"Inflation came down," recalls one seasoned observer, "and people and companies started to borrow because there was so much pent-up demand after 10 years of missed growth." The observer, Andre Cappon, president of the CBM Group Inc., a New York- based consulting firm specializing in Latin financial markets, added: "Sooner or later, at the first sign of recession, they were bound to face tremendous asset quality problems." Jorge Mariscal, head of Latin American equity research at Goldman, Sachs & Co., recalls that "Latin American banks went through a period of high inflation when they were basically playing the float." "As inflation came down," he says, "they returned to more traditional lending. But economic growth slowed after U.S. interest rates rose in February 1994 and banks began to experience severe problems with the quality of their portfolios." In a doomsday scenario that unnerved the Latin banking industry, banks that were once the pillars of their countries were forced to close their doors across Latin America. The round of bank failures - from Banco Latino in Venezuela to Banco Economico in Brazil and Banco Integrado Departamental in Argentina - has also rattled the Latins' relationships with their global partners. And the restoration of integrity and growth has yet to be assured amid the confusion that persists. Effective damage control, observers say, requires a broad restructuring of the roots of Latin banking - possibly beyond the reach of even the most well-intentioned participants. Analysts insist the banks must: *Overcome fragmentation; most assets are now in the hands of just a few banks. *Consolidate; relatively few banks now have assets exceeding $1 billion. *Turn big state-owned banks over to the private sector. *Consider allowing foreign investors to take over troubled local banks. *Expand their customer base beyond the restricted number now served. Some also suggest that Latin American banking regulators will also have to toughen their standards - even if that means going beyond the standards in more mature economies - because of the inherent volatility in emerging markets. "Some Latin American countries are already applying stronger ratios than in industrialized countries," remarked Enrique Iglesias, president of the Inter-American Development Bank, at a conference in September. "Our shoulders are smaller, and the need for more solid systems is imperative." Broadly speaking, banking in Latin America has reached a significant scale in only six countries - Argentina, Mexico, Brazil, Chile, Peru, and Colombia. But even in these countries, banking remains fragmented, divided between large, often money-losing government-owned banks and smaller, sometimes highly profitable privately owned banks. In Brazil and Argentina, for example, state-owned and provincial banks hold around 40% of total assets of the system, while in Peru and Chile they also retain somewhat smaller but still hefty market shares. Overall, banking tends to be fairly concentrated despite the large number of banks, with most assets in the hands of fewer than 20 institutions. Many banks still cater mainly to a restricted number of corporate and retail customers. Only recently have banks in some Latin countries, such as Chile and Argentina, sought to broaden their base of customers by offering banking services to lower-income groups in and beyond the major metropolitan centers. "Banking systems are relatively embryonic compared to developed markets, because a lot of people simply don't use banks," says Mr. Cappon. Analysts believe that trends across Latin America are broadly similar, with some notable exceptions like Chile, where banks have been tightly supervised since the 1982-83 crash. First, the number of banks and lending increased as a result of deregulation. But as problems set in and banks ran into difficulty, the more weakly capitalized institutions ran into problems and got taken over by bigger ones. "It's very hard in Latin America to find a decent-sized bank unless its one of the large state-owned banks," remarks Mr. Cappon. "Most banks, by U.S. standards, are still small, and the market is fragmented and has too many banks." Too many of them, he adds, "don't have the resources or the wherewithal to compete seriously." Brazil, for example, still has 240 banks, but only a handful of these have more than $1 billion in assets. And until a deposit crisis broke out in March, Argentina had nearly 200 banks, many of which have since collapsed. What is most disheartening to bankers across Latin America is that many had hoped the decade of financial crises that followed Mexico's August 1982 default was finally over. Although governments and international agencies like the World Bank would dearly like to let free-market forces solve the crisis, they have been forced against their better judgment in countries like Mexico and Argentina to intervene and provide at least temporary liquidity. The Inter- American Development Bank alone has provided around $1.5 billion so far this year to help prop up banks in Mexico and Argentina. The aid may not be enough to overcome capital shortfalls. As a result, Latin governments are considering the once unthinkable: allowing foreign investors to come in and take over local banks. The Venezuelan government has virtually annexed the country's banking system. The Mexican government is putting considerable pressure on banks to merge while offering banks help with their bad loans until economic conditions improve. In Argentina more than 30 banks are now being run by the regulators, and in Brazil large state-owned banks, as well as the country's oldest bank, Banco Economico, are under central bank control. "Right now things are in a state of flux, regulatory standards are being looked at again, capitalization ratios are being redefined, and the role of foreign investment, joint ventures, and foreign equity ownership throughout the region is becoming again a focus of attention," says Mr. Mariscal. As they adjust to a noninflationary economy and a more liberalized environment, Latin American banks remain firmly focused on their home markets. Only a few, like Brazil's Banco Itau and Mexico's Banamex, have sought to expand into other Latin American markets. Banamex, for example, has acquired Banco del Sud and Banco Shaw in Argentina, while Itau is setting up a network of branches in Argentina. Elsewhere, cross-border expansion remains limited to neighboring markets like Colombia and Venezuela and, for some Argentine banks, Uruguay. Banco de Credito, one of Peru's leading banks, has also indicated that it is considering acquisitions in Colombia and Argentina. But only European and U.S. banks are building a Pan-American presence. Bank of Boston Corp., which is expanding in both Brazil and Argentina, recently opened a subsidiary in Colombia, while Citicorp has branches in almost every Latin country. Bank of Nova Scotia has acquired minority stakes in banks in Argentina, Chile, and Mexico as part of a policy of building strategic alliances. European banks, too, like ING Group and Spain's Banco Santander, are building continent-wide networks for corporate finance and investment banking. Analysts warn that as the banking systems of Latin America rationalize their operations and foreign competition increases, Latin banks are going to have to slash expenses and improve operating efficiencies. Some of that is already evident in countries like Argentina, Brazil, and Mexico, where the number of employees in the banking industry has been steadily declining. In Argentina alone, for example, nearly 40,000 jobs have disappeared since the end of last year. Despite the progress to date, more needs to be done. As Salomon Brothers Inc. noted in a recent report on banking in Latin America: "Banks in the region will have to respond with an increase in operating efficiency to compensate for the expected lower margins that will result from higher competition." Analysts and bankers remain cautious but predict that a sounder, more viable banking system will emerge from the current crisis. "You'll see fewer banks, much larger banks, and greater specialization," says Mr. Cappon. He believes the latest round of bank restructurings across Latin America may be completed in as little as two years. Others are more reserved. Given the scale of the task ahead, they predict, it could take until the end of the decade before Latin America's banking systems are thoroughly revamped.

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