Financial Institutions

Latin American countries continue to accumulate laws, regulations and rules. These legal instruments need to be implemented and then enforced.

That should not be surprising: as new situations arise, new legal instruments are needed to deal with them. Therefore, congresses legislate, ministries issue implementation decrees and decentralized rule-making bodies complement the foregoing. It should be noted that outdated laws and regulations are rarely deleted; at best, they are amended; what happens most often is they just fall into disuse.

In addition, a whole new category of laws, rules and regulations has appeared of late dealing with the environment. Environmental issues reach deeply into the social structure, since there is almost nothing that humans do that does not have an environmental impact. What is more, the major environmental impacts affect third parties. Second-hand smoke is a small example. A much larger one is global warming.

Economists call those third-party effects “externalities” because their consequences are only partially felt by the agent causing them. By the same token, they are not easily reflected in prices and thus cause “market failure.” Think again of second-hand smoke; cigarettes have a price, but there is no price charged for affecting the lungs of third parties. The obvious answer is to address such a market failure with a rule or regulation. Think of smoking again: prohibited in restaurants and other closed spaces. Think of diesel buses spewing out black fumes: prohibited.

Development and social empowerment also create additional demands for regulation. Assurance of quality in products and services, from medicines through food, reduction of noise pollution by outlawing horn-blowing in cars, requirements to wear seatbelts to contain harm in collisions, all become  “public goods” which require government action, i.e. suitable regulation.

All regulations require monitoring and enforcement. Otherwise, the norms are honored in their breach. It behooves the State to enforce compliance, but when the State falls short, it is worth examining whether some private sector institution might provide reinforcement. Therein lies an intriguing possibility.

Latin America’s creaky legal and judicial system

The legal system of Latin America is fundamentally based on Roman Law via the Code Napoleon, with holdovers from Spanish colonial traditions, principally in procedural law. Hence the ubiquitous presence of notaries, court secretaries and the multiple requirements of certifications. Common Law has found its way into financial contracting, where internationalization forced reform. A number of reform efforts are also underway to make the system more agile.

Sweeping generalizations are dangerous. All the same, it is not an exaggeration to say that the Latin American legal and judicial system is not universally fair, nor blind nor even effective.

At best, the system is swamped. Cases drag on for years and backlogs only get longer. Implementation of new and necessary rules becomes undesired casualties. The net effect is that law-abidingness deteriorates as the capacity for effective enforcement falls increasingly short.

A clear imbalance exists between the expansion of laws, rules and regulations and the capacity to enforce compliance. Latin America’s legal system needs reinforcement.

The financial system marches to a different drummer

Consider Latin America´s financial system. It is built around banks, some domestically owned and others subsidiaries of international banks. It is fully modern. The big banks of Latin America are functional at an international level. They are run by modern boards and managements, have modern risk assessment and legal departments, and up-to-date operating systems.

Atop of the financial system sits a financial regulator. In some countries, the Bank Superintendency is part of the Central Bank, in others it is an independent agency. In some countries, bank regulation is part of a broader financial regulation which includes insurance, securities markets, cooperatives and others. The common denominator, however, is that to be a bank requires obtaining a license and that, in turn, involves satisfying the regulator that the applicant is “fit and proper” to operate as a bank.

Once a bank is licensed, it must comply with all banking regulations. These involve the safety of deposits, vetted accounting systems and practices, adequate collateral for loans, a proper amount of equity and many other rules. It must also submit to stress tests and other checks to ensure it continues to be viable. At the core of bank regulation sits compliance. Therefore, banks have developed a high level of expertise in adhering to the rules governing their operations.

On occasion, banks do not comply, either on purpose or by mistake. Then the regulator calls them out on it. Banks amend their behavior, mostly amicably. But when they do not, the regulator can and does impose fines and, in extremis, can withdraw the banking license.

