Download The political economy of the Ecuadorian financial crisis

Cambridge Journal of Economics Advance Access published December 6, 2005
Cambridge Journal of Economics 2005, 1 of 19
doi:10.1093/cje/bei097
The political economy of the Ecuadorian
financial crisis
Gabriel X. Martinez*
This paper takes the unusual step of exploring economic hypotheses through
interviews with key economic agents. It focuses on the causes of Ecuador’s 1999
banking collapse, within an eclectic framework with Minskian elements. Broad
support is found for ‘endogenous’ explanations of financial crises and little backing
for explanations such as accidents or policy mistakes. Interviewees argued that after
the stabilisation programme of 1992, agents became euphoric and accumulated
debt to finance imprudent levels of expansion; that incentives for moral hazard led
to financial corruption and excessive risk taking; and that weak regulation after
financial liberalisation encouraged financial fragility.
Key words: Financial crises, Euphoria, Moral hazard, Financial liberalisation,
Minsky
JEL classifications: E44, E52, G28, N26
1. Explaining the Ecuadorian financial crisis
Between August 1998 and October 1999, half of all Ecuadorian domestic private banks
failed. The State rushed in to protect all deposits: the bailout effort, financed by rapid
monetary expansion, led to a currency collapse. Eventually, the government scrapped the
national currency and instituted the US dollar as legal tender.
What caused the Ecuadorian banking collapse? Many knowledgeable Ecuadorians hold
that banks, already in a situation of extreme vulnerability, experienced significant
confidence and asset-side shocks. Financial fragility (caused by excessively fast credit
growth and liability dollarisation1) was due to euphoria and moral hazard and was made
possible by lax banking authorities, who had been weakened by financial liberalisation.
Between 1992 and 1995, a neo-liberal administration had enacted a drastic stabilisation
plan and liberalised the financial system. A series of political, economic and natural shocks
exposed the weaknesses of the financial system in 1995, but financial reform was
repeatedly postponed owing to political instability and to illusory hopes of general
Manuscript received 28 August 2003; final version received 23 May 2005.
Address for correspondence: Gabriel X. Martinez, Assistant Professor of Economics, Ave Maria University,
1025 Commons Circle, Naples, FL 34119, USA; email: [email protected]
*Ave Maria University, Naples, FL. The author is indebted to an anonymous referee and to Guillermo
Montes for valuable comments, to Martin Wolfson and Jaime Ros for comments on previous versions of this
paper (the mistakes are all mine), to Joaquı́n Martı́nez for contacts with interviewees, to the Central Bank of
Ecuador for an internship at the Guayaquil branch during the spring of 2000, and to the Kellogg Institute for
International Studies at the University of Notre Dame for financial support during 1996–2001.
1
Commercial-bank credit grew by nearly 200% in real terms between 1992 and 1995. The proportion of
foreign-currency loans out of total loans went from 1.6% in 1990 to nearly 60% in 1998 (see Martı́nez, 2002).
Ó The Author 2005. Published by Oxford University Press on behalf of the Cambridge Political Economy Society.
All rights reserved.
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G. X. Martinez
improvement. The latter part of the decade was marked by persistently contractionary
monetary policy, a chronic fiscal deficit, repeated natural shocks and international financial
crises.
As Taylor (1998) pointed out, most financial crises are similar. A review of the empirical
literature on financial crises (International Monetary Fund (IMF), 2002, p. 7) suggests
that they are always characterised by financial or economic imbalances, such as a mismatch
in the currency denomination of assets and liabilities or excessive non-performing loans.
Indeed, Ecuador experienced such imbalances.1 Why did Ecuadorian economic agents
accumulate high levels of dollar-denominated debt and, in so doing, allow themselves to
become highly vulnerable to external shocks?
Taylor (1998) identifies four kinds of explanations of financial crises (macropolicy
weakness, financial liberalisation, moral hazard and euphoria), some of which are readily
quantifiable and some of which are not. His list is consistent with other surveys of
explanations for financial crises, e.g., Palma (1998), Bustelo (1998) or Gavin and
Hausmann (1996).
The first explanation begins with Roberto Frenkel’s (1983) article, whose detailed
macroeconomic model showed how exchange-rate uncertainty (and uncertainty in
general) can generate perverse macroeconomic results (which may imply financial crises).
This rigorous and careful model was in stark contrast to mainstream models in which
financial relations are self-correcting and financial crises are unlikely if agents are rational
and free from government control.
Versions of this explanation reached mainstream circles a decade and a half later. The
mainstream variant also suggests that there are features in the structure of the economy
that lead to financial crises. Yet the difference is that in these stories financial crises take
place when economic agents take advantage of intrinsic weaknesses of macro policymaking, laying the blame not on fundamental factors such as uncertainty, but on outside
forces such as fiscal imbalances (based on Krugman, 1979) or time inconsistency in
monetary policy (following Obstfeld, 1994). That these are popular mainstream
explanations can be attested by the large literature spawned by the East Asian financial
crisis (see, for example, Calvo and Mendoza, 1996; Corsetti et al., 1998B; Dornbusch
et al., 1995; IMF, 2002; Sachs et al., 1995).
Financial liberalisation undermines the regulatory authority (De Juan, 1996) and
encourages a lending boom (Gourinchas et al., 2001; McKinnon and Pill, 1996),
characterised by ‘speculation-led financial development’ (Grabel, 1995). An important
early example of this explanation is Dı́az Alejandro (1985). For the case of Ecuador, see De
la Torre et al. (2001). Also see Goldfajn and Valdés (1997), Chang and Velasco (1998),
Kaminsky and Reinhart (1999), Sachs et al. (1996).
Moral-hazard-driven behaviour weakens financial structures. In particular, economic
agents take advantage of implicit or explicit deposit insurance. Lack of disclosure and
perverse institutional incentives encourage agents toward moral-hazard-driven behaviour
(see De Juan, 1996; Ayala, 1999; Mishkin, 1998), particularly, rapid accumulation of debt
that makes the financial system fragile (Aoki, 1996). A financial crisis occurs when a shock
makes information dramatically more asymmetric (Mishkin, 1996). Moral hazard is a key
mainstream explanation (e.g., Dooley, 2000; Krugman, 1998), but is also well known
outside the mainstream (e.g., Dymski, 1994; Dymski and Pollin, 1992; Grabel, 1995).
