or Global Depositary Receipts (GDRs). These
are foreign currency denominated derivative instruments, issued by international banks, representing home
securities held with a local custodian. ADR trading in U.S. exchanges has expanded from UDS$75 billion in
1990 to one trillion in 2005, and there are currently more than 1,900 sponsored ADR programs issued by firms
from 73 countries. DR programs grow or shrink depending on demand, since the issuance of DRs and the
conversion back to the underlying shares only involves a small transaction cost. See Levy Yeyati, Schmukler,
and van Horen (2006).



                                                       13

issuers and issues to move to international markets and, in the process, adversely affect the
liquidity of the domestic stock market.

          The mentioned evidence (low stock market development in the region despite intense
reforms, pro-internationalization bias of reforms, etc.) raises questions that the dominant
policy paradigm seems ill suited to answer. While much research is still needed, we have
argued elsewhere (De la Torre and Schmukler, 2004b) that a better understanding of the
interaction between globalization, local market size, and key features of equity contracts is a
good place to start in trying to make sense of the evidence. Small market size is a arguably a
key factor behind the illiquidity of Latin stock markets, considering that secondary market
liquidity is a positive function of market size, with the related scale economies and network
and agglomeration effects. This simple fact explains why global liquidity is increasingly
clustering around few international financial centers. It also constitutes sobering news for the
smaller countries in Latin America because illiquidity begets illiquidity (by limiting the
capacity of investors to unwind their positions without affecting prices, illiquidity
discourages the entry of new players which, in turn, further limits liquidity) and
fundamentally hinders "price revelation" (one of the most distinctive functions of stock
markets vis-à-vis, say, banking markets).25

          Another factor that could further foster the internationalization of stock issuance and
trading is that this internationalization does not engender balance sheet mismatches.26 Hence,
by itself, it carries no systemic vulnerability implications, even if the integrating country has
a weak currency. Arguably, this increases the incentives for equity issuers to migrate
towards the larger, deeper, and immensely more liquid international markets, so long as they
can break the size and cost barriers to issuing stocks abroad.27 This reasoning suggests that,
given globalization, the reforms and institutional improvements at home may actually make
it easier and more affordable for large local issuers to go abroad by making them more



25 In the absence of reasonably secondary market liquidity, concerns regarding price integrity cannot be fully
dispelled. Illiquidy means that stock valuation needs to be done via methods that, even where well designed
and uniformly applied, are imperfect substitutes for the real thing--an observable and reliable market price.
Those methods are blunt in their capacity to capture in real time the changes in the actual and perceived risks
and prospects of the issuer. By undermining price revelation--even where disclosure standards are high--
secondary market illiquidity causes "marking to market" to lose much of its meaning and turns fair value
accounting into an inherently tentative task.
26 In this respect, equity contracts sharply differ from debt contracts. In the case of debt, internationalization
can magnify the weak currency problem. This is because in countries where the equilibrium real exchange rate
is subject to significant fluctuations, borrowing in foreign currency exposes debtors in the non-tradable sector to
real exchange rate risk and, as a result, exposes their creditors to the real exchange rate-induced default risk. In
contrast, equity contracts are not subject to default risk because they do not commit the issuer to paying a flow
that is independent of her performance. As a result, the issuer of an equity security does not take any exposure
to exchange rate risk, even if her income is derived from the emerging economy's non-tradable sector. To be
sure, her performance might be affected by real exchange rate fluctuations in various ways, but such effects are
passed on to equity investors via changes in dividend payments.
27 Based on over 30 structured interviews with market participants, Ladekarl and Zervos (2004) conclude that
securities issued in amounts under US$150-200 million "remain unattractive to many large emerging market
investors." Claessens, Klingebiel, and Schmukler (2004), using a large sample of firms from 53 countries,
show that firm size is an important determinant of the probability of accessing international financial markets.



                                                         14

attractive to international investors, which is consistent with the evidence (Claessens,
Klingebiel, and Schmukler, 2006; De la Torre, Gozzi, and Schmukler, 2005).28

         Be it as it may, the point is that a number of difficult questions increasingly haunt
policymakers regarding the future of local stock markets, especially in the smaller Latin
countries.     Is there a suitable "light" version of domestic securities markets for small
countries that is complementary to international financial market integration? Should such
"light version" de-emphasize centralized local exchanges and rather be characterized by
lower accounting and disclosure standards and by relatively more private equity placements
and over-the-counter activity? What could be expected from such a market, given that it
would be structurally illiquid and, hence, would play a very limited "price revelation" role?
What to do with the costly and underutilized infrastructures of centralized stock exchanges?
Should small countries simply "throw the towel," forget about developing a local stock
market, and let their investors and large resident corporations obtain equity market services
in international financial centers? Is there any advantage in pursuing regional stock market
integration compared to simply promoting global integration?

         While our ability to answer these difficult questions is only at an early stage, one
thing is certain: the answers are not likely to be found by simply relying on the conventional
wisdom of the prevailing stability-oriented and international standards-laden policy
paradigm.

         4.2. Financing for Small and Medium Enterprises

         In the history of financial development in the now advanced economies, bank credit
to firms, including small and medium enterprises, preceded the expansion of consumer
credit. In recent years, Latin America seems to be playing that film in reverse--with growth
in consumer credit substantially exceeding growth in credit to SMEs. The loanable funds
available in the local markets for the private sector (i.e., those funds left after the government
has satisfied its, often large, financing needs) are not flowing in significant amounts to
SMEs. Formal financial systems seem to be failing in terms of "irrigating" resources broadly
and bridging the gaps in access to finance.29 SMEs are becoming a focal case in point, which
is raising increasing concerns among policymakers throughout the region.

         SMEs are a segment that appears to be squeezed out of the mainstream circuit of
financing to the private sector. At one extreme of the corporate lending market are the large,
reputable corporations. They have access to a broad a range of products to raise debt or


28The evidence is also consistent with the findings in Aggarwal, Klapper, and Wysocki (2004)--they analyze
portfolio holdings of emerging market equities by U.S. mutual funds and find that funds are more likely to
invest in countries with stronger accounting standards, shareholder rights, and legal frameworks. Similarly,
Ladekarl and Zervos (2004) find that macroeconomic policies, corporate governance, and the legal and
regulatory framework are important determinants of whether countries are considered "investable" or not by
portfolio investors in emerging markets. Wojcik, Clark, and Bauer (2004) find that firms with better corporate
governance practices are more likely to cross-list in the U.S.
29 See Beck and De la Torre (2006) and De la Torre, Gozzi, and Schmukler (2006b) for discussions of
conceptual issues in access to finance.