Fraud also occurs in banks, usually in smaller ones. Depending on the nature of the case, the regulator will assess a penalty or, in extreme cases, may close the bank. In older times, banks were liquidated. In most cases these days, a bank that becomes insolvent due to fraud or another regulatory breach is sold “over the weekend” to another, more solvent bank. The insolvent bank’s shareholders lose their equity holdings, but the customers seamlessly become customers of the acquiring bank.

The Mandate of Regulators gets broadened 

In 2015, the then Governor Mark Carney of the Bank of England gave a seminal speech to Lloyds of London.  He said that financial regulators must take into account climate change. He explained: climate change will affect all human endeavors, therefore finance too! If financial institutions do not take that into account, they are not properly doing their job. Omitting consideration of the risk posed by climate change is equivalent to ignoring the elephant in the room.

The Bank of England did more. Along with the Bank of France, the Bank of the Netherlands and five other central banks, it created a new institution: the Network for Greening the Financial System. This organization, housed at the Banque de France, would henceforth be charged with undertaking research, developing methodologies, and proposing regulations related to the new and expanded mandate to financial regulators, concerned with climate change.

From the initial eight, the NGFS at last count had grown  to 148 members across over 91 countries and 23 observers.

Source: Cour des comptes

Investment Banks discover “externalities”

Since its inception, the World Bank has been charged with making loans to governments conducive to economic development in their respective jurisdictions. A smallish subsidiary of the World Bank, the International Finance Corporation, was charged with making loans to the private sector with the same purpose. This required the IFC to recognize that a project it might finance would most likely have effects going beyond the project itself, it would have externalities.  For instance, the installation of a 24-hour textile mill would cause noise pollution impacting the neighbors. A tannery emptying dyes into a sewer might well cause fish to die in the stream that the sewer eventually emptied into. Not all externalities are negative. For example,  the manager trained in the textile mill might well leave and set up a separate business using his or her newly acquired skills.

Large investments projects are the province of large banks, some specialized in “project finance”. They have come to recognize, just like the IFC, that the projects they finance will have externalities. Since these projects are usually large, ignoring the externalities risks leaving out major positive or negative consequences. In other words, ignoring externalities means benefit/cost analysis will be incomplete, missing important effects that will matter.

Private investment banks thereupon  developed the Equator Principles, a set of rules and procedures designed to do in private banking what the IFC had pioneered in its own finance of private sector projects. Not all investment banks initially subscribed to the Equator Principles, but eventually most Western banks did so.

The operational name for incorporating externalities became Extended Due Diligence.  The name is apt: concern becomes diligently extended to what will happen beyond the confines of a project, to incorporate effects on third parties.  The extent obviously depends on the particular case: at some point reduced additional impacts will be encountered.

Externalities come in all kinds of sizes, shapes and forms. They are often only discovered after the fact. Not surprisingly, climate change constitutes a huge externality, which manifests itself in numerous and unexpected ways.  Accordingly, the recognition that taking account of externalities is part and parcel of proper risk assessment overlaps beautifully with bringing climate risk into the mainstream analysis.

Applying the Equator Principles and fulfilling the NGFS´ mandate turns out to be mutually reinforcing. The private sector and the public sector wind up having overlapping motivations.

Operational consequences: regulation required

As banks compete with each other, they have an incentive to allow their customers to ignore “uncomfortable” laws, rules or regulations. Some of these are social (e.g. maternal leave), some are environmental (e.g. discharging refuse), some reflect other negative externalities. Competition by ignoring rules is damaging to society. Large banks also have an incentive to prevent competition from smaller ones that may undercut their compliance requirements.

Thus, regulation of the terms of competition regarding externalities becomes necessary. Such regulations are called ESRM, “Environmental and Social Risk Management” Regulations. They specify what banks need to do be on the lookout for externalities and take them into account.

As a result of ESRMs, the competitive playing field becomes level. Competing by ignoring rules is no longer part of the game.