1
In the run-up to the crisis, bad-loan levels doubled to nearly 10% of total loans, as an average for
commercial banks, while currency mismatch [defined as (Foreign-Currency Loans/Total Loans)/(ForeignCurrency Quasi-Money/Quasi-Money)] went from 22% in 1990 to 139% in 1999). See Martinez (2002).
The political economy of the Ecuadorian financial crisis
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Euphoria, or self-feeding optimism, leads agents to discount risks and overestimate their
capacity to resist shocks. This explanation is associated with Hyman Minsky (1975, 1982,
1986). Periods of institutional reform and economic prosperity lead to rising expectations,
so that borrowers’ perceived creditworthiness rises, and the perceived risk of financial
expansion falls. The economy becomes financially fragile endogenously because agents have
institutional and psychological incentives to make mistakes in judgment and confuse
temporary increases in creditworthiness with permanent changes (see Crotty, 1994;
Grabel, 1995). McKinnon and Pill (1996) and Lucio-Paredes (1999) also provide support
for this hypothesis. This explanation is similar to the ‘good times are bad times for learning’
(cf., Gavin and Hausmann, 1996, pp. 54–5) explanation of lending booms.
This paper will focus on the banking collapse, even though the Ecuadorian financial
crisis of 1999 was much wider. It will give special importance to the sources of the collapse,
mainly the motivations of economic agents, and less importance to the mechanics of the
collapse (such as the nature and level of imbalances, the aggravating factors, etc.).
Mechanically speaking, banks became fragile because of quantifiable factors such as
excessive credit growth in the early 1990s and excessive loan dollarisation later on (see
footnote 1 on p. 1); and owing to factors that are not quantifiable or for which quantitative data are not reported, such as accounting for bad loans in unregulated offshore subsidiaries and lending to connected businesses; low capitalisation covered up by cosmetic
accounting, and so on. In general, these stories are best understood in terms of how flowof-funds accounts oscillate and interact with capital gains. Yet these mechanics are well
understood and documented for other countries; this paper will therefore attempt to
identify the source of Ecuadorian banks’ fragility.
Palma’s (1998) analysis of the three major financial crises of the late twentieth century is
very similar in many respects to the present work: he also considers over-optimism,
‘distorted domestic incentives’ and weak financial regulation (Palma, 1998, p. 790). While
Palma focuses on the role of international lenders, this paper focuses on the determinants
of the behaviour of domestic agents.
Precisely because, to a large degree, the fundamental causes of the crisis are unquantifiable, this paper relies on personal interviews with bankers, businesspeople, regulators,
economic analysts and authorities. This paper is thus divided into six sections:
methodology; the explanations of bad macro policy-making; financial liberalisation; moral
hazard; euphoria; and conclusion.
2. Methodology
This paper focuses on qualitative hypotheses (such as moral hazard and euphoria), which
are explored through personal interviews with knowledgeable agents, following the
rigorous guidelines of King et al. (1994, ch. 4–5). The sample focused on those individuals
who have the resources and the training to go beyond the moment or the superficial, those
who can suggest overarching themes and deep causes, and, especially, those with exposure
to and influence on behind-the-scenes events.
Interview bias was carefully avoided by interviewing bankers and many kinds of nonbankers; critics and supporters of the banking system and of the different administrations;
people from several regions of the country, from several racial and social backgrounds, of
various ages, men and women; individuals of disparate political affiliations (from neoliberal to socialist and everything in between). Details are available upon request.
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G. X. Martinez
Table 1. Government balance, real interest rates, and real exchange rate, Ecuador, 1990–99
1990
Government surplus
or deficit (% of GDP)
Real loan rate
(%, year-end)
Year-end real exchange
rate (Aug/92¼100)
0.5
3.7
1991 1992 1993 1994 1995 1996 1997 1998 1999
0.6 1.2 0.1
3.2 1.8
108.1 104.4
92.5
0.6 1.1 3.0 2.5 5.6
5.8 16.0
29.0
14.7
7.4
80.1 72.7
78.2
80.1
75.9
12.6
4.6
8.8
82.5 157.7
Source: Banco Central del Ecuador, Base de Datos de Estudios.
Interviewees were allowed and encouraged to suggest their own explanations, after being
directed to the topic of the banking crisis. Interviewees were often quite eager to expound
on their view as to why Ecuador was in trouble. Little prompting was necessary.
The period of study is August 1992–December 1999, that is, from the implementation
of a neo-liberal structural reform package to the collapse of the Ecuadorian economy. The
interviews were carried out in the three main cities of Ecuador, between 28 January and 15
May 2000.
3. Macroeconomic policy mistakes
Financial crises are typically blamed on ‘bad fundamentals’, particularly chronic
government budget deficits and overvalued currency/high interest rate traps. From Table 1,
it is clear that fundamentals were indeed unsound. But these explanations fail to account
for the high levels of private debt, for growing loan dollarisation and for shaky financial
practices. For their role in aggravating or precipitating the crisis—but not in causing it—
along with that of other disastrous government policies, see Martı́nez (2002). Moreover, as
reported in Table 2, the interviewees did not generally support these factors as
fundamental explanations of the crisis. When asked, ‘what caused the crisis?’ a large
number of interviewees did not even consider bad macroeconomic policies as possible
fundamental causes. A few bankers argued that high rates of loan default were due to
persistently high interest rates. But most people agreed with the economist who said that
this explanation is ‘superficial’ and self-serving.
This conclusion, that the crisis is not the result of a policy mistake but an endogenous
product of the system, was Minsky’s main contention.
4. Financial liberalisation
As Dı́az Alejandro (1985) pointed out, financial liberalisation often produces lending
booms and weakens banking regulation; both effects are related to financial crises. Indeed,
in Ecuador there was little financial accountability owing to weak regulation and
supervision, rapidly increasing loan rates and operating costs, and heightened risk-taking
in credit.1
1
There was a ‘minor’ financial crisis in late 1995/early 1996, when many financial companies and one of
the largest banks in the country failed (see Camacho, 1996). In spite of this warning, there was no effective
reform of the financial system, so moral hazard and euphoria deepened the financial system’s flaws until its
collapse in 1998–99.