                                                        15

equity capital, from banks or securities markets, in local or international markets. At the
other extreme are micro-enterprises. Although these firms have traditionally lacked access to
formal financing, in recent years there has been a vigorous expansion of commercial
microfinance. This growth has been driven by the development of innovative lending
techniques and significant technological advances (scoring methods, e-banking, etc.), whose
effects have been boosted by the growing presence of credit bureaus, thereby enabling
microfinance institutions to reach the needed scale and bring costs down substantially.30 In
the middle between these extremes of the corporate credit market are SMEs, for which
financing has tended to stagnate. At the same time, as mentioned above, there has been a
strong growth in consumer credit.              Financial institutions initially focused on providing
consumer finance--ranging from loans for durable goods to flexible credit card lending--to
well-off households. In recent years, with the growing commercialization of microfinance,
financial institutions have also started to grant micro-consumer loans to lower-income
households. In sum, the unfolding story seems to be that, as competition in the lending
market for large corporations has increased--reflecting financial globalization and the
expansion of local bond markets--banks have switched to commodity-like, mass credit
products like financing to micro-entrepreneurs and consumer lending. In the process, the
SME segment has been bypassed, at least for the time being.

         The solutions to this apparent squeezing of SMEs out of the mainstream financing
circuit are not easy. A few reasons--which we put forward mainly as hypothesis, given the
dearth of empirical research--can be submitted to make the point that the problems in SME
finance constitute a tough policy nut to crack. First, individual SMEs are arguably too small
to access capital markets directly and individually. In effect, they are not able to issue debt
or equity securities in the minimum amounts (say, 30-50 million U.S. dollars) required by
institutional investors. (Institutional investors do not normally want to be the only or main
holder of an issue and, at the same time, want an issue with a minimum degree of secondary
market liquidity that would facilitate "exit" when needed.)

         Second, local and foreign pension funds and other institutional investors are not likely
to seek individual SME assets as part of their portfolio diversification strategies. It simply
does not pay. Or, to put it more formally, the marginal risk reduction achieved by including
one more issuer in the portfolio appears to be offset by the marginal cost of issuer screening
and monitoring at a much earlier point than commonly believed. The risk-return frontier is
thus reached with relatively few assets, which adds yet another reason to explain why
participation in capital markets is segmented in favor of large issuers and issues, even in
countries like Chile and Mexico, where corporate bond markets have been growing fast.31 As


30See, for example, Hardy, Holden, and Prokopenko (2002) for a description of how the availability of debtor
information systems combined with scoring technologies has allowed Banco del Trabajo in Peru to become a
commercially-viable microfinance institution. CGAP (2003) presents an overview of how scoring works and its
application to microfinance.
31This hypothesis is consistent with available evidence, although more research is needed to determine whether
it passes more rigorous empirical and theoretical tests. Consider, by way of illustration, the case of Chile,
where efforts have been underway for some time to enhance risk diversification at home via the relaxation of
regulatory limits on domestic investment by mandatory pension funds and the more recent introduction of a
system of multiple funds with different risk-return profiles.       The results of these efforts have been
disappointing. In particular, the range of corporate issuers represented in the aggregate portfolio of pension



                                                      16

Figure 9 shows for the case of Chile, only the largest firms have been able to issue bonds in
the local market. Similarly, for the case of Mexico, only a handful of large, well-known
firms account for most of the amount outstanding in the local corporate bond market.

         A third reason that can explain why the SME segment has been bypassed is that bank
loans to SMEs are not easily "commodity-izable" (Mu, 2002). Because of the opacity and
heterogeneity of risks of different SMEs, the corresponding SME lending technology cannot
rely heavily--as microfinance and consumer lending technologies do--on scoring methods.32
These methods work by analyzing large samples of borrowers to identify the characteristics
that predict the likelihood of default and the loss given default. Hence, they are more
applicable to homogeneous borrowers and lending products that can be mass produced. The
risks of a micro loan can be "scored" with information on personal characteristics of the
micro-enterprise owner, given that the financial viability of the enterprise is closely tied to
that of its owner. This information is easy to gather, including though electronic means. The
risks of an SME loan, by contrast, are less amenable to scoring techniques and therefore,
SME lending cannot be converted into a commodity-like mass-credit product, especially as
we move up the enterprise size from small to medium. In effect, an SME is likely to be a
limited liability company with various owners, which makes the individual characteristics of
the owners less relevant for assessing creditworthiness.                       Such assessment requires an
understanding of the nature of the business, its cash flow projections and operations, and the
specifics that underpin the quality of management. These features, however, are not only
difficult to observe but also different for different SMEs, requiring more individualized
lending techniques to sort out and monitor SME debtors. The associated high monitoring
and screening costs deter capital-constrained banks from developing an SME lending
capacity, especially when more standardized lending technologies in markets for commodity-
like, massive credit products offer profitable opportunities. Moreover, because of their
heterogeneity, SME loans are much more difficult to securitize--that is, to be packaged into
a pool of assets that backs securities to be sold in capital markets--which further limits the
bridging of banking and capital markets in favor of SME finance.33

         Fourth, the SME loan technology makes intensive use the local institutional
infrastructure for credit contract writing and enforcement, unlike, say, the micro-consumer
loan or credit card loan technologies, which make little use of such infrastructure. The latter
technologies do not normally require collateral and their post default procedures consist
mainly on writing off the claim and registering the default with the credit bureau. In credit
card and micro-loan technologies, in effect, the pursuit of post-default recovery through the
judicial system is typically not worthwhile and creditors anticipate this and price it ex-ante

funds has remained narrow (Rocha, 2004). This suggests that, even under a more liberal investment regime,
there seem to be structural factors limiting the extent of diversification of institutional investor portfolios.
32Credit scoring is an automated statistical technique used to assess the credit risk of loan applicants. It
involves analyzing a large sample of past borrowers to identify the characteristics that predict the likelihood of
default and the loss given default. Scoring systems usually generate a single quantitative measure (the credit
score) to evaluate the credit application.
33One exception in this connection is the factoring of SME receivables, especially when such receivables are
claims on large, reputable corporations in connection to goods or services already delivered by the SME. For a
discussion of factoring markets and the possible role of government policy, see De la Torre, Gozzi, and
Schmukler (2006b) and Kappler (2005).



