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Governor Randall S. Kroszner

At the Annual Meeting of the Board of Governors of the Inter-American Development Bank,
Miami, Florida
April 4, 2008

Global Economic and Financial Challenges: Implications for Latin America
Strains in global financial markets first became manifest last summer, when sharply rising
delinquency rates on subprime mortgages in the United States caused investors to become
concerned about the credit quality of home mortgages more broadly and about the exposures of
major financial institutions to credit losses. These strains have persisted and, indeed, spread during
the winter.
In the United States, the continued poor functioning of securitization markets, particularly those for
private mortgage-backed securities and other structured finance products, as well as pressures on
balance sheet capacity at some large banks and a deterioration in loan performance, have led to
tighter credit conditions for many households and businesses. The tightening of credit, along with
information suggesting that the housing correction was likely to be deeper and more prolonged than
initially thought and that the labor market was weakening, led many analysts to revise down their
outlook for economic activity. In turn, the deterioration in the economic outlook seems to have fed
back into financial markets, contributing to lower prices for a range of securities and to trading
conditions that are more volatile and less liquid. Aspects of the U.S. experience have also been felt
in other advanced economies, although generally to a lesser degree.
The origination of mortgages to borrowers with less-than-prime credit profiles fell sharply over the
second half of last year in the United States, and this segment of the market has continued to
function poorly. In addition, the origination of jumbo mortgages to prime-rated homeowners has
fallen since last summer, as lenders tightened their underwriting standards and raised the cost of
those loans. In contrast, mortgages that qualify for backing by the housing government-sponsored
enterprises continue to be readily available to households. For other types of consumer credit, such
as auto loans and credit cards, access has diminished somewhat in recent months as lending
standards have been tightened and securitization of consumer loans has become more difficult.
In corporate markets, highly rated firms have continued to issue a sizable volume of bonds, but
issuance of speculative-grade debt has been sluggish recently. In the leveraged loan market, banks
have found it difficult to syndicate loans previously underwritten to finance large leveraged buyout
deals, and the still-large pipeline of leveraged loans has led to an unplanned expansion of some large
banks' balance sheets.
In addition, some banks have taken onto their balance sheets assets for which they provided
liquidity backstops or other forms of support. These balance sheet pressures have come at a time
when asset write-downs were already weighing on capital. As I will discuss later, this episode
underscores the important connection for banks between capital adequacy and liquidity, particularly
in times of financial market stress.
Despite the adverse developments in recent months, large U.S. banking organizations, in the
aggregate and individually, have maintained capital ratios in excess of regulatory requirements, in
part because of steps taken by many to replenish equity positions. Indeed, since last fall, large U.S.
bank holding companies have raised more than $50 billion in capital. Although the U.S. banking

system will continue to face a challenging environment, it remains in sound overall condition,
having entered the period of recent financial turmoil with solid capital and strong earnings.
Federal Reserve Actions
To improve market liquidity and market functioning, and consistent with its role as the nation's
central bank, the Federal Reserve has supplemented its longstanding discount window by
establishing new facilities to depository institutions and primary dealers. The first of these actions
was initiated in August, when the Federal Reserve modified the terms for borrowing from the
discount window. Then, in December, the Fed introduced a term lending facility that provided
funding to depository institutions without the potential stigma of discount window borrowing. At
the same time, the Federal Reserve, in conjunction with other central banks, established reciprocal
currency swap arrangements to provide dollars to address elevated pressures in foreign interbank
funding markets. Last month, the Fed announced a series of initiatives to address additional stresses
that emerged more recently.
Taken as a group, these actions have had a threefold purpose: to expand the range of institutions
with access to collateralized loans from the Federal Reserve, to broaden the types of securities that
can be pledged as collateral, and to lengthen the terms of the loans obtained from the Fed. To date,
these liquidity measures seem to have been helpful, as funding pressures on some financial
institutions appear to have eased somewhat and as liquidity seems to have improved in several
financial markets. To the extent that these measures improve market functioning, they will have
favorable effects on the availability of credit to the broader economy. More-liquid markets also
increase the efficacy of monetary policy.
In response to the weakening of economic conditions, the Federal Reserve has eased the stance of
monetary policy substantially. The Federal Open Market Committee last month lowered the target
for the federal funds rate to 2-1/4 percent--3 percentage points below its level last summer. The
Committee anticipates that these actions, together with the steps we have taken to foster market
liquidity, will help to promote growth over time and to mitigate the risks to economic activity.
The remainder of my remarks this morning will cover the implications of these financial market
strains for Latin America, focusing on the linkages between the U.S. and Latin economies and how
they have evolved over time. Although there have been major structural improvements in Latin
American economies, the region is also benefiting from favorable global conditions that are helping
to offset potential adverse spillovers from the financial strains. Nevertheless, those strains highlight
some challenges going forward in Latin America, particularly in the area of the regulation of
financial institutions. This is no time for policymakers anywhere to feel complacent.
Developments in Latin America
The recent financial turbulence has been evident in Latin America, but not as strongly as in the
United States and Europe. Spreads on Latin American dollar-denominated sovereign bonds over
U.S. Treasury securities are up noticeably since early last year, but they remain low from a historical
perspective. In the relatively new Latin markets for long-term local-currency bonds, yields have
edged up in a few countries but have remained essentially flat in others. Equity prices in Latin
America are down relatively little compared with their very large increases in 2006 and early 2007.
The pace of economic growth has edged down in many (but not all) Latin countries from high rates
in 2006 and early 2007. The latest International Monetary Fund (IMF) forecast, however, continues
to project solid rates of growth this year and next in most Latin American countries. With a few
notable exceptions, inflation has remained relatively well under control; in most countries, rising
commodity prices have led to only modest increases in headline inflation rates.
In light of the recent indications of a weakening U.S. economy, is there any historical precedent for
Latin America to avoid spillovers? In the past, U.S. slowdowns have typically been associated with
slowdowns in Latin America. Indeed, often the slowdowns in Latin America were much sharper
than in the United States. One of the most famous examples of this effect occurred during the U.S.
economic downturn of the early 1980s, which was associated with high U.S. interest rates. The