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Table 2. Interviewee support for unsound policy as an explanation of the crisis, Ecuador, 2000
Interviewee (No.)
Strongly
agree
(%)
Agree
(%)
Indifferent
(%)
Disagree
(%)
Strongly No
disagree mention
(%)
(%)
The Government’s chronic deficit was a main cause of the crisis
Bankers (18)
0
28
22
6
Businesspeople (13)
15
8
0
0
Authorities/politicians (9)
0
11
0
22
Economists (5)
20
20
40
20
0
0
0
0
44
77
67
0
High-interest rate monetary policy was a main cause of the crisis
Bankers (18)
33
44
11
0
Businesspeople (13)
15
15
8
0
Authorities/politicians (9)
0
56
0
0
Economists (5)
40
20
20
20
0
0
0
0
11
62
44
0
Note: Given the considerable overlap among categories, interviewees were classified according to their
main affiliation.
Source: Author’s interviews.
How are we to measure whether financial liberalisation weakens regulators? Knowledgeable opinions on this topic can be found below, yet an indication of weakened regulation
might be an increasing degree of turnover of Banking Superintendents and abundant
connections with the financial sector. During 1979–92 (from the return to democracy to
the beginning of the neo-liberal administration), the average Banking Superintendent held
his job for 29.4 months: in the post-liberalisation period (1992–99), average tenure fell to
16.2 months, implying the highest turnover rates since the politically turbulent 1930s. A
high degree of turnover and the political/legal weakening of Banking Superintendents
clearly are mutually reinforcing. Moreover, nearly all post-financial liberalisation Banking
Superintendents were well connected with the financial sector, as bank lawyers,
administrators, directors, etc. (see Martı́nez, 2002).
As indicators of financial liberalisation, Kaminsky and Reinhart (1999) use the M2
multiplier, the ratio of domestic credit to GDP, the real interest rate, and the lending–
deposit rate ratio.1 Theory predicts that these indicators should rise at some point during
the liberalisation (1992–95), but a fall in the indicators may not bring a return to non-crisis
conditions (due to hysteresis in the quality of loan portfolio). Table 3 gives a summary of
the evolution of these indicators in the Ecuadorian economy.
Note that the M2 multiplier grew by 53%, while domestic credit more than doubled as
a percentage of GDP between 1992 and 1994. The real deposit rate and the real lending
rate both rose by about 25 percentage points between 1993 and 1995. All four indicators,
consistently with the expectations of the financial crises literature, rise around the time of
financial liberalisation, weakening the financial system. Only the lending–deposit rate ratio
shows no clear pattern (yet it rose in the early 1990s and remained high).
1
For the role of the M2 multiplier and the ratio of domestic credit to GDP, see McKinnon and Pill (1996).
Financial deregulation is associated with high interest rates (see McKinnon, 1973), which can lead to
increased risk taking (see Galbis, 1993). A high lending–deposit rate ratio indicates higher operating costs
and/or decreased loan quality (Kaminsky and Reinhart, 1999). Kaminsky and Reinhart (1999) find that the
real deposit rate predicts 100% of the crises in their sample; the M2 multiplier, 73%; the lending–deposit rate
ratio, 57%; and the domestic credit/GDP ratio, 50%. For more details, see their paper.
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G. X. Martinez
Table 3. Indicators of financial liberalisation, Ecuador, 1990–98
M2 multiplier
Domestic credit/GDP (%)
Real deposit rate (%)
Real lending rate (%)
Lending/deposit rate ratio
1990
1991
1992
1993
1994
1995
1996
1997
1998
2.7
40.5
3.3
7.4
0.9
3
44.9
4.9
1.4
1.1
2.8
43.6
4.9
3.8
1.3
2.8
99.1
9
1.9
1.5
3.7
105.3
4.9
13
1.3
4.3
69.1
16.6
26.7
1.3
4.7
70.5
13.8
24.2
1.3
4.7
79.9
2
9.5
1.5
5.1
105.2
2.4
9.9
1.3
Notes: M2 multiplier is calculated by adding IFS lines 34 and 35 and dividing the result by IFS line 14.
Domestic credit/GDP is calculated by dividing IFS line 52 by IFS line 64 to obtain domestic credit in real
terms, which is then divided by IFS line 99.b.p.
The nominal interest rates (IFS lines 60l and 60p) are deflated by IFS line 64 to obtain real interest rates.
IFS line 60p is divided by IFS line 60l, rather than subtracted, to avoid the distortion of high inflation rates.
Source: International Financial Statistics, IMF.
Table 4. Interviewee support for financial liberalisation as an explanation of the crisis, Ecuador, 2000
Lax/complicit regulation and financial liberalisation were main causes
of the crisis
Interviewee (No.)
Bankers (18)
Businesspeople (13)
Authorities/politicians (9)
Economists (5)
Strongly Agree Indifferent Disagree Strongly
No mention
agree (%) (%)
(%)
(%)
disagree (%) (%)
44
15
44
60
44
8
44
40
11
0
0
0
6
0
0
0
0
0
11
0
0
77
0
0
Note: Given the considerable overlap among categories, interviewees were classified according to their
main affiliation.
Source: Author’s interviews.
Note also that there is strong agreement among bankers, economists and authorities/
politicians in that financial liberalisation is to blame, although (unsurprisingly) support for
this explanation is weaker among the last group (see Table 4). Businesspeople were least
interested in this explanation. However, there was consensus in that, while financial
liberalisation allowed financial irresponsibility, it did not encourage it. The rest of the paper
addresses agents’ motivations: moral hazard and euphoria.
The rest of this section provides a qualitative description of how the 1994 banking law
weakened the Banking Superintendence (SuperBan) and emphasises the perceived effects
of the proliferation of financial institutions.