                                                         17

into the interest rate. This helps explain why micro credit as well as mass consumer credit
are thriving industries even in countries with weak contractual environments. By contrast,
SME lending technologies cannot avoid a heavy reliance on the contract enforcement
institutions. For instance, and given the limited applicability of scoring techniques, SME
lending tends to resort to collateral requirements to adequately mitigate principal-agent
problems and recovery efforts via the courts are the norm in the event of default. As a result,
the quality of collateral laws, the clarity of creditor rights in the event of bankruptcy, and the
reliability of the judicial processes are all highly relevant for SME lending. Consistent with
this argument, there is some--albeit still limited--empirical evidence suggesting that the
quality of the institutional environment has a larger impact on the growth and access to
finance of SMEs. For instance, Beck, Demirguc-Kunt, and Maksimovic (2005) find that the
extent to which financial, legal, and corruption problems affect firm growth depends on firm
size, with smaller firms being most affected by these factors (Figure 10). Similarly, Chong,
Galindo, and Micco (2004) find that SMEs not only finance a significantly lower share of
their investments with bank credit relative to large firms, but also that the difference in bank
financing between SMEs and large firms is higher in countries with worse creditor protection
and less efficient judicial systems. Given that SMEs lack access to securities markets, this
lower level of bank financing implies that a higher share of their investment has to be
financed with retained earnings or supplier credit.

        The fifth difficulty in expanding SME finance is the possibility that Basle-type and
Anti-Money Laundering (AML)-type regulations may be, inadvertently, discouraging loans
to this segment. These regulations may reduce the value for banks of relationship lending
based on individualized knowledge of borrowers. For example, regulations that require
banks to use the information from the credit bureau in the process of loan origination and to
supply relevant loan information to such bureau reduce banks' ability to appropriate the
benefits from their efforts at building individualized SME knowledge.                Thus, these
regulations, contrary to common expectation, may actually deter banks from entering the
SME lending business, especially in the absence of a compensatory improvement in the
contractual environment. Similarly, banks' capacity to deal with informal, opaque SMEs
through relationship lending may be undercut by regulations that require loan origination
dossiers to include formal financial statements, sophisticated cash flow analysis, and
transparency in tax compliance.         Likewise, AML regulations that require substantial
documentation to satisfy the know-your-client requirements may be excluding from the
lending circuit informal SMEs that would have otherwise been included. All of these are, of
course, hypotheses that require more rigorous exploration, but anecdotal evidence throughout
the region suggests that they cannot be readily dismissed.

        In sum, SME finance (or the lack thereof) is a big emerging issue in the minds of
Latin policymakers. As noted, the topic is quite complex and short- or even medium-term
solutions are not easy to identify, raising tough questions on what could governments do,
other than patiently wait for the eventual materialization of substantial improvements in the
contractual environment as a result of reforms. While the search for policy answers must
continue, the discussion above should make it clear that the dominant policy paradigm
provides little guidance for this task.




                                                 18

         4.3. Defined-Contribution Pension Funds

         Chile's pioneering example in pension reform had a major demonstration effect
throughout Latin America, as similar reforms were adopted by many countries subsequently,
during the 1990s--including in Argentina, Bolivia, Colombia, Costa Rica, El Salvador,
Mexico, Peru, and Uruguay. These reforms consisted, basically, in a shift away from
government-administered, pay-as-you-go (PAYG), defined-benefit (DB) pension systems
towards systems that rely mainly on the so-called "second pillar," that is, on mandatory,
privately-administered, defined-contribution (DC) pension funds.                        This type of pension
reforms constituted a salient manifestation of the paradigm shift in favor of pro-market
financial development discussed above. They reflected a strategic, almost philosophical
decision: to give markets the predominant role in administering retirement-related savings
and providing old-age income security.

         There is little question that Chile-style pension reforms point in the right direction, for
a number of reasons, of which we highlight three. First, is the potential for such reforms to
boost capital markets development and economic growth.34                           Second is these reforms'
consistency with fundamental trends in labor markets. In effect, the competitive economies
of today require greater job mobility and frequent career shifts, which can be facilitated via
portable individual pension accounts. Third, and perhaps more importantly, is the fact that
the ongoing rise in life expectancy, which is observed in developed and emerging economies
alike, clearly militates in favor of increasing the role of the individual savings (or self-
insurance) component of national social security systems relative to the insurance (or risk
pooling) component. Let us briefly elaborate on this latter point.

         Rising life expectancies imply a rising probability that individuals will outlive their
capacity to work--that is, that they will likely live for a significant number of years after
ceasing to earn labor income due to the natural deterioration of working capacity that comes
with aging. As this particular probability goes up, individual savings should play a bigger
role relative to insurance (or risk-pooling across individuals) because the cost of insurance
increases with the probability of the loss event in question, while the cost of savings (self-
insurance) is independent of such probability. It follows that, as the likelihood of having a
relatively long life after retiring increases, so does the cost of insurance relative to the cost of
self-insurance, inducing rational individuals to rely more on savings (rather than on
insurance) to deal with the risk of loss due to such a likely event (Ehrlich and Becker,
1972).35 The same logic can be applied at the aggregate social level: pooling risks across
individuals by financing retirement benefits on a PAYG basis becomes more expensive as


34In a comprehensive study, Corbo and Schmidt-Hebbel (2003) concluded that Chile's pension reform, partly
through its positive impact on capital market development, raised GDP grow by an additional one-half
percentage point per year, on average, during the 21-year period between 1981 and 2001.
35In this seminal article, Ehrlich and Becker provide a "comprehensive insurance" theory for old age income
security. They show that, faced with various old-age related risks, rational individuals will allocate their efforts
among self-protection (to reduce the probability of the loss event), savings (to self-insure against the loss event),
and market insurance (to hedge against the loss event via risk pooling). The weight that individuals will give to
each alternative depends in large part on the cost of insurance relative to cost of savings which, in turns,
depends on the relative probabilities of the different types of old-age related risks.



                                                         19

the ratio of the elderly to the working age population increases, while the cost of self-
insurance through individual savings remains unchanged. In sum, it makes sense to give
greater importance to individual savings in social security systems as new generations live
longer than old ones. This does not mean, of course, that there is no significant room left for
an insurance (risk-pooling) component in reformed pension systems. Insurance is relevant to
hedge against the relatively lower-probability risks.                    It can take the form of market
insurance--e.g., annuities to hedge against the risk of outliving in retirement the savings
accumulated while working. It can also take the form of a social safety net--e.g., a PAYG
"first pillar" designed to deal with the risk of falling into poverty in old age.

          As the reformed pension systems in the region continue to mature, new and complex
challenges are emerging that were not well anticipated at the reform inception. The ability of
policymakers to adequately address these challenges is key to enhancing the performance of
the reformed systems and ensuring their socio-political sustainability.                         While the big
emerging challenges in this area can be identified and characterized, the development of
suitable policy answers is at an early stage.