increased pressures on financing flows and the reduced demand for exports contributed to
widespread slowdowns in Latin American economies that in many cases were more severe than the
U.S. slowdown. A milder version of such a synchronized slowdown occurred in 2001.
There have been exceptions to this pattern, however. For example, many Latin countries
experienced solid expansions during the U.S. contraction of 1990-91. A variety of factors, some
unique to individual countries, contributed to this good outcome. Perhaps most notable was the
launch of the Brady Plan in 1989 to restructure the sovereign external debts of a number of
developing countries. This restructuring, along with previous fiscal and financial sector reforms in
the wake of the debt crisis of the early 1980s, encouraged renewed capital flows to much of Latin
America just around the time that the U.S. economy was slowing down.
Linkages between the United States and Latin America
To better assess the prospects and lessons for Latin America from the recent financial strains, it may
be useful to review the various linkages between the two regions. These linkages include trade
flows, capital flows of various types, and shared global shocks such as the recent run-ups in
commodity prices.
Trade has been growing faster than the gross domestic product in many Latin economies. An
economic slowdown in a key trading partner generally reduces demand for a country's exports,
putting downward pressure on overall activity. However, with the exception of Mexico, most Latin
American countries are not particularly exposed to U.S. demand for their exports.
A more important linkage for many Latin American countries has been capital flows from the
United States and other advanced economies. Differences in the environment for capital flows, for
example, appeared to be a key factor behind the much better outcome in 1990-91 compared with
1981-83. Bank lending to Latin America has not regained the leading role it held in the 1970s, but it
has grown significantly in recent years after a long period of quiescence. Local-currency bond
markets are an important recent development that is attracting some interest from foreign investors,
but so far, most of the local-currency issues have been purchased by local investors such as pension
funds.1 Foreign capital has surged into Latin American equity markets in recent years, helping to
push market capitalizations to new heights. Finally, foreign direct investment into Latin America is
substantial and has continued to grow. The IMF estimates that total private capital inflows to Latin
America jumped to $173 billion last year, compared with an average of $79 billion per year over the
previous ten years.2 An important factor fostering these flows has been improvements in
macroeconomic and microeconomic policies.
An interesting and potentially important development in the past five to ten years has been the
decline of current account deficits throughout Latin America and the rise of current account
surpluses in many countries in the region. External debt burdens also have fallen substantially. In
part, these developments reflect greatly improved fiscal discipline. Whereas bond issuance in
international markets was an important source of capital in the 1990s, the improving fiscal situation
led to negative net international bond issuance for Latin America, on balance, during much of the
current decade. Indeed, Brazil recently announced that its foreign assets exceeded its foreign
liabilities for the first time ever, reflecting increases in international reserves, buybacks of global
bonds, and the retirement of its IMF loans. Large holdings of foreign exchange reserves provide a
valuable cushion against fluctuations in foreign demand for a nation's exports or financial assets.
It is important, however, to recognize that the decline of net capital flows to Latin America has not
been accompanied by an equivalent decline in gross flows. Indeed, globalization has led to
increasing gross holdings of both assets and liabilities with the rest of the world. Thus, to a great
extent, all countries have become linked by a common global market for capital in a way that we
have never seen before.
Global shocks constitute a third set of linkages between the United States and Latin America. The
recent global increases in commodity prices have generally had negative implications for U.S.
growth and positive implications for Latin American growth, as the United States is a net