4.1 Regulatory forbearance
The General Act of Institutions of the Financial System (LGISF) was enacted in May
1994. Its framers, according to a former Banking Superintendent, intended it to be based
on ‘liberty for everything except wrongdoing’ (i.e., allowing many services and encouraging innovation) and on self-control, following the Basle recommendations. Bankers
helped determine the shape of the new law and the extent of its enforcement.
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The law reduced the punishing capabilities of the SuperBan. According to a later
Banking Superintendent, it was tampered with for political or personal convenience: it
seemed ‘written by a bankrupt banker’. A former banker added, ‘Lack of self-control was
made manifest in problems of solvency, covered up by authorities who did not fulfill the
law . . . and by ‘cosmetic accounting’ to keep insolvency hidden.’
The new self-control procedures limited supervisors’ role to trusting financial
institutions implicitly and analysing them at a distance with Basle ratios, said a policymaker. Ailing banks would propose their own recovery plan (‘which was expected to be
demanding’, said a bank regulator). For fear of the domino effect, bank failures were
avoided through encouraging banks to behave better and hoping that things would
improve.
In practice, because they lacked instruments of moderate severity, Banking Superintendents strove to avoid any bank failure, with the result that banks faced weak market
discipline. They feared public condemnation because, as a former banker said, the public
lacked quality information or the capacity to analyse it, so that ‘when a bank was closed, it
seemed unfair. Depositors felt they had not had sufficient warning.’ Lack of legal power
and influence encouraged regulatory forbearance: authorities either rescued banks or
covered up their problems (cf., Mishkin, 1998). Indeed, the World Bank reported a ‘lack
of effective financial sector supervision, especially the pre-crisis reluctance of senior
management to take prompt corrective action in troubled institutions when problems were
first detected’ (2000, p. 42).
Some interviewees argued that regulators have conflicts of interest, in spite of their
theoretical autonomy, because of their connections with and dependence on the banking
and the political systems (see above). Even more, up to 2000, the law did not protect the
personnel of the SuperBan against prosecution by the industry they regulated.1
4.2 Excessive financial competition
Between 1993 and 1995, annual growth of real commercial-bank credit averaged over
40%, partly financed by a capital inflow of US$1.5bn over 1993–94 (see Figure 1).
Excessive competition was the main reason for this ‘orgy of credit:’ the number of banks
grew by 57% during liberalisation while the overall number of financial institutions
increased by 180%. The liberalisation law made opening a new bank very easy, which led to
financial fragility (see Tables 2 and 3 and Martı́nez, 2002). Indeed, according to a later
Banking Superintendent, authorities could do little to oppose the creation of a new bank.
Following the conclusions of McKinnon (1973) and Shaw (1973), international financial
institutions (cf., World Bank, 1989), authorities, and some Ecuadorian economists argued
that free entry and exit would strengthen market discipline: there could not be ‘too many’
banks.
Bankers and regulators alike argued that heightened competitive pressures and lax
regulation led bankers to high-stake gambling, including loose credit standards and rapid
accumulation of fixed assets, cutting corners and taking unnecessary risks, price wars in
deposit rates and Ponzi games in deposit-taking. The consequences were historically high
real loan rates (see Table 1) and poorer loan quality. After 1994, when the capital inflows
1
Others blame regulators’ excessively academic training and seclusion, which prevented them from
keeping up with rapid change. Others mention government auditors’ lack of technical quality or savvy; low
salaries; or lack of technical personnel after structural reform. Finally, some suggest that regulators suffered
from the same euphoria as bankers, particularly because of their commitment to free-market ideology.
G. X. Martinez
60.0
6.0
50.0
5.0
40.0
4.0
30.0
3.0
20.0
2.0
10.0
1.0
0.0
0.0
1990
-10.0
1991
1992
1993
1994
1995
Private Capital Inflows (% of GOP)
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-1.0
Fig. 1. Real growth in commercial bank credit and private capital inflows, Ecuador, 1990–95
Source: Banco Central del Ecuador, Base de Datos de Estudios
Note: Private capital inflows are measured as (foreign direct investmentþprivate debt flowsþother
capital flows).
dried up, the non-performing loan ratio rose from 3.8 that year to 9.2% in 1992 (see
footnote 1 on p. 2).
In the opinion of many interviewees, the key to the relation between financial
liberalisation and the breakdown of the financial sector is the prevalence of a ‘lack of
professionalism and professional training in banking’.1 People without experience or moral
character or with other commercial interests—and possibly conflicts of interest—could
easily become managers or owners of new banks.
In conclusion, the Ecuadorian system of bank regulation and supervision was greatly
weakened by the financial liberalisation of the early 1990s. Authorities were loth to apply
the law because of fear of a domino effect or because of a lack of legal power. Deregulation
allowed financial institutions to engage in risky practices that lowered the quality of the
loan portfolio. Indeed, economic agents themselves seemed to prefer risky strategies.
The next two sections look at the plausible motivations for people’s behaviour over the
decade.
5. Moral hazard
The moral hazard explanation of the Ecuadorian financial crisis focuses on (a) the
asymmetry of information in Ecuador and (b) the widespread belief that the State would
protect depositors’ and even bankers’ property. The concept of moral hazard was used by
Keynes and by Minsky to develop the concept of lenders’ risk (cf., Minsky, 1986) and is
present in much of the asymmetric-information literature on financial crises. Moral hazard
is, in itself, unquantifiable: this section is therefore an account of informed opinion on
moral hazard in Ecuadorian banking.
Information is very asymmetric in Ecuador. Interviews confirmed that statistics on
individual and business activities are scanty and unreliable, and that although banks face
1
For example, an important, professional bank manager remarked that, often, after having obtained
a bank charter, groups of wealthy people would ‘grab young men who had been currency traders at this bank,
for example, and would make them bank managers!’