          Arguably, the biggest challenge for the Latin pension systems is posed by their low
coverage (Gill, Packard, and Yermo, 2004). This challenge, however, falls outside the scope
of financial development policy and mainly concerns social protection policy. To be sure,
there are some links to financial policy. For example, reformers had originally expected--
rather naïvely--that involving financial markets in the management of individual savings for
retirement would spontaneously lead to increases in coverage. Workers would no longer see
their pension contributions as a tax, the argument went, but as their own money and would
therefore voluntarily join the system, leading to a natural expansion of coverage.36 From
hindsight, it is clear that the expectation was exaggerated and that the impact of pension
reform on coverage has been rather small.37

          Be it as it may and given the scope of this paper, we must avoid dwelling on the
crucial issue of coverage and move on to discuss some of the emerging issues in DC pension
systems that concern of financial development policy. To this end, we focus on three key
challenges in achieving the objectives of second-pillar based pension system: (i) raising

36 Packard (2001) analyzes empirically the impact of Chile-style pension reforms on coverage in Latin America
and finds a positive incentive effect, but one that occurs only gradually, as workers become familiar with the
new social security system.
37 Pension coverage of the economically active population is worrisomely low throughout the region and it has
not increased appreciably since the reform in most cases. In all Latin countries, with the exception of Chile,
less than half of the economically active population participates in the mandatory pension system, and in many
countries coverage is below 25 percent. Low coverage is clearly a bigger source of policymaker insomnia than
the problems of access to finance for SMEs or the lack of equity market development. Low pension coverage
today means a high and growing risk of people falling into poverty in old age in the future--i.e., a looming
social crisis. The risk of poverty in old age is, compared to the risk of outliving the working age, of a lower
probability type. Hence, as noted, it is a risk that is in principle better dealt with through pooling (insurance)
rather than saving (self-insurance). The debate has, therefore, refocused on the potential complementary role of
a revised PAYG "first pillar" in addressing the coverage problem. First pillar systems are by definition based
on risk pooling across individuals and could be used to set a floor to old age income for most citizens, but that
floor would need to be funded either through additional worker contributions or out of general revenues, not a
trivial task.



                                                        20

expected replacement rates;38 (ii) limiting the volatility of replacement rates over time; and
(iii) building a sound market for annuities.

        Let us first consider the challenge of raising expected replacement rates.                       It is
increasingly evident that there is no easy answer the fundamental question of whether the
system of mandatory, DC pension funds will be able to consistently generate, for those
covered by the system, adequate replacement rates in the future, given current rates of
contribution. By adequate replacement rates we mean an expected stream of income during
retirement that is consistent with life-cycle consumption smoothing and that minimizes the
risk of poverty in old age. One important threat in this regard comes from low accumulated
balances in pension funds at the moment of retirement due to low contribution density
ratios--that is, the problem originated in individuals not contributing continuously to their
pension funds over their working lives due to, say, long unemployment spells or prolonged
dips into the informal sector while working. But even where contribution density is high, the
maximization of expected replacement rates for a given risk is more difficult to achieve
through financial markets than originally believed.                 In particular, the high real returns
achieved during the 1990s--which were of the order of ten percent per year in several of the
countries that implemented pension reforms--are unlikely to be repeated in the future, and
this would lead automatically to lower expected replacement rates for a given risk.

        The reasonable assumption that lower average real returns (compared to those in the
1990s) are in store for the future puts a premium on policy efforts aimed at increasing net
real returns in DC pension funds without unduly raising risk. This necessarily points to
policies aimed at facilitating the achievement of higher gross returns and/or the reduction in
the fees charged by AFPs (pension fund administrators).39 At first glance, the general
direction of the appropriate policies actions appears obvious: make AFPs operate in a
contestable market while giving them freedom to diversify the portfolios they administer,
subject to ensuring that they continuously fulfill their fiduciary responsibilities as managers
of workers' savings. Freedom and competition, the argument goes, will result in lower fees
and higher returns for a given risk. In fact, we have learned that things are not that simple,
with policy tensions and technical issues complicating matters much more than initially
believed, as discussed below.

        Let us first turn to the tensions arising in connection with the policy objective of
enabling higher returns by allowing greater local and international diversification of
mandatory pension fund portfolios. In reality, policy makers in the region have not been free
to pursue this objective; they have rather felt compelled to balance it against three competing
policy objectives. The first competing policy objective has been fiscal: to facilitate the
government's cash flow management given the need to finance the pension reform transition.
Absent a compensatory fiscal adjustment (Chile was the only reforming country in the region
able to engineer it, mainly through a major increase in tax revenue), debt financing has been
relied upon by governments to meet payments to retirees under the old PAYG system while

38The replacement rate is formally defined as the ratio of retirement pension to pre-retirement income.
39The effects of higher returns or lower fees on replacement rates build over time to nontrivial magnitudes.
Rocha (2004) reckons that a permanent decrease in fees by 30-40 basis points of assets would lead to a seven to
nine percent increase in replacement ratios in the case of Chile.



                                                        21

no longer receiving contributions from workers that join the new system. The resources in
second-pillar pension funds have been tapped for this purpose (as well as for general
government deficit financing needs), and this has typically being aided through regulations
mandating a that a high share of pension fund portfolios be allocated to government paper. It
is thus not surprising that the portfolios of most second-pillar pension funds in the region are
rather undiversified and dominated by government debt securities.40

         The second competing policy objective has been to harness pension funds'
investment power to stimulate the development of local financial markets and the local
economy, especially by supplying long-term finance to the private sector, without sacrificing
their primary fiduciary duty.41 This objective has led to a reluctance among Latin policy
makers to give AFPs ample latitude to diversify pension fund portfolios through investment
in foreign assets. This reluctance has been often reinforced by a nationalistic discourse and
concerns that allowing AFPs to find assets in international markets smacks of an official
blessing to capital flight. As discussed in the previous section, expectations that pension
funds would diversify into a very wide range of local assets, including SME finance, proved
to be misplaced. In any case, as the growth of pension funds has been clearly outstripping
the availability of suitable assets at home, policy makers have been prompted to raise the
ceiling on pension fund investments abroad, albeit ever so gradually and reluctantly. Chile is
again well ahead of the pack in this regard, currently allowing up to 30 percent of pension
fund portfolios to be invested in external assets.

