Development of the financial system in Latin America: the funding gap

The financial system in Latin America has gone through major changes over the past two decades. From the 1990s governments in the region began to introduce reforms to liberalise the financial sector, with less government involvement and greater private-sector participation. In particular there was a rise in foreign ownership and banking concentration. Concentration increased substantially in the 2000s, with the three largest banks increasing their average assets from 51% in 2000 to 71% in 2009. Major banks grew in importance in the region while the business model shifted from relationship banking to multi-service banking. Foreign banks have gradually increased their presence in Latin America, raising their share of assets to 31%, one of the highest rates in the world.7 This figure is far above the rates of foreign ownership in South Asia (8%) and the OECD countries (12%), but close to the rates in sub-Saharan Africa (28%) and Eastern Europe (28%). However, bank ownership varies hugely across the region, with almost all banks in Central America and the Caribbean being foreign-owned.

The changes in the Latin American banking system have affected the finance mechanisms for SMEs. The arrival of larger banks with a multi-service business model instilled the idea that, unlike smaller banks, which have more of a relationship model, large banks provide fewer resources to SMEs, since they would not be interested in doing business with these kinds of firms because of information problems, high fixed costs for relatively small transactions, and the impossibility of using the economies of scale that exist when lending to large firms. However, in recent years large banks in the region have shown a growing interest in providing services to SMEs, but their supply is still insufficient (Figure 3.3) (de la Torre et al., 2010).

Various studies on the presence of foreign banks in Latin America have examined their impact on efficiency and competition in the banking sector, stability, the import of external shocks and credit to SMEs. The studies generally show that these banks are operationally more efficient than domestic banks, with lower interest margins and overhead costs (Yeyati and Micco, 2007). In addition, several studies have found no significant difference in lending to SMEs between foreign banks and major domestic and public banks (de la Torre et al., 2010; Beck et al., 2011). However, there is mixed evidence regarding the relationship between foreign banks and lending to SMEs, or at least there is not such a positive correlation with lending to such firms. Foreign banks seem to be more reluctant to lend to small firms without clear information proving their solvency. When they do lend, they prefer providing short-term loans to larger companies (Berger et al., 2001; Mian, 2006 and Ferraro, 2011). While the presence of foreign banks helped bring stability during the crises of the late 1990s, lending by foreign banks fell sharply during the 2008 crisis, increasing the risk of shocks being imported from developed countries (Cetorelli and Goldberg, 2011; Gianetti and Laeven, 2012).

Despite considerable improvements in recent years, the Latin American credit model for SMEs is still faced with challenges both in the supply and demand of finance. From the point of view of supply, the current multi-service banking model, with methods based solely on the company’s solvency and not its projected profitability, has brought about an inflexible way of assessing and measuring risk, a low debt-recovery rate among financial institutions (due to the lack of information and transparency of balance sheets), lower economies of scale (due to the fixed costs of small transactions) and problems with selection methods, which have segmented the credit market. From the point of view of demand, SMEs are faced with various obstacles limiting their access to finance. These include technical requirements for obtaining a loan, collateral requirements, and high interest rates. Because of the nature of supply and demand for finance, commercial banks tend to lend very little to SMEs, which must therefore rely heavily on self-financing and resources from suppliers. So, although credit is available, bureaucracy, such as balance-sheet requirements (which often SMEs report incomplete) or collateral requirements make it hard to access. Financial institutions and financing mechanisms have a crucial role to play in breaking down these barriers and thus improving access to credit for SMEs, providing them with specific instruments and support in applying for and managing loans.

International financial regulation has been highlighted as a possible explaining factor for why the banking sector largely ignores SMEs (OECD, 2012a). Although Basel II9 is still being implemented in the region, its effects need evaluating, especially on lending practices for businesses. The gradual, delayed implementation of Basel II in Latin America has focused particularly on capital adjustments (de la Torre et al., 2012). By requiring larger provisions, the capital available for borrowing (personal or corporate) may have declined in some segments of commercial banking. However, previous financial crises endowed countries in the region with domestic regulations to tackle the problems associated with credit risk. But in several countries it is national rather than international regulations that have tended to damage the availability of credit to SMEs. 

New regulations for managing liquidity introduced as part of Basel III in 2009 in response to the international economic crisis seek to strengthen certain key measures to prevent the kind of liquidity problems that have come to the fore during the crisis, especially those related to capital requirements.10 The new regulation can generate two opposite effects on lending to SMEs: it can increase liquidity requirements for the banking sector and reclassify loans to small businesses with a lower risk level. As in other episodes of crisis, higher capital requirements can trigger commercial credit rationing or higher financing costs (OECD, 2012a; Elliot, 2010). Moreover, classifying loans to SMEs as retail banking could allow financial institutions to reduce the sector’s risk classification. This approach, unlike a corporate loan classification, can allow the risk premium charged to small businesses to be cut. The net effect on SMEs in the coming years will depend on these two factors, once the regulation has come into force.

Credit guarantee schemes allow SMEs to use low-risk assets (financial and non-financial) as collateral and can help downgrade the assessed risk, thus facilitating the provision of credit to such firms. The Basel III regulations allow guarantees to be used to reduce companies’ risk weight and therefore cut down the reserve capital requirements. This may be one of the most significant changes to finance for SMEs, since it encourages financial institutions to become involved in such programmes. National regulations can complement these schemes, allowing the use of mobile assets (e.g. machinery) as collateral. These possibilities open the door for targeted government intervention.