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Table 5. Capital/asset ratios of private domestic banks, self-reported versus bank audits reports,
Ecuador, 1999 (%)
Bank
Marcha
Aprilb
Maya
Préstamos (F)
Progreso (F)
Filanbanco (F)
Bancomex (F)
Crédito (F)
Solbanco (F)
Unión (F)
Pacı́fico (F)
Previsora (F)
Cofiec (S)
Popular (F)
Austro (S)
Amazonas (S)
Pichincha (S)
33.56
232.5
8.82
13.36
19.01
2.90
0.53
0.23
2.07
3.04
0.11
4.26
10.35
4.63
n.a. 377.56 Bolivariano (S)
5.87 241.31 Centro Mundo (S)
12.52 25.46 Guayaquil (S)
11.17 19.55 Litoral (S)
12.56 11.99 Produbanco (S)
20.12
n.a. Aserval (S)
9.01
3.98 Solidario (S)
10.33
0.29 Internacional (S)
9.38
1.84 Machala (S)
22.70
3.48 Unibanco (S)
13.75
3.52 Gral. Rumiñahui (S)
12.20
9.10 Territorial (S)
10.08
9.06 Loja (S)
10.66
9.14 Comercial Manabı́ (S)
Bank
Marcha Aprilb Maya
6.10
9.23
8.42
5.51
9.90
7.12
9.13
12.96
15.85
29.70
14.01
28.56
39.87
55.30
13.32
10.82
11.03
21.95
12.51
9.76
13.66
16.65
21.04
22.43
20.56
29.66
35.03
66.45
9.20
9.26
9.89
10.09
10.20
10.21
10.26
15.34
15.45
15.71
16.34
23.73
30.79
60.25
Notes: S (Surviving bank), F (Failed bank). Six domestic private banks are not included because they
failed before March 1999.
a
From the report by a group of foreign audit firms, hired by the Government in early 1999.
b
From the data published by the Banking Superintendence.
Source: Jaramillo (1999).
heavy regulation reporting requirements, there are many reasons to doubt the figures they
produce (particularly in bad times, when the incentives to misreport increase). Martinez
(2002) finds that cosmetic accounting played an important part in the 1998–99 deposit
runs: as shown in Table 5, the banks that would eventually failed had the most ‘make up’.
Jaramillo (1999) uses similar data to argue that (at least in March–May 1999, the peak of
the crisis) banks did not provide trustworthy data to the public or to regulators (but the
1999 audits uncovered presumably more reliable information). Under the cover of
cosmetic accounting, bankers may have ‘bet the bank’, carrying out inadequate and/or
risky practices, and covering up the resulting weaknesses.
Risky practices would yield generous profits if successful—if they failed, the losses would
be borne by the taxpayer. During an economic downturn—such as experienced by
Ecuador in the late 1990s—deposit insurance allows bank’s expected profits to rise with
increased risk-taking (cf., Corsetti et al., 1998A, p. 4).
Citing events of the 1980s and 1990s and the experience of other countries with financial
crises, interviewees argued that for both technical and political reasons (such as the
political ties of the financial community: see above) an implicit deposit insurance scheme
existed. Interviewees argued that many held the expectation that banks and bankers would
be protected.
Those expectations proved correct. In 1998–99, the entirety of the financial system was
protected (at least in nominal terms) at the expense of the economic and political stability
of the country.
In the interviews, the moral hazard explanation met with mixed success. Table 6
summarises interviewees’ opinions on the role of moral hazard in the Ecuadorian financial crisis. Three bankers flatly rejected the idea; seven interviewees were indifferent; the
remaining 35 interviewees (out of 45) expressed support in varying degrees. Unsurprisingly,
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G. X. Martinez
Table 6. Interviewee support for moral hazard as an explanation of the crisis, Ecuador, 2000
Moral hazard in banking was a main cause of the crisis:
Interviewee (No.)
Bankers (18)
Businesspeople (13)
Authorities/politicians (9)
Economists (5)
Strongly Agree Indifferent Disagree Strongly
No mention
agree (%) (%) (%)
(%)
disagree (%) (%)
11
54
44
40
61
15
44
60
11
31
11
0
17
0
0
0
0
0
0
0
0
0
0
0
Note: Given the considerable overlap among categories, interviewees were classified according to their
main affiliation.
Source: Author’s interviews.
bankers were the least enthusiastic of the sample about this explanation; but even they, as
a whole, admitted that corruption and moral hazard were to blame.
Of those that supported the moral hazard explanation, nearly all argued that immoral
banking practices, endemic as they were, had been encouraged by the deregulation of 1994
and the ideological position of both the authorities and the market. The CEO of
a conservative, surviving bank keenly observed, ‘People believe they have an entitlement
to be saved, businesses and workers alike, before the authorities’.1 This culture of
entitlement explains why people downplay the possibility of a crisis.
5.1 Connected lending
Moral hazard operated in Ecuador mainly through corruption in the banking system.
Interviewees point to the intensification of devious banking practices to explain the
dramatic deterioration of loan quality over the 1990s. ‘Créditos Vinculados’, or connected
lending (i.e., loans to firms owned or managed by directors or administrators of banks or
people related to them), were widespread. The economic literature (cf., De Juan, 1996, pp.
87–8) and the interviewees argue that the quality of those loans is usually lower than that of
regular loans (they are more likely to have faced looser standards and are less likely to be
repaid); and that connected lending lowers the incentives of the managers of the connected
company to perform and to provide quality information. Some of the interviewees had
argued publicly that bankers should not be businessmen, because banking expertise may
be incompatible with running a factory or an import/export business.
In the public eye, the most egregious example of the evils of connected lending is the
Banco del Progreso. Apparently, 86% of the bank’s borrowers were connected to the bank
(Camposano and Avilés, 1999, 26 March). Many seemingly non-connected loans were
made to ghost firms. The loss to the State from Progreso’s failure has been estimated at
about 14% of GDP.
Connected lending—or at least corrupt connected lending—is nearly impossible to
document quantitatively, precisely because of its shady character. But a mark of many of
the banks that survived the crisis is having scrupulously avoided related loans. In one such
1
According to a politician who was a key policy-maker during the bank bailout of the 1980s, bankers’
economic power gave them the ability to obtain government bailouts, both in the 1990s and during the debt
crisis. An important banker and former Minister of Finance said, ‘previous crises are ‘‘forgotten’’ because
moral hazard exists, because in the 1980s bankers stuck taxpayers with the bill and kept their banks and their
posts’.
