How should Latin America regulate its financial markets?

A market is composed of its institutions, regulation (de jure and de facto), incentives, and in general all the rules that define its operation. This is particularly true in markets in which market failures are prevalent and that require regulation for operating. For example, markets in which information is not complete, such as financial or insurance markets, or markets in industries with large fixed costs such as telecoms or electricity markets.

In these cases, markets have evolved from an initial set of rules that set the state as the main provider of a determined good or service. In so-called “market economies”, eventually the state abandons this role and remains the rule setter (the level of intervention varying across different industries), allowing for private actors to provide these goods and services. The incumbent is now a private agent and rules are set to procure consumer protection, and to prevent abuses.

However, markets evolve, and if rules remain unchanged, they prevent the flow of innovation. For example, if technological progress decreases the fixed costs associated with the production and distribution of telecom services, stringent regulation may be no longer needed. Eventually, the original set of rules becomes an entry barrier for challengers, and not always in the best interest of consumers.

In many cases, regulation is meant to protect incumbents from competition. This is the case in industries with large fixed costs of entry where investments have to be recovered for private agents to be able to exist. It is also the case that competition might be inefficient when the technology is new, or when the market is small. However, once the conditions change, the protection may no longer be needed. If this change is not acknowledged, the new equilibrium will be sub-optimal for the consumer.

Regulatory frameworks might eventually hinder productivity and hinder competition, beyond an optimal level. In order to promote productivity, all institutions must be reviewed periodically, balancing the costs of changing incentives provided to private agents, with the benefits to promote innovation and more efficient technologies.

A 1995 report takes a functional approach to describing the financial system, seeking to elaborate on the functions that the financial system has in an economy to evaluate how the institutional framework should evolve.

They argue that: “If regulators want to maintain the safety and soundness of financial institutions currently in place, the development of alternative ways of achieving and economically equivalent result poses a danger. A natural regulatory response is to try to slow down financial innovation or ban it altogether. The important question from a public policy perspective however is whether the institutions currently in place ought to be preserved”.

This question is particularly relevant to the Latin American economies where many structural reforms that where put in place to create a market economy occurred through legal definitions that are inherently inflexible and cannot adapt to changing conditions.

Therefore they are prone to creating rents that will try to be retained by incumbents, making the innovative process costly. It is necessary to be able to create changing institutions that are not rigid, and to promote a sense of evolution. There is of course such a thing as too much evolution, since some stability is needed to secure investment, but it is more probable that the region is well below this sub-optimal level.

The type of reforms needed is in many cases more micro than macro. They respond to the need of aligning incentives that may have deviated from the initial intention of the regulator and are resulting in low levels of productivity. Many good examples come from what we will call the “cost of formality”.

Take for instance the VAT system in Colombia. There are two VAT regimes, determined by the sales volume of the retailer. Below a certain threshold, the retailer will not charge a tariff and is not responsible for the tax; above the threshold and it will pay the ordinary set of tariffs.

The difference between the two regimes is large as it is the complexity of compliance. Small shopkeepers therefore have the incentive either to remain small (in sales volume) or to remain informal, for their sales not to be recorded and therefore catalogued as responsible for the tax. Although it was probably created in a progressive spirit, it encourages small shopkeepers to remain informal, receiving only cash payments, forgoing all the benefits of financial inclusion, digital payments, systematization, interconnection, etc.

This reform would probably neither affect in an important way the level of tax collection, nor does it resolve larger issues as having or not a flat tariff. It nevertheless changes the structure of incentives, inducing shopkeepers to increase their productivity, with a long list of virtuous effects on other agents: suppliers that can now handle their inventories electronically, banks that have now the digital trace of the payment history of shopkeepers (or clients) that can result in better credit origination, better information for tax collection, not on the shopkeeper, but on the suppliers which are most likely large corporates, etc.

In spite of all the difference between countries, in general terms most Latin-American countries have undergone structural reforms trying to create market economies, and in doing so introduced sets of institutions that may have resulted in captured rents, incumbent protection, and in general terms suboptimal barriers that go against innovation and ultimately hurt the region´s productivity.

Have you read?
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This blog is part of a series of articles published ahead of the World Economic Forum on Latin America 2016, taking place from 16 to 17 June in Medellin, Colombia.