commodity importer and Latin America is a net commodity exporter. High commodity prices have
also encouraged foreign investment, and thus capital flows, to help develop the commodity
resources of Latin America. Of course, commodity prices themselves are influenced by global
economic activity; a U.S. slowdown could put downward pressure on commodity prices, providing
an indirect but potentially significant link between the two regions.
The Inter-American Development Bank background paper for this session argues forcefully that
recent strong global growth and high commodity prices provide a very supportive environment for
Latin American economies.3 These developments have helped to mitigate the effects on Latin
America of financial market strains and the slowdown in U.S. economic activity. It is important not
to lose sight of the fact that linkages through trade and capital flows continue to be important and,
indeed, have even increased over the past decade or so.
Lessons Going Forward
What are the lessons that Latin America should draw from the recent financial strains in light of the
growing linkages between Latin America and the rest of the world? I think it is extremely important
to bolster the great progress that has been made in many countries in the framework of
macroeconomic and microeconomic policies and to extend these improvements to those countries
that have experienced little improvement so far. The current attractive conditions for commodity
exporters should not deceive us into thinking that Latin America has permanently escaped
international business cycles.
On the macro front, the good economic outcomes in most of Latin America that I described earlier
reflect greater discipline in both monetary and fiscal policy. Although there have been some
exceptions, central banks in Latin America have demonstrated their resolve to prevent inflation
pressures from becoming entrenched. Governments generally have not allowed spending to absorb
all of the increased fiscal revenue from rapid growth. In terms of microeconomics, bank regulation
has been strengthened, and local equity and bond markets have been developed and are growing in a
number of Latin American countries. Financial fragility from currency and maturity mismatches in
the structure of debt has been pared back.
Together, these structural improvements reduce the vulnerability of the financial system to external
and internal shocks. Not only do better macro policy frameworks help to strengthen local financial
systems, but they provide confidence to investors that prudent policies will be taken in the face of
external shocks. Better microeconomic regulatory policies help markets to operate more efficiently,
thereby increasing economic growth, which makes continued monetary and fiscal discipline easier
to achieve. Continuing this virtuous circle should be a priority. The recent financial strains and the
potential for spillovers to Latin America only heighten the need for policymakers in the region to
avoid complacency.
Among potential microeconomic improvements, developing markets for residential mortgage
securities is obviously an important priority for Latin American countries going forward. Key
elements of such markets in any country are solid underwriting standards, meaningful credit
disclosure policies, and strong protections for consumers from abusive and deceptive practices.
Toward that end, in the United States, the Federal Reserve has recently proposed stricter regulations
for mortgage lenders to protect consumers from abusive practices while maintaining the viability of
a market for responsible mortgage lending. The proposed rules would tighten standards on higherpriced mortgage loans, which we have defined broadly so as to cover substantially all of the
subprime market. The proposed rules also cover a range of practices. For example, the rules would
prohibit a lender from engaging in a pattern or practice of making higher-priced loans that
borrowers cannot reasonably be expected to repay from income or from assets other than the house.
Lenders also would be required to verify the income or assets on which they rely to make credit
decisions for higher-priced loans. The Federal Reserve is also working to improve mortgage
disclosures through consumer testing so they are more effective.
These rules are particularly valuable for households that have little experience with homeownership
and short credit histories. Careful underwriting standards and good transparency for borrowers are