The political economy of the Ecuadorian financial crisis
11 of 19
bank, employees are not allowed to have any other business interest. Connected lending
was banned in 2000.
5.2 Objections to moral hazard as an explanation
It is appropriate to mention the disagreements. One banker asserted that ‘it is in no
way true that bankers bet the money of the depositors: credit did not expand after
economic growth stopped’. (Real commercial bank credit fell by an annual average of
10.9% in 1996–99.)
This argument is disingenuous: credit growth is not the only way to bet a bank.
Interviewees argued that moral-hazard-driven behaviour included (as explained below)
loan evergreening, connected lending, avoidance of regulation through offshore subsidiaries, and the use of depositors’ funds to raise bank capital (see Martı́nez, 2002). Moreover,
although domestic bank credit contracted, many banks lent abroad heavily (especially
through non-reporting off shores). Overuse of foreign-currency loans, another form of
risk-taking, grew in the late 1990s. Finally, pressures to obtain formal deposit guarantees
grew as the economy declined. It is no coincidence that the Deposit Guarantee Agency was
created the day before the failure of one of the largest banks.
5.3 Limits to moral hazard as an explanation
Even if it is clear that moral hazard was a part of the financial crisis, it cannot be an
exclusive explanation, because it does not explain the timing of the crisis.1 If moral hazard
were the main cause, a crisis would have taken place in 1987, when moral hazard was
equally present (the banking system was weak and corrupt; the economy was still
recovering from the debt crisis; the government had very strong business ties) and
Ecuador experienced a series of severe shocks.2 Why did a financial crisis not follow?
Minsky’s Financial Instability Hypothesis would suggest that the financial system did
not break down in 1987 because debt levels were not high enough; and they were not high
because the supply of capital to the private sector was very limited. In contrast, capital flows
were abundant in the mid-1990s. This contrast cannot be due to moral hazard, because
international investors are not politically connected to the Ecuadorian administration; the
neo-liberal government insisted there would be no government bailout; and Ecuador is too
unimportant in the global political and economic scene to guarantee an IMF-sponsored
bailout.
The most plausible explanation for why international investors supplied abundant funds
after 1992 is the credibility of the neo-liberal programme, which is fully consistent with
a Minskian view of the crisis.3 Investors were pessimistic immediately after the debt crisis,
but they were optimistic about ‘emerging markets’ in the 1990s. In short, interviewees held
that depositors, bankers, and borrowers took risks with other people’s money; yet because
moral hazard does not fully explain the timing of the crisis or the behaviour of borrowers, it
is more likely that the crisis had more causes than just moral hazard.
The next section considers euphoria as a complementary explanation.
1
Additionally, there was no safety net for risky borrowers, so it cannot be that they accumulated shortterm, dollar-denominated debt because they expected to be bailed out.
2
In 1987, GDP growth was 6.0%; inflation nearly tripled to 85.7%; foreign-exchange reserves fell into
negative territory as M2 quickly rose; the government deficit doubled to 9.7%; and (in 1988) average yearly
wages were halved to $685.
3
Some commentators point to low asset returns in OECD countries during the early 1990s, to explain the
emerging-markets capital inflow. But if investors had been pessimistic about Ecuadorian prospects, they
would not have lent to Ecuadorian banks in any case.
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G. X. Martinez
Table 7. Interviewee support for euphoria as an explanation of the crisis
Banks’, firms’, and individuals’ euphoria was a main cause of the
crisis
Interviewee (No.)
Bankers (18)
Businesspeople (13)
Authorities/politicians (9)
Economists (5)
Strongly Agree Indifferent Disagree Strongly
No mention
agree (%) (%)
(%)
(%)
disagree (%) (%)
44
54
44
20
50
31
44
40
0
15
11
20
6
0
0
20
0
0
0
0
0
0
0
0
Note: Given the considerable overlap among categories, interviewees were classified according to their
main affiliation.
Source: Author’s interviews.
6. Euphoria
Martı́nez (2002) argues that most mainstream explanations of how lending booms lead to
the deterioration of loan quality have Minskian euphoria as an essential, albeit implicit,
assumption.1 Indeed, the interviews suggested that Ecuadorian bankers, businessmen, and
other economic agents believed that structural reform would eliminate inefficiencies and
encourage development; and that monetary policy was fully able to make the exchange rate
predictable. This section argues that Minskian euphoria over the success of economic
policy led to excessive financial risk-taking.
Euphoria is qualitative: hence, interviews are useful. Table 7 summarises interviewees’
opinions on the role of euphoria in the Ecuadorian financial crisis. Note the strong support
for this explanation (only one academic economist and one banker disagree with it). Part of
business people’s and bankers’ great support for this explanation can be attributed to
a desire to avoid blame, but a euphoria-based explanation also finds abundant support with
other types of agents.2 Interviewees, largely, argued that the success of the neo-liberal
programme encouraged agents to take increasing amounts of financial risk. As a banker
said,
If expectations are positive, you throw yourself in with everything you’ve got to take advantage of
the moment to invest and get into debt. And with [Vice-president and economic guru] Dahik
expectations were positive, as a stabilisation was evident. At the end of 1994, it was predicted that
1995 would be a spectacular year. [The bank I manage today, now in the hands of the State]
operated on those expectations: it bought [the loan portfolio of a finance company] with a large
margin of profit, betting that interest rates would fall.
In terms that echo Minsky, a well-known economist (who, like Minsky, was an unheeded
Cassandra) argued that Ecuadorians suffered from financial amnesia that prevented them
1
For example, Gavin and Hausmann (1996) argue that, during periods of rising expectations, lenders and
borrowers mistake temporary improvements in borrower creditworthiness for permanent shifts in the risk of
credit. Since homo economicus would not make this mistake repeatedly, euphoria (due to the economic boom
that follows structural reform) must be implicitly assumed.
2
There is support for the explanation outside of the interview sample. Pablo Lucio-Paredes, an economic
analyst and professor who was not interviewed, argued in a book, ‘In 1993–1994 . . . we did excessively well,
we acquired bad habits. But when the economic boom ends, the first to suffer are precisely the most euphoric
sectors . . . and then banks become losers: they cannot recover their loans and the guarantees on their loans
have lost their worth’ (Lucio-Paredes, 1999, pp. 279–80).
