POOLING VERSUS SEPARATING REGULATION: THE PERFORMANCE OF BANKS AND MICROFINANCE IN BOLIVIA UNDER SYSTEMIC SHOCKS DISSERTATION Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Marcelo Villafani‐Ibarnegaray ***** The Ohio State University 2008 Dissertation Committee: Approved by Professor Claudio Gonzalez‐Vega, Adviser Professor Mario Miranda Adviser Graduate Program in Professor Joseph Kaboski Agricultural, Environmental and Development Economics i ABSTRACT Bank superintendents implement prudential regulation that simultaneously seeks protection of the stability and solvency of financial intermediaries and several dimensions of financial deepening. If they use only one instrument, a given level of safety is achieved at the expense of some intermediation. The question addressed by this dissertation are the excessive losses of intermediation efficiency from a single, uniform (pooling) regulation, which treated loan portfolios built with a traditional banking technology or with a microfinance technology as if they carried the same risk profile. Given significant differences between the two lending technologies, in their ability to match their clienteles and to recognize different risks, a differentiated (separating) set of prudential norms would contribute more to the dual goals of stability as well as financial deepening and breadth of outreach. This task is specially challenging in developing countries exposed to frequent systemic shocks. The dissertation develops a simple theoretical framework to guide regulators about the welfare shortcomings of pooling regulation, compared to separating regulation. If the risk profiles of the portfolios are different, different prudential norms should be applied. The problem for the regulator, however, is incomplete information ii about these risk profiles and the high costs of overcoming the information imperfections about their characteristics. Given high operational costs, the regulator must determine if the efficiency losses from not differentiating justify the development of a separating regulation. To illustrate the issues, the dissertation discusses in detail the experience of Bolivia with the emergence of a competitive and successful regulated and non‐regulated set of microfinance institutions. Relying heavily on innovation, these institutions have achieved exceptional financial performance (growth, profitability, and low default indicators), even during adverse systemic shocks, in contrast to banks. The regulators are puzzled by this heterogeneous performance and the dissertation offers a framework to guide their efforts. The actual experience of Bolivia indicates that the differences are important enough for the authorities to seriously address the operational costs of a separating framework. It further suggests dimensions of different risk profiles that should be taken into account by the authorities, in order to accomplish the double goal of efficiency and stability. iii Dedicated to my family iv ACKNOWLEDGMENTS I wish to thank my advisor and friend, Dr. Claudio Gonzalez‐Vega, for giving me the opportunity to achieve this goal in my life. Certainly, this dissertation would not have been possible without his encouragement, generous assistance, and unlimited patience. I was privileged to work under his supervision in several projects over these years and I will always be grateful for his mentoring and kind support. I want to thank Dr. Mario Miranda and Dr. Joe Kaboski for their generous help and enthusiastic response. They found time and energy to assist me, despite numerous challenges, and I am deeply indebted to them. I also want to thank my dear friend Dr. Micheline Besnard for her encouragement and unconditional support. Simply, there are not enough words in the world to describe my gratitude to her. Along these years, I was privileged to have the friendship of thoroughly outstanding people. They know my appreciation and I will always cherish the wonderful moments that we spent together and that made this experience enjoyable. Finally, I wish to thank my family. They are my inspiration and my support. This is the reward for their hard‐work, sacrifice and love. v VITA November, 20 1972…………………………………….……… Born – Oruro, Bolivia 1995………………………………………………………………….... B. S. (Licenciatura) Commercial Engineering /Economics Escuela Militar de Ingeniería “Mcal. Antonio José de Sucre” La Paz, Bolivia 1995‐1997……………………………………………………….…. Project Manager Centro de Servicios Integrados para el Desarrollo Urbano PROA El Alto, Bolivia 1997‐2001……………………………………………………….…. Financial Supervisor Superintendencia de Bancos y Entidades Financieras de Bolivia La Paz, Bolivia 2001‐present……………………………………………………..