         Finally, the room to relax pension fund investment regulations has been constrained
by a deeper policy concern, present especially in countries where the second pillar constitutes
the core of the national social security scheme. Allowing pension funds to take on more risk
in order to raise returns implies also that losses would be made now and then. But such
losses would raise greater political sensitivities in countries with a second-pillar dominated
national pension systems, where workers bear all the market risk, compared to countries
where the second pillar is a complement to a core PAYG system and where, as a result,
workers bear less market risk overall (Rocha, 2004). Hence, in the case of the former
countries, a full liberalization of pension fund investment regulations cannot be reasonably
expected. Rather, it should not be surprising to find, as in fact we do, that regulators in such
cases tend to be more risk averse and regulations more biased in favor of conservative
portfolio allocations.

         In all, the policy objective of raising expected replacement rates via the liberalization
of pension fund regulations is caught up in a nontrivial tension with other policy objectives
that pull in a different direction. While reasonable people can differ on the relative weight
that should be given to each of the competing policy objectives, there is no question that the
policy path towards higher replacement rates via a freer pension portfolio allocations is
fraught with complications that were not fully foreseen at the time of the reform.

40Chile and Peru are exceptions where government debt does not absorb the lion share of pension fund
portfolios. Data on pension fund portfolio composition is presented, for instance, in Gill, Packard and Yermo
(2004) and De la Torre and Schmukler (2004b).
41In effect, fostering financial development at home can be in fact consistent with pension funds' fiduciary
duties to the extent that domestic financial deepening promotes growth.



                                                       22

          Let us now turn to the policy issues involved in trying to raise expected replacement
rates by fostering competition among AFPs on the fees they charge for asset management.
This too has proven to be a much more challenging task for the reformed systems than
initially envisioned, mainly because of complications related to industrial organization
features of the pensions industry. These features make it difficult to simultaneously promote
competition and ensure the achievement of economies of scale. Let us explain. Competition
seems crucial to bring down fees. However, increased competition through lower entry
barriers and greater freedom for affiliates to move across AFPs can backfire, as the Chilean
experience in the mid-1990s demonstrated. It can lead to marketing wars between numerous
AFPs, which blunt the ability of the industry to capture scale economies, resulting in high
administrative costs and, thus, high fees. The opposite can also backfire. That is, if the
regulatory authorities were to raise entry barriers, promote cartel-like understandings among
AFPs, and restrict the ability of affiliates to move from one AF to another--all in order to
facilitate the exploitation of economies of scale--the resulting lack of market contestability
will increase the scope for the few incumbent AFPs not to pass the administrative cost
reductions to affiliates and, rather, enjoy abnormally high profits. The appropriate policy to
break away from this dilemma is neither obvious nor easy to design and implement.

          Several approaches have been tried in the region to bring down costs and fees, with
mixed results. One line of attack to enhance competition on fees has been to facilitate
switches to low-fee funds, as done in the case of Mexico.42 Another line of attack has been to
enhance transparency via the disclosure of fees in a comparable manner.43 The effectiveness
of these actions, however, has been dampened by the seemingly general reality that pension
fund affiliates tend to be rather insensitive to differences in fees and net returns across
funds--a phenomenon that begs for greater research.44 Hence, some countries, like Bolivia,
have rather auctioned out licenses for pension fund management to very few operators,
giving them exclusivity (to enable them to capture scale economies) while putting a ceiling
the asset management fees they can charge. The policy debate has, therefore, been wide
ranging, with more radical reforms proposals entering the discussion in recent years. These
proposals essentially focus on unbundling the basic pension-related services that are subject
to economies of scale (contributions collection, accounts management, payouts to retirees,


42In Mexico, undecided pension contributors are assigned automatically to AFPs in the lowest quartile in terms
of fees charged. This policy has been complemented by lowering entry barriers for AFPs, relaxing the one-year
restriction on switches if individuals migrate to lower fee funds, and facilitating switches over the internet.
43Comparability of fees across AFPs is typically complicated by multiple fee structures, as AFPs may charge
fees as a percent of either contributions, wages, or assets under management. In some countries AFPs can also
charge fixed fees. Efforts have been made to mitigate the comparability problem. For example, Mexican
authorities calculate and disclose "equivalent fees over assets" across funds. This calculation, however, is a
second best, valid only for an "average" individual. Fees as percent of contributions were allowed to facilitate
entry into the nascent pensions industry at the time of the reforms. Switching to a uniform fee structure based
on fees as percent of assets at this stage is not trivial, for it would have important distributional consequences
and consolidate the market power of incumbent AFPs, which already have a large asset based on which to
collect fees.
44For instance, in the case of Chile, Berstein and Micco (2002), Berstein and Ruiz (2005), and Marinovic and
Valdes (2005) provide econometric evidence of switching patterns of affiliates from one AFP to another,
showing that switching is only weakly related to APF performance.



                                                         23

etc.) from those services where competition can thrive (asset management), along the lines of
the Swedish model.45 The basic, and promising, idea of this type of proposals is to promote
centralization and cooperation in infrastructure and back-office services, where scale
economies are most significant, and competition on prices and quality in asset management
services, where scale economies are lower. While this idea carries a significant potential of
increasing expected replacement rates via lower fees, its specific design and tailoring to
individual country circumstances are a highly complex affair.

         Let us now consider the challenge of limiting the volatility of replacement rates over
time. The point we wish to make in this connection is that there appears to be a significant
policy tradeoff--inherent in DC funded pension systems--between raising expected
replacement rates (by increasing competition on fees and returns), on the one hand, and
maintaining stable replacement rates over time, on the other.46 To develop this point, we first
note that there is an unavoidable degree of volatility in replacement rates across cohorts in
pure DC funded pension systems. In these systems, individuals bear all the investment risk
(market, credit, inflation, etc.) during the accumulation phase and the annuitization risk (the
risk of receiving a low stream of old age income because the annuity is bought when interest
rates are low) at retirement. As these two sets of risks do not necessarily offset each other,
replacement rates are volatile over time. This means that individuals in different generations
may obtain different replacement rates even if, over their working lives, these individuals
have similar real earnings and make a similar saving effort for retirement. In sum, under
pure DC funded systems, some variance in the retirement incomes of similar individuals in
different cohorts is unavoidable and depends on luck--creating a problem of
intergenerational horizontal inequity.