The political economy of the Ecuadorian financial crisis
13 of 19
Table 8. Indicators of prosperity and stability, Ecuador, 1991–96
Inflation (%, year-end)
Exchange-rate depreciation (%, year-end)
Government balance (% of GDP)
M2/foreign reserves
Capital inflows to private sector (% of GDP)
1991
1992
1993
1994
1995
1996
49.0
45.9
0.6
2.4
2.5
60.2
40.9
1.2
2.6
1.2
31.0
10.8
0.1
2.2
5.1
25.9
10.9
0.6
2.3
4.7
22.8
28.9
1.1
2.8
0.3
25.5
24.3
3.0
2.7
3.8
Note: Private capital inflows¼foreign direct investmentþprivate debt flowsþother capital flows.
Source: Banco Central del Ecuador, Base de Datos de Estudios.
from remembering the debt crisis of the 1980s. The interviewee asserted that by mid-1998
it was clear that the growth of private debt in the 1990s was parallel to that of the 1920s
and 1970s.
6.1 The Ecuadorian miracle and exchange-rate euphoria
Euphoria can be a credible explanation only if the neo-liberal programme seemed to be
a clear break from the past in a number of areas. And euphoria is distinguished from merely
improved expectations if this radical change was only an appearance. Clear reasons to be
euphoric were mentioned repeatedly in the interviews: macroeconomic stabilisation,
capital inflows, Washington Consensus inspired structural reform, and so on (see Table 8
and Lucio-Paredes, 1999, p. 20). Many interviewees noted that in the fourth quarter of
1994, the economy grew at an annualised real rate of 6%. Many of them were encouraged
by the repeated neo-liberal statements of the government and described the strict
adjustment packages, of clear neo-liberal inspiration as courageous. The policy successes
and their consistency with the ideological inclination of the administration led to unusually
high presidential approval rates.
People talked about an Ecuadorian economic miracle; an economist recalls that it was
commonly said that the country was close to take-off. With the economy looking more
stable and prosperous, economic agents felt more comfortable spending and running
up debt. Graffiti at the end of 1993 proclaimed: ‘what God gives is to save, what Sixto
[Durán-Ballén, the President] gives is to spend’.
One of the clearest indications of a ‘break with the past’ (cf., Kaune, 1997) in the
Ecuadorian economy was the stabilisation of the exchange rate, which Lucio-Paredes
(1999) lists as one of the top three successes of the neo-liberal administration. The average
monthly devaluation was more than halved and the standard deviation of the exchange rate
fell to less than a third of its pre-stabilisation level (see Table 9).
Notice that the exchange rate remained ‘stabilised’ until the onset of the crisis: the
average and standard deviation of the monthly devaluation rate were at their lowest
between the end of the neo-liberal administration and the beginning of the crisis. Overconfidence in the predictability of the exchange rate, particularly after the neo-liberal
administration, encouraged people to amass dollar-denominated debt (cf., Jácome, 1998;
Lucio-Paredes, 1999). Figure 2 documents the tendency towards liability dollarisation in
Ecuador, especially since 1994.
An ironic example is that of a highly respected economic analyst, who told the author
that (to finance a family business) he had borrowed heavily in dollars, even though his
14 of 19
G. X. Martinez
Table 9. Percentage change in the exchange rate, Ecuador, January 1982–December 1999
Period
Pre-stabilisation: January 1982–August 1992
Stabilisation: September 1992–August 1996
Post-stabilisation: September 1996–August 1998
Crisis: September 1998–December 1999
Average Std. dev. Minimum Maximum
3.30
1.43
2.17
8.21
6.45
2.02
1.58
10.83
9.11
3.59
0.52
10.08
37.24
9.09
7.38
28.24
Source: Banco Central del Ecuador, Base de Datos de Estudios.
income was denominated in sucres, because he ‘expected . . . devaluation would be much
lower’.
Was this ‘break with the past’ only an appearance? Hyman Minsky emphasised that, as
the economy prospers, people begin to see—otherwise unchanged—financial relations as
more robust, and they begin to take more risks on the basis of the same fundamentals. This
is the conceptual difference between euphoria and simply improved expectations: that
based on fundamentals, the new optimism is excessive.
The key indication that these improved expectations were actually euphoria is that (as
interviewees argued repeatedly) agents’ confidence in the success of the structural reforms
was based on the presumed technical and political ability of the Vice-President’s economic
team (and on the flood of capital inflows, which are of notorious fickleness). In the banking
community, the enormous majority of respondents thought of Vice-President Dahik as
‘the compass of the government . . . the motor of the economy . . . the strong leader we
needed . . . the economic guru . . . a visionary man capable of choosing well among economic
policy alternatives . . . the axis, heart, and nerve of this government of transformation’.1
But Dahik had little support in Congress and was not popular outside the business
sector; his political weakness led to his resignation in September 1995. In hindsight,
interviewees admitted that they expected too much of the administration’s capacity to solve
the country’s problems, especially given the lack of coherence and continuity of
Ecuadorian policy-making (cf., Araujo, 1998).2
6.3 Objections against euphoria
Most interviewees believed that there was widespread euphoria in 1993–94 and that it was
responsible for agents’ excessive risk-taking. Lucio-Paredes (1999, fn. 13) suggests this is
the undisputed consensus explanation. Only two interviewees objected. Yet they are well
known for their anti-neo-liberal political views and their objections to the explanation seem
to be directed towards neo-liberalism rather than based on evidence regarding bankers’
(and bank customers’) expectations.
The strongest objection against a euphoria-based explanation is that the domestic/
foreign interest-rate differential was large in the 1990s, over and above the pre-announced
devaluation rate, which suggests high expectations of devaluation (see Figure 3). If agents
1
In contrast, a very important banker held that the ‘Dahik effect’ had no importance (yet he
contradictorily asserted, ‘it is not true that his departure took away the confidence his presence inspired’.)