… Graduate Research Associate, The Ohio State University Columbus, Ohio PUBLICATIONS “Las Microfinanzas en la Profundización del Sistema Financiero. El Caso de Bolivia.” With Claudio Gonzalez‐Vega. El Trimestre Económico, LXXIV(1), 5‐65. (2007) “Tasas de Interés y Desempeño Diferenciado de las Entidades de Microfinanzas ante Múltiples Shocks Sistémicos.” With Claudio Gonzalez‐Vega. Latin American Journal of Economic Development, Num.(8), p.11‐51. (2007) FIELDS OF STUDY Major Field: Agricultural, Environmental and Development Economics Field of Concentration: Development Economics and Finance vi TABLE OF CONTENTS Page Abstract …………………………………………………………………………………………………..……………….. ii Dedication …………………………………………………………………………………………………..…………… Iv Acknowledgments ……………………………………………………………………………….………………….. v Vita ………………………………………………………………………………………………………………………….. vi Table of contents ...…….……………………………………………………………………………………………. vii List of tables ..……….…………………………………………………………………………………………………. xi List of figures .…………………………………………………………………………………………………………. xii Chapters: 1. Introduction………………………………………………………………………………………………… 1 1.1 Research question……………..…………………………………………………………………. 5 1.2 Research objectives…………….……………………………………………………………….. 6 1.2.1 General objectives…….…………………………………………..…………………. 6 1.2.2 Specific objectives……….……………………………………………………………. 6 1.3 Earlier research ……………………….………………………………………………………….. 7 1.4 Contribution……………………………….……………………………………………………….. 15 vii 2. Credit rationing and innovation in microfinance lending technologies………. 16 2.1 Credit rationing……………………………………………………………………………........... 16 2.2 Stochastic ability to repay …………………………………………………………………….. 17 2.3 Adverse selection…………………………………………………………………………………… 18 2.4 Incentive incompatibility and moral hazard…………………………………………… 20 2.5 Opportunistic behavior by intermediaries……………………………………………… 26 2.6 Innovation in microfinance lending technologies…………………………………… 33 3. Regulatory regimes for scenarios characterized by frequent successive and cumulative systemic shocks.............................................................................. 35 3.1 Loan‐loss reserves…………………………………………………………………………………. 36 3.1.1 Perspectives about loan‐loss reserves……………………………………….. 37 3.1.2 Loan‐loss provisions and credit risk……………………………………………. 39 3.2 Lending Technologies …………………………………………………………………………… 41 3.2.1 Heterogeneous performance of lending technologies….………..…. 44 3.2.2 Lending technologies and systemic shocks..………………….…………… 46 3.3 Capital adequacy ratio………………………………………………………………..………... 51 4. Bolivian microfinance: Performance under Systemic Shocks………………………. 56 4.1 Bolivia: a history of successive systemic shocks…………………………………….. 61 4.1.1 Political turmoil…………………………………………………………………………. 61 4.1.2 Social upheaval………………………………………………………………………….. 64 viii 4.1.3 Economic instability…………………………………………………………………… 69 4.2 Microfinance: Differential performance……………….………………………………. 88 4.2.1 The Bolivian financial system…………………………………………………….. 90 4.2.1.1 Market shares and competition………………………………… 96 4.2.1.2 Evolution of market shares……………………………………….. 97 4.2.2 Evolution of the loan portfolio………………………………………………..….. 101 4.2.3 Microfinance and the mobilization of deposits …..…………………..... 116 4.3 Trends in the Bolivian microfinance industry………………………………………….. 117 5. Pooling versus separating regulation: Minimum capital adequacy ratio……… 120 5.1 Basic framework: one financial intermediary‐one period……………….......... 123 5.1.1 Profits from the lending activity…………………………………………………. 124 5.1.2 Profits from investing in government bonds………………………………. 145 5.1.3 The financial regulator’s objective……………………………………………… 146 5.1.4 The Lender’s optimization problem……………………………………………. 148 5.2 Lender’s investment rule………………………………………………………….……………. 153 5.3 Effect of systemic shocks on asset allocation…………………………………………. 157 5.4 Lending Technology: two financial intermediaries – one period…………….. 158 5.5 Pooling versus separating regulatory regimes………………………….……………. 160 5.5.1 Case I: Regulation binding for both lending technologies..………….. 164 5.5.2 Case II: Non‐binding regulation……………………………………….………….. 167 5.5.3 Case III: Regulation is binding only for intermediaries with a superior lending technology………………………………….……...... 168 ix 5.6 Separating regulation…………………………………………………………….......…………. 169 6. Conclusions and policy recommendations …………………………………………………… 173 Bibliography…………………………………………………………………………………………….……….. 181 x LIST OF TABLES Table Page 4.1 Banks that exited the Bolivian financial market (1970‐2007)………………..... 73 4.2 Non‐banking institutions that exited the Bolivian financial market (1980‐2007)……………………………………………………………………………………………. 74 4.3 Bolivian microfinance institutions: Institutional evolution and dates of incorporation…………………………………………………………………………..…………….