The Argentine Banking System Crisis of 2001: Were Strong Regulatory Reforms Enough? by Victor Malca

The economic problems of the late 1980s and the hyperinflation of 1989 and 1990 destroyed the Argentine financial system. However, macroeconomic stability returned with the imposition of the currency board and the significant opening and liberalization of the economy. Between 1992 and 1999, Argentina's banking system was liberalized by lifting controls and interest rates, deregulating the banking sector, allowing the entry of foreign capital, privatizing, and adopting international regulatory standards. Private market discipline within the Argentine banking system was also improved by policies that involved credible minimum risk-based capital and subordinated debt requirements.

These changes were seen as the most radical attempts to strengthen a banking system in Latin America and the end of ineffective regulation and supervision in Argentina. Even when the Tequila crisis hit Argentina, the government continued the reform process and ensured market discipline by strengthening the regulatory framework through the BASIC system[1] of banking regulation. Nevertheless, those changes were not enough to prevent the Argentine banking crisis of 2001.

The banking system had several vulnerabilities[2] that were not revealed through CAMEL type bank fundamentals, but showed up as the government was trying to defend its currency board. Through those vulnerabilities, banks and depositors were adversely affected as fears of the currency board’s sustainability mounted. Depositors reacted by transferring larger and larger portions of their funds into foreign currency denominated accounts and banks continued increasing their exposure by providing foreign currency lending to unhedged borrowers. In the end, the crisis led to a full-fledged run affecting all kinds of deposits. The result was the withdrawal of 6% of all bank deposits and the use of the ‘Corralito[3]’ to contain the bank run.

The Argentine government did not recognize the adverse effects on the capacity to pay of the non-tradable sector in the case of a major real exchange rate (RER) adjustment towards a more depreciated equilibrium level. According to Roubini (2001), convertibility does not immunize a country from the balance sheet effects of the RER adjustment. In fact, through the Convertibility Plan, the RER adjustment occurred slowly through unemployment and inflation. In the case of a protracted deflationary adjustment in a currency board, the value of non-tradable income in terms of tradables is lower, implying an increase in the burden of the debt for the non-tradable sector. As a result, debtors who rely on the non-tradable sector to earn income are most affected, increasing the banking systems’ credit risk. In Argentina, the exchange rate risk transformed into credit risk for the non-tradable sector.

The Argentine government also failed to sufficiently isolate the solvency of the banking system from the solvency of the government. According to De la Torre (2003): one silver lining of convertibility is that, in principle, it makes it possible to protect banking intermediation from the vagaries of the fiscal process, including an event of government debt default, as long as banks are not significantly exposed to domestic government risk. This is possible because the dollar is the store of value that underpins financial intermediation in a currency board and does not depend directly on the solvency of the domestic government. Because the debt was denominated in dollars and financed through domestic banks, the banking system became considerably exposed to government default. This spillover was greatly a result of the government’s failure to consolidate the budget for the federal government and its provinces and the indiscriminate financing through international and domestic sources.

Finally, the liquidity safeguards for the banking system proved to be inadequate to protect the payment system during a depositor run. Reputable foreign banks did not provide enough capital or liquidity assistance to their subsidiaries as expected by the markets. In the absence of a credible lender of last resort, the payment system became vulnerable and finally collapsed, even though liquidity was high. According to Hausmann (2002): the protection of a payment system from bank runs may actually require some form of narrow banking structure; a structure where there is full liquidity backing for transaction balances (demand deposits). Liquidity would be earmarked to these balances and thus able to preserve the functioning of the payment system, even in the extreme scenario where banks are unable to honor withdrawals of time deposits.

Argentina’s vulnerabilities were mutually reinforcing in such a way that left a seemingly strong banking system highly fragile. The real depreciation severely affected public finances since most of the government debt was denominated in dollars while public revenues were not. Moreover, the peg itself hid the impending solvency problems of public and private debtors as banks’ fundamentals seemed to be strong and banks were backed by a much improved banking supervision and regulation system. As a result, the non-traded sector debtors and the government (and thus banks) came closer to insolvency while their debts still appeared manageable at the observed real exchange rate. Ultimately, these vulnerabilities left the banking system exposed to shocks and opened to a banking crisis that materialized in 2001.

[1] The BASIC system of bank regulation in Argentina was part of a new plan for bank oversight developed after the Tequila crisis.

[2] Argentina had three hidden vulnerabilities that prevented the country from directly confronting its banking crisis: under-pricing of risk, exposure to government default risk, and overreliance on liquidity safeguards.

[3] Domingo Cavallo, the Minister of Economy, responded to the bank run by placing a cap of $250 per week on withdrawals, a measure that became known as el “Corralito.”