ESRMs also place a burden on the regulator. Where in the past, the main concern was to keep banks safe, evaluating liquidity, capitalization and business risk, once Extended Due Diligence is required, it also needs to be audited. Hence, there are costs involved for the supervisor and the supervisees. However, these costs also bring benefits. Compliance with laws, rules and regulations has a payoff in the functioning of a society and its economy. As a result, growth and equity will improve. Environmental sustainability is part and parcel of both.

Source: Absa Africa https://www.absa.africa/wp-content/uploads/2023/08/Environmental-and-social-management-system-summary.pdf

A plethora of regulations: the cavalry to the rescue!

As noted at the beginning, the expansion of laws, rules and regulations have far exceeded the capacity of Latin America´s formal legal system to ensure compliance.

As a result of ESRM, non-compliance with a broad range of regulations becomes an explicit financial risk with clearly visible consequences. Accordingly, banks are obligated to take action. Their regulators need to make sure that they do!

Extended Due Diligence implies banks writing new covenants into their loan contracts, essentially saying that if customers do not comply with any laws, rules and regulations on the books, the loan can be called. The implications are momentous.

Teams of bank officers (lawyers, loan officers, risk officers, etc.) now have the sole occupation to generate compliance with any law, rule or regulation potentially affecting the viability of their loans. They do this for their own very traditional business reasons.  They are not paid by the State, nor are they concerned with the good functioning of society´s legal system.  They sit in a sector of society in which compliance is regarded as essential, and they get paid to make sure that compliance occurs.

There are now also teams of lawyers and others working for the banks´ customers who are newly  tasked with making sure that defaults do not occur and loans do not get called.

Compliance has suddenly become the name of the game!

What might a bank pursue a customer for? The typical ESRM Regulation will require bank management to ensure compliance with laws, rules and regulations pertaining to the environment, impacts on third parties, safety at work, management-worker relations, women´s and parental rights and other social legislation, rights of native peoples and quite a bit more.   Banks will therefore become much more inquisitive than before about the internal operations of their clients, especially the larger ones. The ESRM Regs will also usually require a bank customer to detail what remedial actions it commits to taking for any violation of norms. There is thus a built-in provision for improvement.

Size requires a caveat. Banks are unable to police all their clients´ compliance. Accordingly, they need to privilege those that have major externalities. The ESRM Regulations typically allow for such differentiation, specifying levels of due diligence related to the potential impact.

The cavalry´s demonstration effect

Finance is everywhere; next to climate it is the most pervasive. As a consequence, financial norms tend to become social norms. With Extended Due Diligence and ESRM, banks become teachers of compliance for all they come into contact with, and that is practically everybody. Once citizens learn that compliance is required by banks, they will save themselves time and effort and comply before the banks ask them to.  What is more, financial compliance turns out now to be compliance across a broad front. Thus, as compliance in financial matters increases in a society, it can be expected to spill over to a more general norm of respect for the Rule of Law.

Strengthening the Rule of Law in Latin America turns out to have an unexpected ally: financial regulation. The follows that instituting ESRM systems in Latin America will have benefits not only in ensuring greater attention to climate change, but it will have much broader impact on the improvement of societal functioning.

The empirical reality regarding the existence of ESRM systems is encouraging. They either exist or are in process in Brazil, Colombia, Ecuador, Honduras, elsewhere in Central America, Paraguay and Peru. Regulations with similar objectives exist in Argentina and Chile.  Where the cavalry has not yet arrived, it is close by.

The future of the Rule of Law in Latin America is encouraging for completely unexpected reasons!

Daniel Schydlowsky was Superintendent of Banking, Insurance and Private Retirement Funds of Peru, 2011-2015, Board Member, Central Bank of Peru 2002-2006, President, Peruvian Development Corporation 2002-2006, Presidential Counselor in Economic and Financial Affairs, Peru, 2001-2002, Robert F. Kennedy Visiting Professor, Harvard University, 2009-2010.