         This unavoidable core of intergenerational horizontal inequity can, however, be
greatly exacerbated by policies aimed at increasing competition among AFPs on net returns.
This poses a policy tradeoff, at the heart of which is the principal-agent problem in DC
pension fund administration. Let us explain. AFPs are pure asset managers--they do not
have a formal liability that is payable to workers at retirement; rather, as noted, they pass on
to the worker all the risks. This entails an inherent agency problem, as the investment
behavior of AFPs need not be consistent with the life-long interests of the contributing
worker.      To mitigate this agency problem, policies seek to increase transparency and
competition on fees and returns through, for example, continuous mark-to-market accounting
of pension fund portfolios, periodic disclosure of fees and investment returns, and freedom


45In 1994 Sweden reformed its pension system, replacing its pay-as-you-go, defined benefit system with a
system that combines a pay-as-you-go notional defined contribution pillar and a funded defined-contribution
second pillar with privately managed individual account. This second pillar is based on a clearinghouse model
where a public agency acts as an intermediary between contributors and asset managers and centralizes most of
the activities that are subject to economies of scale (contributions collection, accounts management, record-
keeping, etc.). Workers can choose how to allocate their funds among (several hundred) registered mutual
funds and the central clearinghouse then transfers their contributions to the selected funds. Asset management
companies only know the total investment of pension contributions, not who the individual investors are,
reducing the danger of a marketing war among funds (see James, Smalhout, and Vittas, 2001 and Palmer, 2000
for details).
46We owe much of the ideas in the following paragraphs of this section (particularly the formulation of the
policy tradeoff in terms of replacement rate volatility) to enlightening discussions with Gregorio Impavido.



                                                         24

for affiliates to move across AFPs. But increased competition and greater transparency are
likely to result in a shortening of AFPs' investment horizons, an intensification of their herd
mentality, and a greater emphasis placed on tactical (versus strategic) investment
considerations. All of this can exacerbate the volatility of replacement rates over time.
Furthermore, short investment horizons imply that AFPs will not be the dedicated and
continuous investors in long-duration assets as people tend to expect.                        In fact, recent
experiences in Mexico and Colombia show that AFPs can buy long duration assets as easily
as they can dump them, depending on their expectations regarding interest rates and the
associated short-term capital gains or losses.

         In sum, the policy tradeoff between promoting price competition and maintaining
stable replacement rates is inherent to DC funded pension systems. A movement towards
one policy goal is at the expense of the other. This tradeoff is bound to create greater tension
in countries where the second pillar is the only, or the dominant, component of the national
social security system. Striking an appropriate balance given this tradeoff is clearly not an
easy task. The thinking on policies to reduce the volatility of replacement rates without
unduly reducing their level is at an embryonic stage. However, the direction of reforms
seems clear: reforms would have to aim at more tightly and smoothly linking the
accumulation phase (DC pension funds) with the decumulation phase (annuities and other
retirement products). A number of options on the debate table seem to warrant consideration
in this regard. In particular, the choice of pension funds could be made life cycle-dependent.
For example, older workers could be constrained to choose only among portfolios heavily
weighted in favor of long-duration and relatively safe fixed income securities.47 In addition,
a default, life-cycle pension fund could be introduced, with portfolio composition changing
automatically with the age of the worker. Complementary, more adequate information on
replacement rates could be provided.

         Finally, we turn to the challenge of whether all Latin countries will be able to build a
well-regulated, deep, and efficient local market for annuities.                    This market is the key
complement to DC pension funds and is crucial to enable pensioners to deal with the so-
called "mortality risk"--i.e., the risk of outliving in their retirement the savings they
accumulated during their working life. As suggested earlier, since this is a lower-probability
risk (compared to the risk of outliving one's working capacity), it is better dealt with through
the insurance rather than through self-insurance. An annuities market that functions well
enable that precisely--it allows workers to transfer mortality risk to life insurance
companies, which manage it for a price, through pooling and complex asset-liability
modeling, passing on to insured individuals the benefits of risk diversification through
pooling. The annuities market is, however, a highly sophisticated market where risks are
complex, demanding high quality risk managers, appropriate institutional and market
infrastructures, access to suitable assets, risk-oriented regulation and supervision, etc.
Whether all countries in the region will be able to develop such a market locally remains an
open, yet crucial question. This, of course, raises the question of whether, to what extent,



47To fully eliminate annuitization risk, the portfolio composition of the pension fund as the worker approaches
retirement age should converge the portfolio composition of the life insurance company that that sells an
annuity to the worker at the moment of her retirement.



                                                        25

and under what conditions would a global pension fund and annuities industry be a
substitute, or even a superior alternative, to having a local industry.

        The discussion above has hopefully been enough for the reader to get a flavor of the
big emerging issues with respect to the markets for DC pensions and annuity products. It
should also have made it clear that, while improving the performance of the reformed
pension system constitutes a policy imperative in the region, the associated policy issues fall
largely outside the radar screen of the dominant policy paradigm on financial development.

5.      Final Thoughts

        This paper has argued that the big emerging issues for the policy agenda regarding
financial development in Latin America have less to do with financial stability and the
principles codified in international standards and codes, and much more with completing
markets in the context of increasing globalization. These emerging issues, which to a large
extent grew out of the interaction between the reforms adopted in the region over the past 25
years and developments in global financial markets, pose technical challenges and political
economy dynamics whose nature and complexity were not well anticipated at the time of the
reforms. The dominant financial development policy paradigm appears ill suited to confront
these issues. In effect, an underlying and significant tension for the current policy paradigm
comes from growing questions among Latin policymakers of whether the more stable,
internationalized, and better regulated financial systems of today are actually contributing to
social and economic development as much as expected.

        Financial system stability and the pursuit of convergence to international standards do
not seem, of themselves, to be leading to the desired results--in terms of breadth, depth, and
diversity in key financial services that households and firms need. For example, the markets
for SME and small-farmer finance do not appear yet to be taking off in most of the region.
Affordable housing finance remains underdeveloped. Only the largest firms in the larger
countries in the region seem to have access to long-duration local-currency finance. Much of
the Latin population does not have access even to basic banking services, let alone to pension
or insurance products to hedge risks. Moreover, the segmentation of access to financial
services seems to be deepening as local financial systems grow and get better integrated into
international markets.    The financial globalization process is arguably producing major
benefits, but these seem to be concentrated in favor of large corporations and higher-income
households.

        The related policy challenges are thus daunting.          What reforms could redirect
financial systems to more rapidly and effectively bridge the access gaps?          How could
countries overcome short-termism in financial contracting? Which financial services should
be provided at home and which abroad? Is there a suitable version of domestic stock markets
for small countries? How could we reduce the volatility of replacement rates in mandatory
DC pension systems without unduly reducing the expected level of replacement rates?
Should governments take a more proactive policy role to foster financial development, going
beyond the current focus on stability and improving the enabling legal and regulatory
environment?