important building blocks for a healthy market in mortgage-backed securities, which can help to
foster the flow of credit to the housing sector in Latin America.
Risk Management around the Globe
Sound banking regulations are another high priority for Latin America and the rest of the world. In
particular, I'd like to emphasize how recent market events underscore that financial institutions
around the globe face important risk management challenges. One of the most basic riskmanagement challenges relates to concentration of risk. As banks have extended their range of
activities and involvement in new markets, including the markets for securitized assets, they must,
for a number of reasons, be particularly mindful of the potential for concentrations of risk to arise.
First, there is simply less information available to evaluate risks on new activities. Second, risk
concentrations can be hidden during normal times and may manifest themselves only during times
of stress, such as the recent marketwide increase in the demand for liquidity. Third, there is an
important linkage between risk concentrations and capital: The concentration of risk of a given
portfolio markedly affects the amount of capital that should be held against it.
I would like to elaborate on these themes by briefly describing how they can be used to improve the
practice of risk management in three fundamental areas: risk identification and measurement,
liquidity risk management, and governance and risk control.
Risk Identification and Measurement
The first fundamental of sound risk management relates to risk identification and measurement.
Timely and accurate information is the lifeblood of sound risk management. A good riskmanagement structure is designed to identify the full spectrum of risks across the entire firm,
gathering and processing information on an enterprisewide basis in real time. In short, you cannot
manage your risks if you do not know what they are. Gathering information should be done with
appropriate care and with adequate resources for checking timeliness and veracity. Risk managers
should live by the adage, "Trust but verify," being careful not to rely on assessments or data from
others without conducting proper due diligence.
It is also worth noting that financial institutions should gather information before they see market
troubles brewing. In other words, scrambling for information once turbulence sets in is not a good
practice. Thus, even if Latin America has not experienced the strains that other markets are
experiencing, it is nonetheless important to be proactive about stress testing and scenario analysis.
Understanding a firm's true risk exposures requires examining not just risks on the balance sheet,
but also off-balance-sheet risks that are sometimes more difficult to identify and often not so easy to
quantify. Latent risks from certain complex products and certain risky activities are particularly
problematic, because they can manifest themselves when market turbulence sets in. Careful analysis
is particularly important for new financial products that have not been fully "road-tested"; this
caveat also applies when products with a track record in one country are introduced to another
country for the first time or markets develop rapidly in a country. Stress testing and scenario
analysis are essential tools in the analysis of risk, because they can reveal potential concentrations of
risk that may not be apparent when using information gleaned from normal times.
Liquidity Risk Management
Next, I wish to consider the second fundamental, liquidity risk management. Because of its central
role in the business of banking, liquidity risk requires rigorous and effective management. This is a
fundamental truth that may have even greater relevance in Latin American markets, where securities
tend to be less liquid than in the United States and where banks rarely have the luxury of selling
their loans.
Recent events have shown that during times of systemwide stress, liquidity shocks can become
correlated so that the same factors that can lead to liquidity problems for the bank's assets or offbalance-sheet vehicles can simultaneously put pressure on a bank's own funding liquidity. Again, we
see the trouble that risk concentrations can cause if an institution has not tried to identify them in
advance and has not taken steps to mitigate their effects.

As I mentioned earlier, we also have noticed the potential for liquidity risk to have an impact on
capital adequacy. In a few cases, unplanned increases in a bank's balance sheet led some banks to
take measures to bolster their capital. Because risk concentrations have the potential to manifest
themselves during times of stress and at that time adversely affect capital positions, it is particularly
important that firms assess how liquidity events could place pressure on capital levels. In a nutshell,
liquidity problems always have the potential to affect bank balance sheets and, in doing so, bank
capital adequacy.
Governance and Risk Control
The third fundamental, governance and risk control, has been a key factor that differentiated
performance across financial institutions during recent events.4 Clearly, senior management of
financial institutions must take on a very active and involved role in risk management. In some
cases, it appears that managers were not fully aware of the extent to which the risks of the different
activities undertaken by the firm could, first, become correlated in times of stress and, second, result
in high concentrations of risk exposures. For example, those in senior management may not have
been cognizant of a firm's overall concentration to U.S. subprime mortgages, because they did not
realize that in addition to the subprime mortgages on their books, they had exposure through offbalance-sheet vehicles holding such mortgages, through claims on counterparties exposed to
subprime, and through certain complex securities.
Senior managers should encourage risk managers to dig deep to uncover not only risks within each
business unit, but also risk concentrations that can arise from the set of activities undertaken by the
firm as a whole as well as latent risks--such as hidden risk concentrations that can arise from
correlation of risk in times of stress. It can be very difficult to challenge one's colleagues by pointing
out business activities that may be creating too much risk, and that is why it is crucial for the risk
manager to be known both inside and outside the firm as an independent voice who is influential
with top management. Executives also must set the appropriate tone at the top with respect to the
importance of independent and unbiased risk evaluation.
While improvements in both macroeconomic and microeconomic policies have helped to make
some Latin American countries less vulnerable to outside shocks, the region is not decoupled from
the United States and the rest of the world. As globalization has proceeded, Latin America is
increasingly connected to the world through global capital flows and capital markets. Further
improvements in both macroeconomic and microeconomic policies are imperative to maintain those
flows and economic health, particularly in the face of global financial turbulence. One area that
merits particular attention is enhancing the management of risk in financial institutions and markets
in Latin America as well as emerging markets more generally.

1. Committee on the Global Financial System (2007), Financial Stability and Local Currency Bond
Markets, CGFS Publications No. 28 (Basel, Bank for International Settlements, June). Return to
2. International Monetary Fund (2007), World Economic Outlook: Globalization and Inequality,
World Economic and Financial Surveys (Washington: International Monetary Fund, October), p.
239. Return to text
3. Inter-American Development Bank Research Department (2008), "All That Glitters May Not Be
Gold: Assessing Latin America's Recent Macroeconomic Performance" (Washington: InterAmerican Development Bank, April). Return to text
4. See, for example: Senior Supervisors Group (2008), "Observations on Risk Management
Practices during the Most Recent Market Turbulence (373 KB PDF)" (New York: Federal Reserve

Bank of New York, March 6). Return to text
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