2
Moreover, structural reform was only partially carried out, as Lucio-Paredes (1999) shows; and, as
Grabel (1995) argues, structural reform itself can be a cause of economic instability. The economic boom led
to a growing current-account deficit (5% of GDP); to a bubble in real estate and securities; and to private
accumulation of bank debt (see Lucio-Paredes, 1999, pp. 20–1). An econometric study (Banco Central del
Ecuador, 1998) showed that that Ecuador was still highly vulnerable to exogenous shocks.
The political economy of the Ecuadorian financial crisis
15 of 19
Fig. 2. Foreign currency in commercial bank credit, Ecuador, 1990–99.
Source: Banco Central del Ecuador, Base de Datos de Estudios.
were pessimistic about the exchange rate, it would be hard to argue that they were overconfident about any other government policy, given the importance of exchange-rate
policy in the Ecuadorian economy.
Yet those who criticised monetary policy, however, in general believed that the exchange
rate was controlled too well (and without regard to other national objectives): those who
praised it were impressed with the defence of the peg. Most interviewees repeatedly
suggested that expected devaluation between 1993 and somewhere in mid-1998 was no
larger than that indicated by the slope of the crawling peg.1
What, then, caused high sucre–dollar interest rate differentials? The data plotted in
Figure 3 suggest that political uncertainty had a major role.2
The results of the interviews, the anecdotal evidence available, and the quantitative
evidence seem to suggest that euphoria can account for agents engaging in what in
hindsight is imprudent behaviour. The promise of prosperity contained in the structural
reform plan encouraged businessmen and bankers to expand imprudently. Dollardenominated debt expanded steadily, because the stability of the exchange rate caused
financial euphoria.
Yet there should be no euphoria about having found the cause of the crisis. Few (if any)
of the people interviewed seem to think that the crisis was entirely due to an excess of
optimism; most blame also regulatory failures and moral hazard.
7. Conclusion
This paper has focused on the role of motivations of individual behaviour in the
Ecuadorian financial crisis. Yet it is important to consider that a complex event such as
this cannot be explained satisfactorily by only considering one piece of the puzzle. An
1
Lucio-Paredes (1999) summarises the exchange-rate thinking of the 1990s: ‘The sucre barely moves
vis-à-vis the dollar during the year, the sucre deposit rate is 25% and in dollars abroad, it is 8%, the loan
interest rate in sucres is 38% and in dollars, it is 12%. In what currency do you save and borrow? I believe your
answer will evidently be: save in sucres and borrow in dollars’ (Lucio-Paredes, 1999, p. 21).
2
Additional explanations include differences in the level of financial development and in country risk
premia and differential taxation (offshore dollar-denominated accounts were not taxed while interest income
on sucre deposits faced an 8% tax rate).
16 of 19
G. X. Martinez
Fig. 3. Political events, sucre–dollar interest-rate differential and the slope of the exchange-rate band,
Ecuador, June 1995–February 1999.
Source: Banco Central del Ecuador, Base de Datos de Estudios.
important component of the story is how individual motivations lead to changes in
macroeconomic relations (such as monetary creation by the Central Bank and exchange
rates, the impact of the cost of credit on investment, liability dollarisation and uncertainty,
etc.). This suggests an important topic for further research into the Ecuadorian financial
crisis. A good starting point is Frenkel (1983), who pointed out how a lack of perfect
foresight may lead to monetary non-neutrality, even in an otherwise neoclassical model.
And, in a conclusion that is reminiscent of Minsky’s cycles of euphoria and depression, he
showed how sufficient uncertainty and volatility of expectations might lead to large changes
in international reserves that make an exchange rate peg untenable. Exploring the relation
between moral hazard and euphoria, on the one hand, and macroeconomic variables, on
the other, is beyond the scope of this paper, yet it is clearly a promising avenue of research.
Largely in agreement with Hyman Minsky (who saw systemic fragility as resulting from
the normal functioning of our economy and not from ‘accidents or policy errors’ (1977,
p. 139)), interviewees rejected an explanation of the Ecuadorian crisis based entirely
on exogenous factors: these played an aggravating role, and were not fundamental causes.
Simply put, banks, businesses and individuals took too many financial risks.
Euphoric economic agents downplayed the risks of imprudent financing; they believed
in a stable exchange rate policy, even if accompanied by high interest rates and rapid
liability dollarisation; they believed in the ‘new economy’ but ignored the calls to prudence
and wariness.
Implicit deposit insurance encouraged the development of moral hazard. Because they
used other people’s money, Ecuadorian bankers indulged in connected lending.
Finally, de facto and de jure financial deregulation made banking and economic
authorities blind or impotent to prevent or punish abuses in the financial system, especially
those spawned by liberalisation itself.
From Tables 2, 4, 6, and 7, it can be seen that interviewees strongly supported the three
main explanations. Moral hazard was least popular among bankers as an explanation (yet
still very popular), who tended to prefer less incriminatory explanations such as euphoria
or (to a lesser extent) bad policy-making. Businesspeople supported both the euphoriabased explanation and the moral hazard explanation (and were the least interested of the
The political economy of the Ecuadorian financial crisis
17 of 19
sample in the topic of bad regulation or in blaming the crisis on exogenous events).
Authorities and politicians were least likely to favour self-incriminatory explanations (bad
regulation/policy-making), and most likely to point out the (moral, perceptual) failings of
the financial system. Economists, finally, preferred the interplay between bad regulation
and moral hazard (and, to a lesser extent, euphoria). In agreement with Minsky, most
disliked ‘simplistic’ explanations such as bad policy-making. These subtle differences
should not obscure the overall support received by the three main explanations and the lack
of popularity of alternative explanations.
The three elements of the crisis—over-confidence, corrupt financial practices and weak
regulations—and the aggravating effects of exogenous shocks can be summed up in this
statement by a regional manager of the Central Bank:
As the exchange-rate was stabilised, the amount of [dollar-denominated] credit rose considerably, and not at fixed but variable interest rates [ . . . ] As [nominal] interest rates rose to 70,
80%—while inflation fell—loans became impossible to pay: no productive activity was that
profitable. Yet, high interest rates seemed not to affect solvency because of cosmetic accounting
and the castles in the air.
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