                                                26

       The more these questions intensify, the clearer it becomes that the dominant policy
paradigm, for all of its richness, is unlikely to shed much light and provide significant
guidance on these issues. This does not mean, of course, that the policy prescriptions of this
paradigm (as discussed earlier in this paper) should be abandoned or ignored. By and large,
such prescriptions are enduring, especially with regard to financial stability, as they are based
on strong theory and well-digested lessons from experience. The question going forward is
whether and how this paradigm will be revisited and modified to provide fresh answers to the
pressing new issues. More research is clearly needed. The evidence needs to be carefully
reconsidered to develop better diagnoses. And a degree of intellectual modesty will be
required to suitably revise the policy paradigm and amend expectations.




                                              27

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                                             32

                                                                                    Figure 1
                                                 Financial Sector Reforms
The top figure shows the extent of financial liberalization across regions and the bottom figure shows the cumulative
percentage of Latin American countries having implemented reforms in different areas of capital markets at different points
in time. The financial liberalization index is calculated as the simple average of three indices (liberalization of the capital
account, domestic financial sector, and stock market) that range between 1 and 3, where 1 means no liberalization and 3
means full liberalization. The series are averages across countries in each region. The data for G-7 countries are averages
for Canada, France, Germany, Italy, Japan, United Kingdom, and United States. The data for Latin American countries are
averages for Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. The data for East Asian countries are
averages for Hong Kong, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand. The data for European countries
are averages for Denmark, Finland, Ireland, Norway, Portugal, Spain, and Sweden. Data on financial liberalization are
annual averages calculated from monthly figures.



                                                 Financial Liberalization

More            3.0

liberalization



                2.5




                2.0




                1.5


Less
liberalization
                1.0

                  1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001


                                        G-7 Countries                                                                     Latin American Countries
                                        East Asian Countries                                                              European Countries



                  Percentage of Latin American Countries Having Implemented Capital Market
                                                   Average Maturity of Corporate Dollar Bonds by Jurisdiction
                                                                                  Reforms
         12

         10
 120%     8

   s
          6
    ear
       Y
          4
                                          1.0                                                                       1.0
          2




                                                                                                                                      100%
 100%                                           94%
                                                                                                                    91%                                     92%
                         88%

  80%

                                          63%                                                                64%                62%
                    56%
  60%


  40%        31%                                                                                                                                     33%
                                   25%                                             27%

  20%                                                                                                                     15%

                                                                                                                                                0%
        0%

             Supervisory Agency     Establishment of                                                       Custody         Trading Systems        Clearing and
                  Creation       Insider Trading Laws                                      Arrangements                                      Settlement Processes


                                       Before 1990                                                          By 1995         By 2002


Source: De la Torre and Schmukler (2004b), Kaminsky and Schmukler (2003)


                                                                                                  33

                                                                        Figure 2
                                        Domestic Financial Sector Development Across Countries
This figure shows credit to the private sector by deposit money banks and other financial institutions over GDP, domestic
stock market capitalization over GDP, and the amount outstanding of private sector domestic bonds over GDP at year-end
2004 for selected countries.


Percentage of GDP, 2004
  200%                                                                                                                   250%


  175%


  150%


  125%


  100%


   75%


   50%


   25%

                                                   n/a
    0%
             A           Br       Chile   Colom          Mexico   Pe              Ko      Malays     Thailand
              rgentina     azil                                     ru              re                           France   Jap     U.S.

                                                                                      a                                      an
                                               bia                                              ia


                                                  Credit to the Private Sector by Financial Institutions
                                                  Stock Market Capitalization
                                                  Amount Outstanding of Private Sector Domestic Bonds



Source: BIS, IMF International Financial Statistics, S&P Emerging Markets Database, World Bank




                                                                          34

                                                                                      Figure 3
                                                            Domestic Stock Market Development
This figure shows the evolution of domestic stock market capitalization over GDP and value traded domestically over
GDP. The series are averages across countries. The data for G-7 countries are averages for Canada, France, Germany,
Italy, Japan, United Kingdom, and United States. The data for East Asian countries are averages for Hong Kong,
Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand. The data for Latin American countries are averages
for Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.


                                                                Market Capitalization / GDP


  160%
                                                                                                                                                                                 146.3%

  140%


  120%

                                                                                                                                                                                  93.6%
  100%


    80%


    60%

                                                                                                                                                                                      41.7%
    40%


    20%


     0%


             1978          1980      1982          1984         1986         1988           1990       1992          1994          1996          1998          2000          2002        2004



                                                            Value Traded Domestically / GDP



  120%


                                                                                                                                                                                  98.5%

  100%

                                                                                                                                                                                  85.6%

   80%



   60%



   40%



   20%

                                                                                                                                                                                  3.4%

    0%


         1978     1979 1980     1981     1982 1983     1984 1985    1986 1987     1988  1989      1990     1991 1992     1993 1994      1995 1996     1997 1998     1999 2000     2001       2002


                                     Latin American Countries                                   G-7 Countries                          East Asian Countries


Source: S&P Stock Markets Factbook, World Bank


                                                                                            35

                                                    Figure 4
                                      Domestic Bond Market Development
This figure shows the evolution of the amounts outstanding of public and private sector bonds in domestic markets
over GDP. The series are averages across countries. The data for G-7 countries are averages for Canada, France,
Germany, Italy, Japan, United Kingdom, and United States. The data for East Asian countries are averages for Hong
Kong, Korea, Malaysia, Taiwan, and Thailand. The data for Latin American countries are averages for Argentina,
Brazil, Chile, Mexico, and Peru.


                        Amount Outstanding of Public Sector Domestic Bonds/GDP


  80%


  70%                                                                                                    68.0%


  60%


  50%


  40%


  30%
                                                                                                         25.6%


  20%
                                                                                                         20.7%

  10%


   0%

      1994      1995      1996      1997       1998    1999      2000      2001       2002      2003      2004



                       Amount Outstanding of Private Sector Domestic Bonds/GDP



 60%




 50%                                                                                                     47.3%



 40%
                                                                                                         36.3%


 30%




 20%


                                                                                                         10.7%
 10%




  0%

    1993       1994     1995    1996      1997     1998    1999      2000     2001      2002     2003      2004


                        Latin American Countries       G-7 Countries         East Asian Countries



Source: BIS, World Bank


                                                      36

                                                     Figure 5
                                          Financial Sector Development
This figure shows the evolution of credit to the private sector by deposit money banks and other financial
institutions over GDP. The series are averages across countries. The data for G-7 countries are averages for Canada,
France, Germany, Italy, Japan, United Kingdom, and United States. The data for East Asian countries are averages
for Indonesia, Korea, Malaysia, Philippines, and Thailand. The data for Latin American countries are averages for
Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.


