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The Venezuelan Banking Crisis

Nick Rosen

The implosion of the Venezuelan sector had been coming for years. President Carlos Andres Perez, a free-market reformer who took power in 1989, had created an ostensible paradise for banking executives in Venezuela. He shielded the industry from foreign competition, while allowing banks nearly unlimited freedom from regulation. Consequently, bank directors engaged in high-risk lending—often to their own tenuous business ventures. These directors were also suspected of providing low-interest loans to the public sector enterprises in return for kickbacks. Allegations of corruption in the banking sector were rampant. In 1994, political and economic instability forced these problems to the surface, resulting in a “domino effect” of collapsing banks that eventually cost the government $11 billion and inflicted trauma on the Venezuelan economy that would last for years.

Prelude to the Crisis

Corruption and fragile financial institutions were not new concepts in Venezuela, a nation with a history of banking problems. Despite numerous costly bailouts, the country never seemed to learn from its mistakes, and remained without solid regulation or an effective template for restructuring failed banks.

While times were high for the oil-rich Venezuelan economy, the dangerous flaws in the banking system remained latent, as asset values remained inflated by booming stock and real estate values. But, in an effort to stay competitive amidst booming profits, the worst-performing banks made increasingly riskier investments—including shadowy off-shore deals, lending to bank affiliates at favorable interest rates, and allegedly fraudulent and illegal activities. President Perez abolished limits on the interest rates banks could offer on deposits, giving banks the tools to raise fast cash despite the precarious state of their balance sheets. Predictably, these investments eventually began to fail, though problems did not immediately come to light as bankers shifted money between businesses in a shell game to conceal their losses.

When oil prices fell and the boom economy began to decline in the early 1990s, cracks in the edifice became visible. Severe political unrest set in, marked by successive coup attempts that rattled investors and caused ongoing capital flight.

President Perez was impeached on corruption charges in 1993, and the following election year ushered in bloating deficits and a new cycle of inflation. This compelled the central bank—whose warnings of an impending crisis seemed to fall on deaf ears— to ratchet up interest rates. The interest rate hike effectively cut off private borrowing—the banks’ main source of income— while banks were paying up to 65% to depositors.

Ironically, the Venezuelan banking crisis was preceded by efforts to reform the haphazard financial system. In 1993, a new banking law was enacted that sought to build a stronger regulatory system, increase capital requirements and open the door to foreign competition. But enforcement of the new law was delayed, and proved too late to head off a crisis.

The Banco Latino Collapse

On January 16, 1994, just days before the incoming president Rafael Caldera was inaugurated, Banco Latino collapsed. Venezuela’s second largest financial institution, Banco Latino had enjoyed a cozy relationship with the Perez administration, which provided political and financial support as well as protection from competitors. FOGADE, the public deposit insurance agency, held one-third of its funds in Banco Latino’s vaults. Many Banco Latino depositors were unwitting of the impending collapse. But others believed that the government, which had a solid record of bail-outs, would never allow such a politically connected bank to fail. The Venezuelan government had a long history of rescuing banks and depositors, after all, and none had been more privileged than Banco Latino. But when the bank’s crumbling loan portfolios finally gave out, the new administration was slow to react, in part because of its disdain for the patronage that the deposed President Perez had lavished on the bank for so long.

The collapse of Banco Latino—whose account-holders made up more than 10 percent of Venezuela's adult population—would prove devastating. Shocked and disillusioned depositors, once lured by higher interest rates and the belief that Banco Latino was blessed by a public safety net, now rioted angrily in the streets. Whole towns of Venezuelans faced financial ruin. The loss of confidence immediately spread, sparking a contagion of bank runs across the country. Hordes of citizens and businesses withdrew their bolivars, converted them into dollars and took them abroad. 300 bankers fled the country. The Venezuelan central bank estimates that capital flight drained more than $3.5 billion from its initial $12.7 billion total reserves in the first half of 1994.

Venezuela Devastated

By the time the crisis abated, the government had taken over or bailed out more than half of all banks in Venezuela. The government appointed new members to the bank boards, who used funds from FOGADE, the state deposit insurance agency, to recapitalize the banks. When these funds ran out the government seized and shut down numerous banks, and issued arrest warrants for bank directors on charges of fraud. The $11 billion bailout plan would amount to 13% of GDP and 74% of the total budget that year. In order to pay for the bailouts, the government turned to the mint, cranking out bolivars and eventually growing the money supply by 50%. Predictably, inflation ran wild, and the purchasing power of Venezuelan consumers was cut in half.

The banking crisis had a dramatic impact on Venezuela’s economic policy. Years of free-market reforms were interrupted by emergency measures, such as a suspension on currency trading followed by a currency peg in order to arrest the fall of the Bolivar. Price controls were introduced to tether inflation, and taxes were hiked in order to cover the deficits incurred by the government. All of this came much to the disappointment of the business community, which lamented the rolling-back of years of economic reforms. President Caldera suspended constitutional rights, putatively to allow the government to seize the assets of the thieving bankers.

Eventually, by mid-1995, the disaster had run its course. All the weakest banks had already failed, and as government takeovers subsided, confidence slowly returned. Exchange rate controls were removed and the bolivar stabilized.

And although the banking crisis in Venezuela was devastating (it was followed by four years of recession), the financial system would in some ways emerge stronger for it. Laws mandating higher reserve ratios and loan loss provisions were introduced. A fund was created with the help of the International Monetary Fund and the World Bank to re-capitalize the ailing financial sector. In 1996, the government began selling off the banks it had taken over in order to raise funds. This led to a slew of privatizations, and within two years, 40% of the failed financial houses had been purchased by foreign banks. Some observers credit the “foreign-ization” of the Venezuelan banking sector with the cleaner books and improved corporate governance it enjoys today.

Looking back at the event, former Central Bank president Ruth de Krivoy, who resigned at the height of the disaster, noted that “In some ways, our crisis was unique, because virtually all of the factors that could lead to a banking crisis were present simultaneously: a souring economy, severe and protracted social instability, political interference, a poor bank regulatory framework, weak supervision of banks—and bad banking too.” 

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