                       Credit to the Private Sector by Financial Institutions/GDP



 140%

                                                                                                           125.5%

 120%



 100%


                                                                                                            75.7%
  80%



  60%



  40%

                                                                                                            25.5%

  20%



    0%

       1978   1980    1982    1984    1986   1988     1990   1992    1994     1996   1998     2000   2002    2004


                         Latin American Countries        G-7 Countries          East Asian Countries

Source: World Bank




                                                        37

                                                   Figure 6
                                          Stock Market Delistings
This figure shows the number of listed firms in domestic stock markets for selected Latin American countries.




                Number of Listed Firms in Domestic Stock Markets in Latin America

600



500



400



300



200



100



  0

         Argentina        Brazil          Chile       Colombia        Mexico            Peru       Venezuela


                              1990               1995             2000               2004



Source: S&P Stock Markets Factbook




                                                       38

                                                       Figure 7
                    Internationalization of Stock Markets Relative to Domestic Activity
This figure shows market capitalization of international firms over total market capitalization, value traded abroad
over value traded domestically, and capital raised abroad over capital raised domestically. The series are averages
across countries. The data for G-7 countries are averages for Canada, France, Germany, Italy, and Japan. United
Kingdom and United States are not included because they are considered international financial centers. The data
for East Asian countries are averages for Hong Kong, Indonesia, Korea, Malaysia, Philippines, Taiwan, and
Thailand. The data for Latin American countries are averages for Argentina, Brazil, Chile, Colombia, Mexico, Peru,
and Venezuela. International firms are those identified as having at least one active depositary receipt program at
any time in the year, or having raised capital in international markets in the current or previous years, or trading in
the London Stock Exchange (LSE), New York Stock Exchange (NYSE), or NASDAQ.



              Market Capitalization of International Firms / Total Market Capitalization
 75%
                                                                  64.0%

 60%
                                                           48.7%
                        45.1%
                              43.1%
 45%

                                                                                                      32.6%
                                                   28.6%
 30%                                                                                          24.3%


 15%                                                                                   8.1%
               3.5%

   0%

             Latin American Countries                  G-7 Countries                   East Asian Countries


                            Value Traded Abroad / Value Traded Domestically
 150%

                               122.4%
 125%

                        96.2%
 100%


   75%


   50%


   25%
                 0.7%                               0.2%    4.3% 3.4%                  0.2%    2.6%    4.0%

    0%

              Latin American Countries                  G-7 Countries                  East Asian Countries


                            Capital Raised Abroad / Capital Raised Domestically
  140%
                        118.5%
  120%

  100%                          91.9%

   80%

   60%
                                                            41.6%
   40%                                                             32.5%

                                                                                                      17.1%
   20%           8.8%
                                                     4.5%                                      7.8%
                                                                                       1.9%
    0%

              Latin American Countries                  G-7 Countries                  East Asian Countries

                                                1990       1996     2000


Source: De la Torre and Schmukler (2004b)




                                                          39

                                                               Figure 8
                                                     Stock Market Concentration
This figure shows the share of total stock market value traded represented by the top ten firms in each market in
2004. Data for the U.S. correspond to the New York Stock Exchange.


                                           Share of ValueTraded by Top Ten Firms
90%


80%


70%


60%


50%


40%


30%


20%


10%


 0%
         A          Br      Chile  Colom       Mexico     Pe           Ko     Malays    Thailand    Jap    U.K.  U.S.
          rgentina    azil                                  ru           re
                                                                           a                           an
                                        bia                                         ia




Source: World Federation of Exchanges




                                                                 40

                                                           Figure 9
                                  Segmentation in Access to Domestic Bond Markets
The top figure shows the distribution of the cumulative amount of corporate bonds issued in the Chilean market over the
2000-2003 period by firm size. The bottom figure shows the distribution of the amount outstanding of corporate bonds in the
Mexican market on October 2003 by issuer. Mega firms are defined as those with annual sales net of VAT above UF
600,000 (17.2 million U.S dollars); large firms have sales between UF 100,000 (2.8 million U.S dollars) and UF 600,000;
medium firms have sales between UF 25,000 (US$0.7 million) and UF 100,000; small firms have sales between UF 2,400
(68,688 U.S dollars) and UF25,000 and micro firms have sales below UF2,400. Micro firms represent around 82 percent of
all firms in the economy, while small firms are 15 percent and medium firms two percent. Large and mega firms combined
account for one percent of all firms.



               Chile - Cumulative Amount of Corporate Bonds Issued in the Local Market by Firm
                                                       Size (2000-2003)
                                                                       0%
                                                                        0%
                                                        7%             0%




                                                                                          93%




                    Mega Firms        Large Firms          Medium Firms       Small Firms       Micro Firms



                Mexico - Amount Outstanding of Corporate Bonds in the Local Market by Issuer
                                                          (Oct-2003)


                                         Other, 12%                             Cemex, 16%



                             IMSA, 5%


                                                                                            A. Movil, 13%
                       Pemex, 7%




                    Bimbo, 7%

                                                                                             Ford, 12%


                           GMAC, 7%


                                  Telmex, 10%

                                                                         KOF, 11%


Source: Bolsa Mexicana de Valores, JPMorgan. Sirtaine (2004)


                                                              41

                                                    Figure 10
                                Institutional Environment and SME Growth
This figure shows the impact of different constraints on firm growth by firm size. The reported values are
calculated as the mean value of each obstacle for the different firm groupings multiplied by the coefficients for
the different firm groupings estimated from a regression of firm growth over the previous three years (measured
by firm sales) on measures of ownership, industry characteristics, firm size, country-level variables, and
interaction terms between dummies for the different firm groupings and the reported obstacles to firm growth.
Firms are classified as small if they have between 5 and 50 employees, medium if they have between 51 and 500
employees, and large if they have more than 500 employees. Data on the relevance of obstacles are based on
survey responses to questions requiring firms to rate the extent to which financing, legal, and corruption problems
present obstacles to the operation and growth of their businesses. Data are based on the World Business
Environment Survey (WBES) and cover over 4,200 firms from 54 countries.




                   Impact of Financial and Legal Obstacles on Firm Growth by Size


                Financing Obstacles                  Legal Obstacles                   Corruption Obstacles

   0%




 -3%




 -6%




 -9%




-12%
                         Small Firms                    Medium Firms                       Large Firms




Source: Beck, Demirguc-Kunt, and Maksimovic (2005)




                                                        42